The Investor October 2021

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ShareFinder’s prediction for Wall Street for the next 12 months

Fuel tax blow to the poor

By Richard Cluver

Its official! The rising problem I have been warning readers about for months is now very much on the world front burner. I am talking about inflation, the consequence of altogether too much money being printed.

Latest data from the US Fed shows that a broad measure of the stock of dollars, known as M2, rose from $15.34 trillion at the start of the year to $18.72 trillion in September. The increase of $3.38 trillion equates to 18 per cent of the total supply of dollars. It means almost one in five dollars in circulation was created in 2021.

Meanwhile, Paul Dales, Chief UK Economist at Capital Economics was quoted this week as saying that the British inflation rate is, “Now well above the Bank of England’s 2.0% target and above the 3.0% forecast by the Bank back in August and looks set to remain above target for months to come.”

Support for this view also came this week from Elias Haddad, Senior Currency Strategist at the Commonwealth Bank of Australia who argued that the pound is likely to edge higher because “the Bank of England is more worried about runaway inflation than the Fed and ECB.”

Inflation is, in fact becoming the new talking point among economists throughout the world and it should surprise nobody when authorities like Britain’s Office of National Statistics publish consumer price inflation graphs like the one below:

Relative to the US Dollar, the British Pound has furthermore been gaining significant strength because members of the Bank of England’s Monetary Policy Committee have indicated that they could soon raise interest rates to avoid inflation expectations amongst businesses and consumers becoming more entrenched.

Although the Bank recognises that much of the current surge in inflation is down to supply side issues – which they have no control over – the fear is that by not acting inflation becomes embedded elsewhere in the economy. Readers should therefore be alert to the next scheduled meeting of the US Federal Reserve Governors next Tuesday and Wednesday when it is reasonable to expect some guidance to emerge on future Fed policy regarding its approach to tapering off purchases of US Government paper and, indeed, whether an early increase of interest rates might be expected.

If, as I wrote to readers in my Richard Cluver Predicts column last Friday, these events might seem remote for ordinary South Africans, it is important for readers to recognise that they are signalling the beginning of the end of a benign interest rate regime which has, for example, fuelled a massive boom in property sales as a consequence of the ultra-cheap mortgages it made available. Meanwhile, South African consumer inflation has picked up pace, quickening slightly to 5 percent in September from 4.9 percent in August, mainly fuelled by food and petrol prices.

Cheap money has also, of course, driven a phenomenal stock exchange recovery both here and abroad and, as my graph below make clear, the markets have been anticipating rising borrowing rates by themselves going into decline…probably in most cases at least until the middle of next year if ShareFinder’s predictions are as accurate as always. Below I have reproduced what ShareFinder predicts is likely to happen to the JSE Overall Index over the next 12 months. The point here, is that if corporate profits in South Africa fail to deliver dividend increases which outpace our inflation rate, share prices need to fall in order for dividend yields to match the rising return on SA sovereign bonds.

Investment in shares is, of course, a more complex game than that involving sovereign bonds. Bonds issued by governments are judged by just two main considerations. The most obvious risk is that the issuing government might default on payment. That is why, as South Africa’s debt to GDP ratio has inched steadily upwards, the ratings agencies have steadily degraded the value of our government bonds. The graph on the right details how our debt ratio has more than doubled over the past decade:

As a consequence the interest rate South Africa has to offer to attract investors in ten-year bonds has risen steadily to a current rate of 9.475 percent. Furthermore, because of our rising indebtedness the international market takes a deeply pessimistic view of our future ability to repay our debts. Thus SA bonds with a 90 day maturity horizon attract interest at an annual rate of 3.99 percent currently while one has to pay 10.865 percent to investors who are prepared to lock up their money for the next 30 years. Hence one can derive a view of what risk the market fears might occur in the future by looking at the difference between these two rates; the yield curve as it is known. The table on the right provides a very clear idea of the rising risk the world senses for South Africa’s future:

However, usually far more important, is monetary inflation. Long-term investors use bonds to guarantee income streams for pensions and annuities and they need to know that they will be able to maintain the buying-power of the future income they plan to provide. Thus the “real” value of a bond return is paramount; the income after inflation is stripped out. Add to risk the fact that on average South Africa’s usually relatively higher inflation rate sets us at a disadvantage to our global peers and you can understand why we have problems. Temporarily I am sure, our inflation figure of 5 percent is low compared with the US rate of 5.4 percent as illustrated by their soaring graph on the right. It, for once, puts SA bonds in a temporarily favourable light. Subtract 5 from the 10.865 current yield on SA 30-year bonds and you get a real return of 5.865 percent. Compare that with the highest yield lately on a US 30-year bond of 2.17 percent less current US inflation of 5.4 and you can see that holders of US sovereign debt are losing money at an annual rate of 3.23 percent a year. It’s a massive differential and explains why the Rand is being strengthened by a temporary investment capital inflow.

