Do you think Milton Friedman is regaining some respect at the Federal Reserve and among Modern Monetary Theorists as the +30% rise in M2 appears to be fueling an increase in inflation? Our January 2021 Cassia Capital Partners newsletter led with a shout out about M2 growth and the linkage between liquidity and inflation and the ramifications for public market returns this year.
August CPI was up +3.3%, which is well above the Federal Reserve target (+2%), and current estimates for Q4 2021 is an annualized rate of +5.4%. Rents, which make up approximately 30% of CPI, are moving up with the eviction moratorium being lifted, and supply chain disruptions mean that more dollars are chasing fewer products on the shelves.
In fact, one measure of how the velocity of money (the number of times $1 is used to purchase multiple items) reveals itself in the economy is GDP/M2. From 1959 to 1990 this metric averaged about 1.8 (i.e. $1 in M2 account for $1.80 of GDP), but it has dropped since 1990 to approximately 1.12 given the growth in M2 relative to GDP. However, as consumers unleash their pent-up demand for goods and services by drawing upon pandemic savings and stimulus dollars courtesy of the Federal Government, a reversion to the long term metric of 1.8 is expected to generate strong, sustained inflationary pressure in the economy (i.e. think about the 30% increase in M2 with each $1 resulting in $1.8 of nominal GDP). Our economy grows but in nominal terms not real terms (inflation adjusted growth)
Looking at the same analysis through a less technical lens, government mandated lockdowns during COVID reduced the supply of both goods and services (i.e. tight labor) while at the same time Congress and the Fed have thrown “jet fuel” on demand through stimulus spending and monetization of debt. For example, the cost of a shipping container to transport goods has risen from $20,000 to $500,000. Dollar Tree which brands itself for products costing $1 or less has abandoned the dollar limit on the goods which it sells. Finally, the US Postal Service is proposing a slow down in delivery times to offset rising costs in their delivery system.
What does it cost you to fill up your car with gas now compared to January 2021? Oil is trading at $80 per barrel and natural gas prices are soaring. In Europe, energy market supplies are extremely tight heading into the winter months. Natural gas prices there, in oil barrel equivalent terms, are reported at over $240/barrel. In a global economy these trends have ripple effects into our energy markets over time.
Therefore, our view is that we are ending the year with a continued strong caution about the effects of inflation and monetary and fiscal policy on asset prices. Stay alert and keep monitoring the price of milk, eggs, and gas as we head into December.
Although the inflation picture sounds quite alarming, there are several dominant bright spots impacting both equity and fixed income markets.
First, notwithstanding the Fed’s announcement of a gradual tapering in bond purchases, interest rates have only moved up modestly and the markets are ignoring the move for the time being. Therefore, the power of historically low rates on asset prices remains a positive factor. It all could change if the market anticipates a more aggressive rate normalization by the Fed, but most economists forecast the bulk of normalization in 2023.
Second, the forecast for both corporate profits and GDP growth remain robust and above normal trends for the remainder of 2021 and into 2022. U.S. equity EPS growth is forecast to be up +46% for 2021 and +9.2% in 2022 with GDP growth coming in at +5.7% for the current year and +3.5% in 2022. Corporate balance sheets remain strong, and most economists expect continued private sector capital spending in technology and traditional capital infrastructure, which should help maintain strength in the economy as reopening spending fades and lead to further improvements in productivity.
Third, the American entrepreneurial spirit is alive and well, and companies are finding unexpected ways to maintain profit margins and new disruptive business models are emerging which have the potential to add real growth and productivity gains to GDP in the months ahead.
The bottom line is the U.S. economy and equity values are transitioning back to fundamentals. Currently, our view on corporate earnings growth, investor sentiment, and economic sustainability is positive. However, the risk factors which could impede the positive macro landscape include sustained higher inflation, faster rate normalization, continued supply line disruptions, gas shortages, higher tax rates, and excess stimulus spending.
Finally, we have seen rapid sector and style rotations in equity flows this year. Most notably the early rush into value versus growth reversed long term correlations by almost 40%. Forecast annualized returns for equities based on current valuation levels and historical returns suggest annualized returns going forward of less than 4% per annum. It seems likely that investors will need to take on added risk to maintain returns above inflation + a risk premium. Therefore, matching asset allocation strategies with financial goals and personal risk tolerances will be increasingly important. Cassia Capital Partners is here to help our clients figure that out.