The much-anticipated March Consumer Price Index came out even higher than expected. Does this point to higher inflation ahead? The report has plenty of nuance.
Key Points:
- CPI rose 0.6% from the prior month, the biggest monthly jump since 2009. Core CPI, which excludes food and energy, rose 0.3%.
- Energy prices rose 5% and food only 0.1%. Rent and Owner’s Equivalent Rent had small increases.
- Airline, hotel and restaurant prices all rose as more people ventured out into public.
- Apparel prices fell for a second month but we expect this to change as people make up for the “lost” spring and summer of 2020.
- We expect companies to delay price increases as long as possible, but at some point rising wholesale costs will feed through to consumers.
The most significant item in this report was the sharp one-month jump from February to March. This reflects rising economic activity as businesses and consumers gain confidence the pandemic is under control. Now the question is whether this confidence can keep climbing into the summer. If so, CPI will keep rising in response.
I think the Consumer Price Index will print 4% sometime in 2022. It’s at 2% now.
US Economy
- US consumers are ramping up their travel plans.
- Dining out is recovering, led by southern states.
- The US budget deficit continues to widen.
- China continues to dominate the rare earths market.
- Global food prices are up nearly 25% over the past 12 months.
- Central banks are starting to hike rates, especially in emerging markets due to concerns about rising inflation
- The March CPI figures were a bit stronger than expected, but there was little in the report to indicate that inflation is gapping higher. The core CPI remains relatively benign, suggesting that the Fed will stay the course.
- Markets breathed a sigh of relief. The US dollar tumbled – a green light for risk assets (such as equities, commodities, etc.).
- The “job openings hard to fill” indicator hit another record high, pointing to labor shortages.
- The compensation index is rebounding but remains well below pre-COVID levels.
- The Fed’s Beige Book report was more upbeat than the markets were expecting. The survey also showed an increase in inflation.
- Economic uncertainty and COVID concerns are easing
- Stocks pulled back from the highs after the Beige Book report was released (due to inflation concerns).
- Import price inflation surprised to the upside.
- Small businesses are gaining some pricing power.
- Refi activity continues to slow due to higher rates.
- US mortgage rates declined sharply this week (with Treasury yields).
- The nation’s economic growth is accelerating. Retail sales rose nearly 10% in March.
- Americans were spending their stimulus checks.
- Capacity utilization moved higher.
- Furthermore, the regional reports from the NY Fed and the Philly Fed point to exceptionally strong growth in factory activity this month.
Corporate Earnings
Wall Street is upgrading an already expensive earnings season: We’re entering Q1 earnings season with high valuations and high expectations. The Shiller PE ratio is among the highest in 70 years, and Wall Street analysts have been upgrading price targets and earnings estimates.
As markets surge to record highs, analysts are rushing to ratchet up earnings estimates as optimism explodes. The first quarter of 2021 marked the largest increase in the bottom-up EPS estimate during a quarter since FactSet began tracking the quarterly bottom-up EPS estimate in Q2 2002. The previous record was 5.4%, which occurred in Q1 2018 after tax reform was passed.
Of course, with markets at record highs, Wall Street needs drastically higher estimates to rationalize bullish allocations. Through the end of 2020, quarterly operating earnings increased $0.01 to $38.19 from $38.18 at the end of 2019.
You read that correctly.
Quarterly operating earnings, which are mostly useless as companies exclude all the “bad stuff” and fudge the rest, increased by just $0.01 while markets exploded 16.28% in 2020.
It is far worse when looking at “real” reported earnings, which declined -11.4% from $35.53 to $31.45.
However, the good news is these are very sharp recoveries from the Q1-2020 lows of $19.50 and $11.98 per share, respectively, as the economy reopened.
With markets at record highs, have investors “priced in” the most optimistic outlooks for the economy and earnings growth?
Analysts always over-estimate earnings by about 33% on average.
The biggest single problem with Wall Street is the consistent disregard of the possibilities for unexpected, random events. In a 2010 study, by the McKinsey Group, they found that analysts have been persistently overly optimistic for 25 years. During the 25-year time frame, Wall Street analysts pegged earnings growth at 10-12% a year when in reality earnings grew at 6% which, as we have discussed in the past, is the growth rate of the economy.