 Furthermore, as my next graph below illustrates, US inflation has been rising steadily for years and the reason is obvious: excessive money printing. But since the Biden administration came into power it has worsened dramatically and this year there are now a fifth more US dollars in circulation than there were a year ago. Simple logic thus implies that, in the absence of an equal amount of Gross Domestic Product growth, that the dollar which underpins the majority of international trade has effectively lost a fifth of its value. Against that US long term GDP growth has averaged a mere two percent and inflation 3.24 percent so one should not be surprised that the long term U.S. inflation rate has been accelerating and has now gone exponential as it rose to a 13-year high in September driven by rising costs for food and shelter which pushed the rate up to 5.4 per cent.

Ever since the US became the sole arbiter of world monetary value following the Breton Woods meeting in the closing stages of World War 2, it has long been a long-term abuser of that position. They exploited their currency by continuously printing more money than their GDP grew. If you have any doubt of that consider the relationship of the dollar with the gold price. In the graph on the right I have illustrated how the dollar has lost value relative to this prime commodity at five percent compound over the past 35 years.

But the clincher is the long-term US money supply graph below. Despite their unique position as the holder of the reserve currency position coupled with the sheer size of the US economy, neither are enough to protect the US dollar from such serial abuse!

So the fact that the official September US consumer inflation rate came in way ahead of market expectations, means the problem is, to use current parlance, becoming “Sticky” and it increases the risk that the whole world might soon begin to suffer.

Furthermore, it is also becoming entrenched in China which is likely to confuse orthodox students of economics. In their theory book, central command economies which do not need to worry as much as market-driven capitalist democracies when too much easy credit is created, because they do not suffer from quite the same problem as market economies like the US. But, as the graph on the right illustrates, China’s factory-gate prices grew at the fastest pace in almost 26 years in September, adding to global inflation risks and putting pressure on local businesses to start passing on higher costs to consumers.

The Chinese producer price index climbed 10.7% from a year earlier, the highest since November 1995, data from the National Bureau of Statistics showed Thursday. That exceeded the 9.5% gain in August and the 10.5% median estimate in a Bloomberg survey of economists. The consumer price index rose 0.7% last month from a year earlier, lower than a 0.8% gain in the previous month.

The jump in PPI, says Bloomberg, was mainly fuelled by skyrocketing coal prices and other energy-intensive products. Surging coal prices and policy goals to cut energy consumption have led to an electricity shortage, resulting in power rationing and factory production halts in over 20 provinces in September. Prices of other commodities such as crude oil also continued to climb, with the Bloomberg Commodity Index rising 5% for the month.

Stat: Alibaba founder Jack Ma criticized Chinese financial regulators in a bombshell speech on October 24, 2020. In the year since, the e-commerce giant lost $344 billion in market cap, the biggest drop in value of any company in the world, Bloomberg reports.

Add to this news the growing crisis in China’s property development market which has been epitomized by the phenomenon of “Ghost Cities” of apartment blocks whose construction is a result of the artificially cheap money which has been sloshing around the world in recent years. But even cheap money comes at a cost as China’s Evergrande property company has recently learned….and the whole world heard about this month week when the company began defaulting on its interest payments.

Evergrande is, furthermore, China’s largest property company by far but it is by no means expected to be the only Chinese company likely to go into default…and shortly thereafter into liquidation. The development perhaps explains why Chinese Premier Xi Jinping has lately led a clamp down on Chinese corporates which began a year ago with the purging of Jack Ma, founder of the tech giant Alibaba and poster boy until then for China’s supposed economic miracle.

South African investors woke up to this new reality in China when the value decline of their Naspers holdings began tumbling as a result of the Chinese Central Committee beginning to enact radical changes intended to control its entrepreneurs whose excesses have been highlighted by the Evergrande saga.

As my graph below illustrates, Naspers whose principal value lies in its ownership share of the Chinese tech giant Tencent, has long been used to share price gains of the order of the 44 percent compound rate illustrated by my green trend line between October 2018 and February this year – and indeed a compound annual average growth rate of 30.7 percent throughout the past decade which saw local share prices rise from R267.88 to R3 844.25 on January 17.
The price then fell at a gut-wrenching compound annualised rate of minus 45 percent until it managed to find some sort of base at R2 314.35 on September 2. That was a 40 percent capital loss which has severely dented many pension portfolios in this country. Happily, since then the shares have begun a convincing recovery which ShareFinder’s orange AI projection on the right of the graph, expects to continue until April at least.

