Now that the economy is opening up, we are concerned with inflation and lingering high unemployment rates.
Money Supply
If we go back one year, the money supply was at $15.4 trillion, and now it’s at $19.4 trillion. That’s a 25.9% increase. Going back even further, we were at about a 5-6% growth rate each year. Now the growth rate has increased to about 25-26%. That’s a lot of money being produced even as you read this. In fact, money pumping is so prominent today that the Wall Street Journal published an article warning its readers about the amount of money pumping into the system.
Major Spike in Producer Price Index
The Producer Price Index (PPI) jumped significantly last week. PPI measures the average changes in prices received by domestic producers for their output. In other words, if it costs more to make something, you’re probably going to be paying more for it. However, some companies can pass that on, and some cannot. The market started to decline at the same time this spike happened, but I wouldn’t go as far as saying it is the primary source that caused the slowdown in the market appreciation.
Breakeven Inflation Expectations and an 8 Year High
It is not just the PPI causing an effect in our market, but inflation expectations. You can use bond yields over different times with different bonds to estimate the bond market as an inflation premium.
We are at an eight-year high for inflation expectation at 2.2%. Remember, the Fed’s target is 2%, so if you start to look at the bond market, it expects inflation to be at 2.2%. This inflation is essential to pay attention to; we have inflation showing up in the PPI, the money supply is exploding, interest rates are starting to price in inflation expectation, and the inflation hedge commodities are a topic of concern with multiple warning signs.
Broad Basket of Commodities
We can see inflation in commodities when we look past the recent deflationary selloff. The broad commodity index is up only 2-3%, but the inflationary hedges are up tremendously. For example, lumber is up 100%, which we have discussed in previous market insights regarding home builders and citizens moving from urban to suburban areas.
Therefore, as the economy opens up and people start to do things more freely, that will create higher demand and push these prices up. If we focus on the commodity broad basket index, there has been a 50% increase over time. If this trend continues, it will show up with inflation. We had a pullback in the diversified basket of commodity goods of 2-3%, but it will be an issue if this prolonged trend continues.
A New Commodity Supercycle has begun
JP Morgan quant, Marko Kolanovic, and JP Morgan are advocating a supercycle of commodities. The idea is that every 12 years, you shift from a supercycle for commodities to a 12-year cycle where they’re out of favor.
2008 was the end of the last supercycle, also referred to as the rise of China. Since then, no one has wanted to own commodities during the correction. However, we believe a variety of goods will have a special place if inflation shows up going forward.
U.S. Treasuries
Rates, also known as inflation expectations, are moving upward. If you run a trendline in the graph below, you can see people are lending 2.19 for 30 years to the government. You may be thinking, is that extraordinarily high? It is not high at all; however, we can see that interest rates are rising quickly because of inflation expectations increasing.
Higher interest rates should help offset the effects of inflation, but not on the long end of the curve. If the increase in long-dated bonds goes up faster than the short end, then the yield curve will widen. The wider the spread, the easier it is for banks to make money. This incentivizes banks to lend money, expanding the money supply in banks from loans.
For those concerned about market valuations, bonds may not be a great place to go. This was our point last week. The iShares 20+ Year Treasury ETF (TLT) is down nearly 10% year to date. We are only two months in, and this fund is already at a technical correction.
Data Based on Feb. 23, 2021
Goldman Sachs Concern in Commodities and the Rising Interest Rate
Goldman Sachs has an ample write-up warning about bonds and an inflationary environment. They look at the classic 60/40 allocation during times when bonds drop in value. During these downward moves, the S&P 500 equities average 4.1%, while the U.S. treasury is down 14.4%.
When we move into an inflationary environment above 3% (with inflation continuing), 60/40 allocations struggle. The 60% equities and 40% bonds are typically considered a balanced portfolio, so you could see less volatility there.
What do policymakers say about inflation concerns?
Treasury Secretary Janet Yellen stated, “We think it’s imperative to have a big package that addresses the pain this has caused.” When she was asked whether the surge of federal spending could prompt a sustained rise in the inflation rate, Yellen said it is still a risk. She added that inflation has been very low for many years and that the Federal Reserve has the tools to confront that risk by raising interest rates.
Yellen also mentioned a second economic recovery package that would include spending on longer-term investments, such as infrastructure, renewable energy, education, job training, and research and development. That proposal would also include tax increases on corporations, and wealthy Americans phased in over time, she said.
U.S. Unemployment Rates
In January 2021, the United States unemployment rate has dropped 6.3% as more people continue to find employment. As an additional headwind to unemployment, there could be a $15 minimum wage change. If it passes, we could have higher unemployment. The Congressional Budget Office (CBO) estimates 1.4 million people out of jobs. High unemployment with high inflation is stagflation, a situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high.
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