Second Quarter 2021 Write-Up

The equity markets ran hot in the first half of 2021.  Through June 30th, the Dow Jones Industrial Average advanced 12.7%, the Standard & Poor’s 500 Index surged 14.4% and the Nasdaq Composite gained 12.5%.   During the second quarter, the Dow, S&P and Nasdaq advanced 4.6%, 8.2% and 9.5%, respectively.  Inflation also ran hot in the first half of 2021, alarmingly so.  The June Consumer Price Index was 5.4% above year-ago levels.  Federal Reserve Chairman Jerome Powell, whose job entails quashing runaway inflation, is not worried.  He attributes the June CPI reading as the result of “base effects” (i.e., an artificially weak comparator period last year) coupled with supply chain bottlenecks, exacerbated by pent-up demand as the economy re-opens.  He states that inflation expectations are “well-anchored” at the Fed’s target rate of around 2%.  We are not so sure.  

The June inflation indicators were soberingly high.  The CPI was 5.4% above the June 2020 reading.   The Producer Price Index, which measures wholesale prices, surged 7.3%.  The PPI was up 5.6% if adjusted for volatile components (food and fuel).  Looking at some of the CPI’s components, we see milk up 5.6%, fresh fish up 6.4%, shoes up 6.5%, fruit up 7.3%, bacon up 8.4%, furniture up 8.6%, lodging up 16.9%, airfares up 24.6%, laundry machines up 29.4%, gasoline up 45.1%, used cars up 45.2%, and car rental rates up 87.7%.  In prepared remarks on June 16th, Chairman Powell told Congress, “Our new framework for monetary policy emphasizes the importance of having well-anchored inflation expectations, both to foster price stability and to enhance our ability to promote our broad-based and inclusive maximum employment goal.”  We do not see inflation expectations as Mr. Powell does.  The Conference Board’s survey of inflationary expectations over the next 12 months jumped to 6.7% in June.  Additionally, the Federal Reserve Bank of New York tracks inflation expectations in their Survey of Consumer Expectations.  In June, the survey reported median one-year ahead and median three-year ahead expected inflation rates of 4.8% and 3.5%, respectively.   The survey also reported median one-year expectations for gas (+9.2%), food (+7.1%), medical care (+9.4%), and rent (+9.7%).  These rates seem well-anchored well above the Fed’s policy target of 2% inflation.  

 Since the Second World War, there have been six episodes of inflation exceeding 5%.  They occurred in 1946–48, 1950-51, 1969-71, 1973-82, 1989-91 and 2008.  The 2008 episode only lasted 2 months, and was related to a doubling of oil prices.  The 1989-91 episode was also a reaction to an oil shock that ended after the Gulf War.   The 1973-82 episode was the most pernicious, with two oil shocks and a long period of stagflation.  It was also a time of very lax monetary policy and large budget deficits arising from funding the Viet Nam War and Great Society government programs.  The 1969-71 episode was related to easy money, large budget deficits and the failure of the Bretton Woods currency accord.  The same Fed chairman, Arthur Burns, oversaw these two aforementioned inflationary spikes.  The 1946-48 and 1950-51 episodes came after the demobilization from WWII and the Korean War, respectively.  It is the theory of the White House that the current inflationary situation is most similar to the spike in prices that followed WWII, as price controls were eliminated, supply shortages developed and pent-up demand emerged.  We acknowledge some parallels in a time when everyone wants to go out to dinner and no one wants to wait tables.  But we also need to consider the possibility of defective fiscal and monetary policy.  

Writing in Project Syndicate, Stephen Roach offers an interesting account of working at the Federal Reserve in the 1970s under Chairman Arthur Burns.  Roach writes: “Like business cycles, Burns believed price trends were heavily influenced by idiosyncratic, or exogenous, factors – “noise” that had nothing to do with monetary policy.”  When oil prices tripled because of the OPEC embargo, Burns thought that this had nothing to do with monetary policy and should be ignored when setting policy.   He asked for data excluding energy prices from the CPI.  When food prices surged, and Burns identified an exogenous event as the cause, he asked that food data be removed from his CPI report.  By eliminating these two factors, comprising 36% of the CPI’s components, Burns thought he could focus on the true underlying inflation trends.   Burns continued to identify special factors that created noise in the CPI, and had them deleted from his reports.   Over the next few years, he eliminated home ownership costs, mobile homes, used cars, toys and jewelry.  By 1975, Burns had eliminated 65% of the components from his bespoke CPI, and what was left was rising at double-digit rates.  By the time Burns had finally adjusted his course, inflation expectations were greatly increased. Burns’ efforts were too little, too late.  It would take the determined work of Paul Volcker to put the inflationary genie back in the bottle.

 In previous episodes of ramping inflation, we see several themes: oil shocks, large amounts of deficit spending, and inappropriately loose monetary policy.  It would be wrong to not examine these today.  The Congressional Budget Office (CBO) estimates a deficit of 10.3% of gross domestic product for 2021.  This would be the second largest since 1945, exceeded only by the 14.9% shortfall recorded last year.  In the CBO’s projections, deficits decline as the effects of the pandemic wane.  But they remain large by historical standards and begin to increase again during the second half of the decade.  Deficits increase further in subsequent decades, from 5.7% of GDP in 2031 to 13.3% by 2051—exceeding their 50-year average of 3.3% of GDP in each year during that period.   By the end of 2021, federal debt held by the public is projected to equal 102% of GDP.  Debt would reach 107% of GDP (surpassing its historical high) in 2031 and would almost double to 202% of GDP by 2051.  Debt that is high and rising as a percentage of GDP adds to federal and private borrowing costs, slows the rate of growth of economic output, and increases interest payments abroad.  A growing debt burden could increase the risk of a fiscal crisis and higher inflation as well as undermine confidence in the U.S. dollar, making it more costly to finance public and private activity in international markets.  We are living beyond our means, and central banks are enabling this behavior.  The combined balance sheet of the three major central banks now tallies to $24 trillion and is up six-fold since 2008.  The Federal Reserve is buying $120 billion of treasuries and mortgages every month.   Real interest rates are negative.   The Fed is effectively monetizing the government’s deficit spending, which is probably why the general public’s inflation expectations remain above Chairman Powell’s “well-anchored” 2% target.   Which brings us to the Battle of Texel.

 In 1795, The War of the First Coalition pitted France against pretty much the rest of Europe.  An unusually cold January resulted in a Dutch fleet of fourteen warships being frozen at anchor off the coast of the Netherlands.  Despite this precarious position, the Dutch were sure that the sea ice would prevent them from being attacked by sea and confident that they were anchored outside the range of land-based enemy artillery.  The French, however, had other ideas.  The 8th Hussar Regiment, a French cavalry unit, wrapped their horses’ hooves in fabric to muffle their noise on the ice.  Under cover of dark, the French began a march across the frozen sea toward the Dutch fleet.  Then, the Regiment, with each Hussar riding with an infantry man, silently surrounded the ice-bound Dutch fleet.   Upon dawn, the Dutch surrendered without a shot being fired.  The French gained 14 warships, 850 guns and several merchant ships.   The Dutch lost the bulk of their naval fleet to a cavalry unit.   The moral of the story, Chairman Powell, is that sometimes “well-anchored” might not mean what you think it means.   Especially if there are ponies wearing tube socks involved. 

Sincerely,

Your Team at Baxter Investment Management