Happily too I can attest that I was one who bought at the bottom of that wave. But it was more a flutter on the basis of the ‘return to mean’ argument. My decade-long mean line illustrated in my second graph on the right, indicates how far Naspers has fallen recently. On that calculation alone the shares might be expected to at least regain 25.5 percent as they revert back to the green line. But I certainly would not bank on it because China’s troubles are only just beginning and some very unpleasant things might happen as the Chinese Government indulges in classic diversionary tactics – like last week’s invasion of Taiwan’s airspace which drew warnings of a serious retaliation.
Back to the inflation issue, however, the fact that it is becoming a serious problem in China is likely to become the basis of major academic study by both economists and political scientists. In market-driven economies like the US it is understandable that money supply needs to closely follow GDP if one is to avoid the twin dragons of inflation and deflation. That is why investors listen very closely on a regular basis to every nuance of statements emerging from the US Fed because changes in monetary policy can have a dramatic impact upon the valuation of securities if the central bank fails to anticipate GDP trends with reasonable accuracy.

But in a central command economy where the government is far less concerned about placating an electorate and is, furthermore far less subject to internal market forces and their implications for interest rates, scholars have long thought that problems surrounding inflation and deflation are far less likely to manifest in China.

I think, however, that the problem is really one of the extent of the excess that politicians exert upon monetary policy which eventually results in major crises. One would have thought that America’s major monetary opposition, China, might have done things a little differently since it is openly committed to, in time, taking over the US role of world monetary leader. And since its leaders do not have an electorate to placate, one would have imagined their economic policy might have followed a completely different trajectory.

Instead, however, as I wrote in the preface to my book ‘The Crash of 2020,’ The likely trigger event for the next global share market correction could originate in China where, in its rush to grow it has built far too many buildings, produced far too much steel and other commodities and made far too many bad loans. Its overcapacity is so pronounced that it will take years for demand to catch up with this oversupply. Furthermore, China is compounding the problem by continuing to over-lend and overproduce though with diminishing returns. China’s non-government loans have grown almost a trillion dollars recently and yet they continue producing 40 percent more steel than the world needs.

In 2015, China’s stock market collapsed costing investors 45 percent of their savings. Now its economy is decelerating and its soaring private debt ratio has reached 300 percent of GDP signaling the inevitability of a further economic slow-down.

The Chinese are taking a problem whose size and scope is unprecedented and making it all that much bigger. So here it is worth turning to China’s Asian neighbour Japan, where a not too dissimilar process led to very high GDP growth in the 1980s. Fueled primarily by runaway lending, Japan suffered a stock market crash in 1990, then a real estate collapse in 1991, and finally a bank rescue in 1998. And Japan has posted 21 years of near-zero growth since that rescue.

Even if it can avoid catastrophic collapse, China’s economic trajectory is to continue slowing, resulting in downward long-term pressure on commodity prices. Deflation will inevitably spill over to countries that are economically intertwined with it in the Asia Pacific region, such as South Korea, Australia, Thailand, Vietnam, Singapore, and even Japan as well as Africa and South America which will be profoundly impacted because both continents are disproportionately dependent on commodity exports.

Deflation, following a long period of uncontrolled monetary expansion was, of course, what caused the Great Depression.

Of course I was expecting a monetary crisis to originate in China when I penned The Crash of 2020 late in 2019. I got it right that the crash would originate in China but had not expected the cause to be a pandemic. However, China’s economic problems are getting steadily worse and many observers have begun talking of a domino effect which might get completely out of control.

Thus, lone among world share markets, Wall Street is continuing to climb because investors are understandably fearful of the coming inflation problem. But these problems are not isolated to inflation. The Biden administration, like so many socialist administrations before it, has made it clear that it plans to spend its way out of trouble and, failing to learn the lessons of the past, thinks it will find the money by taxing the rich who, in turn, are fleeing for the anonymity of the cryptocurrency-denominated markets in a lemming like headlong rush of proportions that have never before been equaled. It echoes the South African situation where irresponsible Government borrowing and some of the highest taxes in the world have led to a massive exodus of the wealthy. Socialists never seem to learn!

The immediate future is worrisome in the extreme. That is why I have created large amounts of cash in my portfolios and I urge readers to do the same!

A Tax on everyone

Now, for a country like South Africa with its tremendous difference between rich and poor, it is very important to ponder the social consequences of inflation as a tax. It is always argued that because the rich have broader shoulders and access to excellent investment advice that it is fair to load them with extra taxes. Of course that was before the advent of cryptocurrencies which have allowed them to up and leave with such ease.