As of the latest report, expectations for 2021 are now $13 lower at $158/share. Yet, investors are paying 20.4x earnings today for what they thought would be 18.8x earnings.
In the latest earnings report from S&P, they also included estimates through the end of 2022. Those initial estimates currently suggest earnings will surge from $158 to $183 per share. Such would be a $25 per share increase. That certainly seems impressive until you realize it’s only $12 higher than the original botched estimates.
This is not an isolated case due to the pandemic. As Mackenzie noted in their study, on average, “analysts’ forecasts have been almost 100% too high,” which leads investors to make much more aggressive bets in the financial markets.
Here is the problem for investors currently. Given analysts’ assumptions are always high, and markets are trading at more extreme valuations, such leaves little room for disappointment. As shown, using analyst’s price target assumptions of 4700 for 2020 and current earnings expectations, the S&P is trading 2.6x earnings growth.
Such puts the current P/E at 25.6x earnings in 2020, which is still expensive by historical measures. That also puts the S&P 500 grossly above its linear trend line as earnings growth begins to revert.
Through the end of this year, companies will guide down earnings estimates for a variety of reasons:
- Economic growth won’t be as robust as anticipated.
- Higher corporate tax rates will reduce earnings.
- The increased input costs due to the stimulus can’t get passed on to consumers.
- Higher interest rates increasing borrowing costs which impact earnings.
- A weaker consumer than currently expected due to reduced employment and weaker wages.
- Global demand weakens due to a stronger dollar impacting exports.
Such will leave investors once again “overpaying” for earnings growth that fails to materialize.
Stock Buybacks to the Rescue….Again!
As noted in “Powell’s Easy Money Promise,” share repurchases have made up roughly 100% of the net purchases of stocks previously. During the economic shutdown, companies issued shares for capital and drew down credit lines. However, with the crisis past, that mountain of liquidity is flowing into stock buybacks.
Instead of expanding production, increasing sales, acquiring competitors, or making capital investments, the money gets used for a one-time boost to earnings on a per-share basis. This past week, share buybacks hit a new record.
Without the reduction of the share count, the vast majority of companies would miss earnings estimates.
Since 2009, corporate operating earnings have grown by 278%. During that same period, the cumulative growth of revenue is only up 60%. It is through “accounting magic” that revenue gets multiplied to the bottom line. Out of each dollar of earnings, 76% is from accounting “management,” and 24% is from revenue. While tax cuts certainly provided the capital for a surge in buybacks, revenue growth, which is a function of a consumption-based economy, has remained muted.
As noted, since 2009, operating earnings have risen by 278%. However, reported earnings rose 318% in total. However, the earnings increase was not a function of an increase in revenue. Such only grew 66% during the same period. Concurrently, investors bid up the market more than 463% from the financial crisis lows of 666.
The problem with stock buybacks is they create an illusion of profitability.
If the economy is slowing down, revenue and corporate profit growth will decline also. However, it is this point which the ‘bulls’ should be paying attention to. Many are dismissing currently high valuations under the guise of ‘low interest rates,’ however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the market and corporate profits after tax. The only other time in history the difference was this great was in 1999.
Here is the critical point – when markets grow faster than profitability, eventually, a reversion occurs.
However, with investors paying more today than at any point in history for each $1 of profit, the subsequent mean reversion will be a humbling event.
This has been one of the largest pre-earnings season rallies on record.
Conclusion
While none of this suggests the market will “crash” tomorrow, it is supportive of the idea that future returns will be substantially weaker in the future.
There are few, if any, Wall Street analysts expecting a recession currently, and many are confident of a forthcoming economic growth cycle. Yet, at this time, there are few catalysts supportive of such a resurgence.
- Economic growth outside of China remains weak
- Employment growth is going to slow.
- There is no massive disaster currently to spur a surge in government spending and reconstruction.
- There isn’t another stimulus package like tax cuts to fuel a boost in corporate earnings.
- With the deficit already pushing $1 Trillion, there will only be an incremental boost from additional deficit spending this year.
- Unfortunately, it is also just a function of time until a recession occurs.
Wall Street is notorious for missing significant turning points in markets and leaving investors scrambling for the exits.