However, inflation is also a tax and it arguably batters the poor much worse than the wealthy who are actually able to profit from it. Since inflation is almost entirely the result of poor government fiscal policy it becomes a huge indictment upon governments when they piggy-back upon inflation-boosted commodity prices by adding layers of taxation as in the case of petrol, electricity and water.

There is accordingly a major moral question. So I do wonder at a time when politicians are out knocking on doors and kissing babies, whether anyone has asked them uncomfortable questions about the morality of taxing these items? Currently, when a litre of petrol costs you R19.30, R6.11 of that will go to the Government in taxes. That is R3.93 into the state’s coffers to be used any way the government sees fit and R2.18 into to the Road Accident Fund (RAF).

To put that into a practical example, every time you spend R850 on a 50l tank of petrol, R196 of that goes directly to the Government to pay for things like the Digital Vibes scandal while R109 goes to the RAF.

In all the government is collecting R120-billion a year from the fuel tax and that figure will soar as the fuel price rises and the Rand weakens again. And it will weaken again because the Rand LOSES value relative to the Dollar at compound 6.6 percent a year because of ANC mismanagement of the economy.

If you think that only the rich drive cars, ponder the feelings of the labourer who comes to tend your garden once a week when his taxi fare rises by R3.50 a ride. Given, I am told, that the current average daily pay for such people is around R200 a day, that’s a 3.5 percent rise just in his transport costs.

And what about the impact upon the loaf of bread he takes home to his family when the transport costs ripple through the economy?

Now I know the Government is desperate for tax revenue given, as I reported last month that so many high net worth taxpayers have fled our shores recently, but layering heavy taxes upon basic commodities like fuel is simply immoral. Furthermore it fans the flames of insurrection which in turn persuades the wealthy to leave the country and discourages foreign investors which in turn worsens an already catastrophic unemployment rate.

If any of my readers vote ANC next week, SHAME on you!

Global inflation – South Africa is not a typical case

Professor Brian Kantor

Professor Brian Kantor

While inflation rises across the globe, South Africa’s monetary and fiscal authorities should take note of the weak state of demand locally.

Prices are busting out all over the world. Prices charged by all US producers are 20 percent higher than they were a year before. Consumer prices were up by a ‘mere’ 5 percent in August, and that was before the recent tripling of natural gas prices.

The cause of higher prices is clear enough. They are a response to buoyant demands stimulated by Covid-inspired extra government spending and central bank funding of much larger fiscal deficits that have dramatically increased the supply of money (bank deposits) held by households and firms. In the US, these savings have also reduced the incentive for people to get a job – of which there is an unusual abundance, as firms struggle to match surprising strength in demand with extra output and willing workers.

This mixture of strong demand with constrained supply has caused prices to rise. The effect of higher prices is also predictable. Higher prices reduce demand while they serve to encourage extra output. They also act as a drain on disposable incomes and spending power. Higher prices, particularly when they respond to supply side shocks, can therefore lead to slower growth as these higher charges work their way through the economy.

What is critical therefore for the control of longer-term inflation trends is how the monetary and fiscal authorities react to this slower growth. Should they attempt to mitigate the impact of higher prices on growth by stimulating demand for goods, services and labour, then the temporary surge in inflation can become longer lasting. Firms and trade unions will then budget for expected and uncertain inflation.

US headline inflation rates, (annual percentage growth in consumer and producer prices) chart

US headline inflation rates (annual percentage growth in consumer and producer prices)
Source: Federal Reserve Bank of St Louis, Investec Wealth & Investment

 Central bankers believe that inflation depends on inflation expected, modified by the state of the economy. Independent central banks accept responsibility for the state of demand, but they hope that inflation expectations are anchored at low rates, to make their task of containing inflation an easier one. The markets, to date, have largely believed that the observed rise in inflation is a temporary one. But the markets will be watching the reactions of the fiscal and monetary authorities closely for signs of the policy errors that can turn a temporary supply side shock into enduringly higher inflation.

Real gross fixed capital formation by type of organisation
Source: Stats SA, SA Reserve Bank, 28 September 2021

South Africa – not a typical case

It is striking how the South African economic circumstances have not been typical. We too will have to deal with an energy price shock that will depress demand. But demand already remains depressed. Particularly depressed since 2016 have been the demands of firms, including the public corporations, for plant, equipment, workers and credit.

Households have helped to sustain spending, but only a little. Total spending by households grew by 1% in the first quarter of this year, but only by half as much in the second quarter. Those in jobs have earned more, yet many more (over a million) have lost their jobs since the lock downs. Formal employment outside agriculture is now below 2009 levels.

The money supply has flat lined as nominal GDP has grown strongly. The closely watched government debt-to-GDP ratio has been further reduced by extraordinary growth in government revenues. Tax receipts have accelerated in response to the global inflation of metal prices that make up the bulk of South Africa’s exports; so much so that the total borrowing requirement of the government in all its forms has declined from 13.5% of GDP in the first quarter of last year to as little as 1.8% of GDP in the second quarter of this year. Fiscal austerity has been practised in Covid-ravaged South Africa. And monetary policy, judged by its effects on money and credit supply, has not been accommodating enough.

Money supply and gross domestic product

The output gap – the potential supply exceeding realised spending – is likely to remain persistently wide. Inflation expectations therefore remain unaltered. The case for higher interest rates to further depress demand seems weak in the circumstances. Yet the gap between short- and long-term interest rates has widened further in recent days. This implies an expected doubling of policy determined rates over the next three years.

The bond market indicates that any improvement in South Africa’s fiscal circumstances is sadly expected to be temporary rather than permanent. It can prove otherwise with fiscal discipline and sympathetic monetary policy.

The slope of the SA yield curve (SA 10-year yields minus money market rates)
Source: Bloomberg, Investec Wealth & Investment

When Tools Stop Working

By John Mauldin

Because I believe in the division of labour, I rarely use hand tools today. In the ‘80s and ‘90s, I had two 4 x 8 pegboards on my garage wall full of tools along with my large toolbox. I had the right tool for every job around the car, house, and yard. I worked on the plumbing, electricity, built rooms, and flooring.

Now, I know others can wield them more efficiently and I’m pleased to let them do so. My tools of choice today are my computers, iPad, and phone. I am much more productive with my current tools than trying to fix a light switch.

The right tool in the right hands can do miracles. However, it gets more complicated when you want to work on the markets and the economy. Hammers work because nails don’t unpredictably reshape themselves. The economy does. Fiscal and monetary authorities must rely on tools that don’t work consistently and may not work at all. As we’ll discuss today, this is a big part of our current dilemma.

We’d all like to think it has an easy explanation and a quick solution. Readers tell me all the time: “John, the problem is really ______.” Unfortunately, it’s not one problem. We face a swirling mess of different problems, interacting in ways we don’t fully understand. We do have some clues, though. It now looks more and more like August/September marked some kind of turning point. Economic data has weakened considerably since then.

You know what I think of economic models, but they have a kind of objectivity. The numbers do what they do. It’s probably important that the Atlanta Fed’s third-quarter GDPNow estimate crumbled from 6.1% as of August 23 to 0.5% on October 18. That’s a whale of a change in less than two months.

Note the chart also shows a consensus of private forecasts dropping at the same time, though not quite as dramatically. Clearly something changed in the last 60–90 days. Here are some possible factors, in no particular order.

Increasing supply chain snarls

Jumping energy prices

COVID-19 Delta variant case surge

Evergrande and China housing crackdown

A hasty US Afghanistan withdrawal

End of enhanced US unemployment benefits

Difficulties for pending infrastructure bills

Oh, yes, the return of 5%-plus inflation which deducts from Nominal GDP to get Real GDP.

We can’t pin it on any one of these. They all had some influence, along with others not listed, adding up to the lower growth estimates. And let’s note, “lower growth” isn’t the end of the world. If Q3 real GDP growth is 0.5%, it won’t be what we hoped but it won’t be recession, either.

The economy is performing well in many ways. Plenty of jobs are available, new businesses are being launched, companies are profitable (third-quarter earnings season has started off with a bang!) and stock prices are strong. We could do much worse. But we could also do better, and the missed opportunities are frustrating.

Today’s letter will be the first of at least two parts. Next I’ll describe where I think this is heading, and how we still have a chance to save the recovery if certain people/institutions make the right choices. But first, I want to establish three important points. They are foundational to my outlook. Here they are, summarized in one sentence.

We are facing demand-driven inflation as a consequence of misguided monetary policy and misdirected fiscal stimulus.

That may sound simple and obvious, but this one short sentence has a lot to unpack. We’ll start below.

Demand Is Booming

Recently I wrote about the growing Logistical Sandpiles problem. It shows no sign of improvement. That’s not good, but I think this situation is also a clue to our deeper problems. The ports and railroads are clogged because the economy is demanding more goods, and this demand is driving inflation pressure.

My friend Jim Bianco explained what is happening in a magnificent Twitter thread you should read. I’ll excerpt his key points and charts below.

“The Los Angeles and Long Beach ports collectively unload just under one million containers a month. For the last year, they have been running at/near a record pace. In other words, they are running as fast as they can. The problem is they are at their limit.”