While no one on Wall Street told you to be wary of the markets in 2018, we did. We also warned you early in 2020. but it largely fell on deaf ears as “F.O.M.O.” clouded basic investment logic.
It is pretty likely before we get to the end of 2022, it will happen again.
Is Bitcoin A Bubble?
Inflation
Inflation is not caused by the actions of private citizens or businesses. It’s caused by the artificial expansion of the money supply by the government. It slowly takes money out of all of our pockets. That’s why American economist Milton Friedman once called it “taxation without legislation.”
From an economic point of view, what really matters is price inflation relative to wage inflation. In economics, that’s known as your “real wages.”
According to the Economic Policy Institute, a nonprofit think tank, productivity in the U.S. is up around 250% since 1948. However, wages are only up 116% over the same span.
You can see when the disparity started to occur in the following chart. Notice from 1948 to the early 1970s, productivity and wages increased at about the same rate – around 2.5% per year. But in the five decades since then, wages have remained flat while productivity has soared …
When President Richard Nixon took the U.S. off the gold standard. Starting in 1971, U.S. dollars no longer needed to be backed by gold.
In other words, it gave the Federal Reserve free rein to print as many dollars as it wanted and when more dollars in the system chase a fixed amount of goods and services, prices rise.
As long as your income is rising faster than the rate of inflation, you’re getting richer. In other words, your real wages are increasing. But on the flip side… if the rate of inflation is rising faster than your income, your real wages are declining and you’re getting poorer.
Many people make the mistake of thinking that a small amount of inflation is good – that it’s some byproduct of economic growth. After all, the Fed targets 2% inflation… so that must mean that this is a good amount, right?
But have you ever asked yourself why the Fed wants inflation? It allows the US to pay back it’s debt with cheaper dollars.
Drop the mic! That’s it.
The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy. It’s a result of government policy.
Let’s turn to the U.S. “M2” money supply. You might remember from previous Digests that M2 is essentially all the money in the system… It includes cash, checking and savings accounts, money-market accounts, and mutual funds.
Now, take a look at what has happened to the M2 money supply over the past year or so…
The money supply is up 28% since the end of 2019. We’ve never before seen such a steep rise in such a short time. Since the start of the COVID-19 pandemic, the Fed has committed to printing more than $6 trillion to support its stimulus programs. That’s more than three times the amount of money that the central bank spent bailing out the U.S. economy during the last financial crisis.
And this likely isn’t the final number either.
It doesn’t include the $2 trillion that President Joe Biden just proposed in new infrastructure spending in his recently announced American Jobs Plan… or any other “relief” efforts that pop up in the coming months.
Any rational human also knows that this game can’t go on forever… We’re fast approaching a tipping point where it will be “game over” for the Fed. And the game the Fed is playing is called Modern Monetary Theory (“MMT”).
basic tenet of MMT is that governments shouldn’t worry about budget deficits…
And MMT says we shouldn’t even think of income taxes as the government’s main source of revenue. It reasons that governments pay for the things they want by printing more money. (I’m not making this up.) Increasing taxes is just a way to cool an overheated economy.
According to MMT, a government can print as much money as it wants as long as there is “slack” in the economy. Slack means things like stable prices and less-than-full employment.
If any slack at all exists in the economy, the printing presses can keep on running.
How fast will all of this recently printed Monopoly money make it through the economy?
Today, banks hold much of it as reserves.
Inflation is not only unnecessary for economic growth. As long as it exists, it is the enemy of economic growth.
We’re already seeing signs of it in parts of the economy, like energy and housing. Gasoline prices spiked 9% in March. And housing prices rose 11.2% in January, according to the latest data.
Once the official inflation rate starts running closer to 3%, the printing party will end abruptly.
That’s because the government’s only way to fight inflation is through raising interest rates or raising taxes. And neither of those outcomes are good for the markets.
Here’s the bottom line… While we can’t know for certain exactly when it will happen, higher interest rates will be the bubble-popping pin for both the stock, real estate and bond markets.
Higher interest rates make stocks less valuable. Many investors will sell them in favor of safer, higher-yielding fixed-income securities.
Thought of the Week
Allow yourself to be easily amazed, then life changes black and white to living color!
– Soul (2020)
Picture of the Week
All content is the opinion of Brian J. Decker