“There are also problems getting these containers off the dock. Unfortunately, there is a trucking shortage, which has led to soaring trucking rates (chart below). Demanding more trucks at 3 am to get these unloaded containers off the dock is going to be a taller order.”

“This is leading to a backlog of ships anchored off LA. And since these containers are taking longer to unload, shippers now have to factor in this dead time anchored off shore. This is a disincentive to ship, so the number of empty containers are piling up in the ports.”

“This is leading to a recent fall in container rates. No one is in a hurry to ship these containers back to China for reuse if they are going to just sit anchored off LA for many days. Then one has to struggle to find a truck to haul it away.”

After illustrating the problem, Jim explained the cause.

“Simply, demand is booming. Below is personal consumption since ‘09, its trendline, and residuals (actual-trend). Consumption is off the charts at $662B > trend.

Again, we want a record amount of stuff and the supply chain cannot handle it.”

Interestingly, Paul Krugman highlighted some of the same problems but he notes a different distinction: Consumers have shifted their buying from services (experiences) to materials and specifically durable goods.

This makes sense as the government sent trillions of dollars of “hot money” directly to consumers and/or businesses. Restaurants, hotels, and airlines were generally off the market, vacations were crimped, so people bought “stuff.” Thus, those ships off the shores of California contain extra goods that both manufacturers and shippers hadn’t planned for.

Jim thinks prospects for near-term relief are nil, and it will generate more inflation.

“Many assume increasing the throughput of the supply chain to meet overstimulated demand over the short term is doable.

But if the problem is the supply chain is at capacity now, expanding will be hard/impossible over the next several months. (JM: And if you are a business, do you increase your capacity for what will likely be a short-term demand increase?)

So to bring everything into balance, prices will rise until enough demand is destroyed to bring everything into line with the limits of the supply chain.

We might be seeing this happening as Q3 growth expectations are crumbling as prices are soaring.” John here again. Let me add a couple of notes. First, as noted above, the consumption growth Jim describes is partly a consumption shift. Thanks to COVID, Americans have reduced spending on services (restaurants, concerts, hotels, airlines, etc.) and spent more on goods. It’s pretty clear in the inflation data. In barely more than a year we reversed a shift that unfolded over decades. Of course it’s not going smoothly!

Second, it would be nice to know more specifically what is in all these containers. I suspect a big part of it emanates from housing construction growth. Building materials are bulky and consume a lot of shipping capacity relative to their value. New homes, once occupied, also spark many other purchases: furniture, lawnmowers, garden hoses, etc.
If I’m right on that, then a break in the housing boom might have a swift effect on the supply chain problems. But right now there is no sign of such, in part because the policies driving it aren’t changing. Which brings us to my next big point.

Running It Hot

Traditionally, the Federal Reserve prevents the economy from overheating by taking away the punchbowl, as the old saying goes. That skill set seems to have atrophied from disuse. Understandably so, too. We have seen nothing you could reasonably call “overheating” since the 1990s. Surging first-half 2021 growth simply recovered the prior year’s decline, more or less, and now seems to be ending.

So the current generation of Fed leaders and staff has spent years looking for ways to fill the punchbowl. They have long talked of letting the economy “run hot,” tolerating higher inflation for some extended period that would balance out years of lower inflation.

If that’s your perspective, then the idea this post-COVID period would bring only “transitory” inflation was likely disappointing. Look at Jim Bianco’s chart above, and you’ll see it has been many years since core CPI stayed above 2.5% for very long, and it’s often been well below. These last few months, while sharply higher, are still nowhere near restoring long-term “normal” inflation.

In my view even 2% inflation is too much. Some officials at least claim to be concerned about current levels. But as an institution, the Fed doesn’t seem to think the party is out of hand. They are certainly doing nothing to stop it.

Yet the supply-chain inflation Bianco describes is partly a result of the Fed’s actions since early 2020. Their initial dramatic moves were appropriate. We were in an unprecedented situation that could have destabilized the banking system. That risk passed pretty quickly, leaving a garden-variety recession they could have addressed without the drama. Yet their crisis programs and policies are still in place today. Why? I see two reasons.

First, they’re using new tools (like loan guarantees) because the old tools don’t work anymore. Debt loads, both public and private, are so gigantic that injecting more money no longer has the stimulative effect it once did. Lacy Hunt says declining velocity is key to this. They can create liquidity but they can’t force banks to lend, or businesses and consumers to borrow. Here’s Lacy in the most recent Hoisington quarterly (emphasis mine).

“As velocity declines, each dollar of money produces less GDP. The drop in velocity to lower levels indicates that monetary policy becomes increasingly asymmetric in its capabilities. While tightening operations are effective, Fed actions to support the economy are largely counterproductive even when they are novel in scope and massive in size. Benefits can accrue but their impact on economic growth has proved to be extremely minimal.

The Fed is able to increase money supply growth but the ongoing decline in velocity means that the new liquidity is trapped in the financial markets rather than advancing the standard of living by moving into the real economy.”

In other words, the Fed can still take away the punchbowl but is unable to refill it. They don’t want to take it away because they have this fantasy it will eventually work. So they are keeping short-term rates at zero and buying $120 billion in bonds every month, along with assorted other programs. You can see what it’s done to their balance sheet.

That $120 billion monthly bond buy goes $80 billion to Treasury securities and $40 billion to mortgage-backed securities. This is a giant rate subsidy to the federal government’s borrowing as well as home buyers. No surprise, both have been adding leverage. And as noted, the latter group is probably aggravating the supply chain problem.

All this monetary stimulus had some effect, of course, but the latest growth forecasts suggest it is already dissipating. The Fed did so much, so fast, it produced a self-limiting recovery in which supply-chain inflation caps potential growth.

That’s not good, but we have another culprit.

Bipartisan Failure

In March 2020, with COVID-19 spreading in the US, no one really knew what to expect. Just as the Fed was right to aggressively protect the financial system, the federal government acted correctly to help the millions who lost jobs and income. But details matter, and time is showing the stimulus programs were poorly designed and often counterproductive.

Let’s start with the core problem: They got the goal wrong. The target shouldn’t have been to stimulate the entire economy, but to maintain the status quo for affected individuals. At the time we (wrongly) thought a few weeks of inactivity would suffice. The goal should have been to replace the lost income and only the lost income, for the people who actually lost it.

But as a practical matter, that was apparently too hard. So instead we pushed them into an unemployment insurance system unprepared for the task and added a flat $300 weekly supplement that was more than some people needed and not enough for others. Then we also sent checks to almost everyone (excluding the highest income groups) whether they needed them or not. Then we did it again in late 2020, and again in 2021.

Note, this was a bipartisan policy failure. The first two COVID relief bills, totaling over $3 trillion, passed a Democratic House and Republican Senate. President Trump signed both. President Biden and a Democratic House and Senate added $1.9 trillion more. Everyone’s fingerprints are on this.

But whoever you blame, this money had a giant effect on consumer spending. Not all of it was bad. If the government is going to kill people’s jobs, it can at least help them buy groceries. The problem is that large amounts went not to basic needs but to discretionary luxuries, some of which are on those ships the ports can’t unload fast enough.

Easy Money

I have been trying to explain for years the subtle difference between QE (Quantitative Easing) and outright money printing (MMT). Essentially, the Fed does not buy government debt directly from the government. They go into the open market and buy it from people/institutions that originally bought that paper at Treasury’s auctions.

Typically, the money the Fed uses to buy that debt goes back on the Fed’s balance sheet as excess bank reserves. You can zoom in on the chart on the right and see what looks like a flat line up until about 2009 is actually composed of very tiny bumps. A small amount of “excess reserves” was normal. Then they started QE in 2009 and the amounts exploded. They began slowly tapering down in 2018 until the amounts jumped again from the COVID QE.

Again, in theory, banks could lend this money. That is not happening. It is ending up in margin accounts and other products, directly or indirectly boosting the stock market. That easy money policy coupled with extremely low interest rates is boosting home prices, exacerbating wealth and income disparity.

Low interest rates are of limited help to first-time homebuyers when the average price goes from $380,000 to $420,000 in a little over a year. This is what happens when government, in this case the Federal Reserve, meddles in the market, albeit with good intentions. Now, if you already own a house that’s rising in value, you are not upset. But if you are trying to buy one the Fed is making it harder on you. It’s a corollary to financial repression.

An intended consequence? As many as 25% of homes are now being bought by yield-seeking funds that will rent them. When bonds no longer even keep up with inflation, investors look for other ways to get yield. And residential real estate offers not just yield but depreciation. That would not be possible or even necessary if Treasuries were 2½%.

So where is the inflation coming from if it is not directly from QE? It is coming from the $6 trillion in high-powered Fed money plus fiscal stimulus spending. That money did not end up on the Federal Reserve balance sheet; it went directly into consumers and some businesses. The stimulus programs are the real helicopter money that Ben Bernanke mentioned almost 20 years ago.

For the record, I agree with Lacy Hunt. We will eventually go back to a slow-growth, disinflationary environment. I think real GDP will likely average 1% for the rest of this decade because of the debt burden. But in the meantime, until the stimulus and supply chain issues work out, until we figure out how to entice potential employees back to work, we’re going to have to deal with uncomfortably high inflation.

This from Grant Williams’ recent Things That Make You Go Hmmm:

Not only that, but recent comments by Fed officials suggest the Fed is trying to gently convince their adoring public that inflation may actually turn out to be “a little stronger than they forecast for a little longer than they forecast.” Sigh.

As you can tell, this is a vast problem with many moving parts. It has other elements I haven’t mentioned today, too. Like, for instance, low interest rates and quantitative easing can’t solve supply chain issues, microchip shortages, or changes in the labor market.

Together, the federal government and the Federal Reserve have put us all in a jam with no good alternatives.

Your convinced the Fed has made a monetary policy mistake analyst,

John Mauldin


Why are so many people quitting their jobs?

People (in the US, at least) are quitting work in extraordinary numbers. In August almost three percent of workers left a job, the highest ever, in a phenomenon being dubbed The Great Resignation. Unsurprisingly this has become a political Rorschach test (“It’s a revolt against labour exploitation!” “No, it’s the consequence of over-generous unemployment benefits!”). There’s lots of hobby-horse analysis out there, but this piece by Greg Rosalsky is excellent and touches on some more interesting hypotheses.

Rosalsky looks at the literature on the ways that exposure to macro events shapes worldviews for a long time, even generations. For example, there’s evidence that Weimar hyperinflation still shapes elite German attitudes to inflation. Or see this 2011 paper suggests that “Depression babies’” lifetime investment behaviour was shaped by early exposure to stock market disaster. The obvious question, then, is what exposure to a global pandemic and a mass, enforced experiment in remote working does to people’s attitudes to employment.

Rosalsky cites this new paper by Ulrike Malmendier which argues that exposure to these sorts of macro experiences almost literally rewires our brains and changes our preferences, attitudes to risk and more. We saw some evidence for this at Entrepreneur First during the pandemic; applications soared (see this piece in the FT for more). Is this a glimpse, as Sam Altman suggests, of our post-employment AI future? There are certainly more prosaic explanations. But it wouldn’t be a surprise if COVID produced a generation of people with very different – and perhaps unpredictable – attitudes to work.

Should political parties try to be popular?

We talked last year about David Shor, the US progressive data scientist who was fired during the BLM demonstrations for a tweet that cited research showing that historically violent protests have tended to damage Democrats electorally. Despite that, Shor’s career has since boomed; he’s now one of the most in-demand political analysts in the US and he has a simple but (surprisingly?) controversial message for Democrats: talk about popular things and shut up about unpopular things! Without that, he thinks, the party is electorally doomed. Ezra Klein has an excellent long profile here.

Why’s this controversial? Primarily because the policy positions about which (some) party activists are most passionate are precisely those that are most unpopular with the electorate. “Defund the police” is Shor’s favourite example. What’s complicated is that even popular policies can backfire if voters infer from them something they dislike about who you are. Here’s Shor on climate change:

“Very liberal white people care way more about climate change than anyone else… So when you talk about climate change, you sound like a weird, very liberal white person.”

This doesn’t play well in West Virginia (see Adam Tooze for more on this)

This matters even if you care nothing for the fortunes of the US Democratic Party, because it’s at the heart of an important question about how to make change happen. Should activists try to take over a political party (at risk of being in thrall to its electoral needs) or attempt to influence from the outside (at risk of never obtaining the levers of power needed to effect the change they seek)? On this, I highly recommend this interview with David Schlozman, a political scientist who studies party takeovers. Whatever you think of “popularism” it strikes me that if you want to change the world, you need a grounded theory of how change happens; few do.

The future of biotech startups

On the TiB podcast this week is Tony Kulesa, one of the founders of Petri, a new approach to supporting academics to build companies at the intersection of biology and engineering (It’s worth listening to in conjunction with the episode with Ilan Gur, as there’s a lot of thematic overlap). I recommend Tony’s piece, “The Future of Biotech is Founder-Led” for a good introduction to what he’s trying to achieve. Readers may also remember Tony from his essay on Tyler Cowen and talent curation, which we discussed a few weeks ago in TiB 181.

We spend most of this conversation talking about what it takes to build innovative biology-based companies. Tony does a great job of articulating why biotech is so exciting today and how the landscape has changed in the last decade.

Among other things we discuss:

  • How bio- and computer science-based tech ended up with such different company creation models – and why that’s changing
  • The infrastructure that makes building biology-based companies easier today, and what’s still missing
  • The big themes he’s most excited to see bio founders explore right now
  • Why Tyler Cowen is so good at talent curation

I loved this conversation; enjoy!

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