All Things in Moderation

Vital Statistics:

Stocks are higher this morning on no real news. Bonds and MBS are up.

Home prices rose 1.6% in October and were up 7.9% on a year-over-year basis. With mortgage rates continuing to hit new lows, and a complete dearth of inventory, home price appreciation should continue.

Doug Kass released his 15 surprises for 2021. Doug’s surprises are always an entertaining read. Note that by definition, a “surprise” is not a high-probability event, it is like picking an upset in your NCAA bracket. Some of more interesting predictions revolve around inflation:

Surprise #5 Bottlenecks Multiply and Inflation Surges –There are bottlenecks everywhere in 2021 and inflation in places beyond financial assets. As the economy reopens, there are shortages of almost everything. Commodities boom, but so do service prices. It seems that prices of everything from shipping to manicures are on the rise. The infrastructure bill sends construction material prices through the proverbial roof. Pent up savings are unleashed in robust consumer demand. Concerts, sporting events reopen with limited capacity and tickets are in hot demand. Residential real estate (single and multi family) soar in price, as people put stimulus, the recovery and stock market winnings into real estate. By mid-year, even the badly manipulated CPI is running up +4%.

Surprise #6 Inflation and Interest Rates Rip Higher Leading to A Valuation Reset (Lower) For Equities in 2021… At first, the bond market reacts “normally” to rising inflation. The 10 year yield breaks 2% (to the upside). The stock market has a late spring/early summer wobble in response to rising rates and the possibility that target inflation will force higher rates. A mid-year Treasury auction goes poorly. The Federal Reserve, faced with the dilemma of choosing between a lower stock market and higher inflation, chooses to accept higher inflation. The Fed announces a cap on the 10 year yield at 1.5% and expresses its willingness to do whatever it takes to enforce it. In effect, the Fed becomes the Treasury buyer of first resort. This sends stocks, commodities and most everything briefly higher (towards the upper end of the 3600-3800 S&P trading range) – except the dollar, which falls 10%-15%. Though temporarily ignored by infinite liquidity and easing financial conditions at all costs, it grows clear that Covid-19 spurred a dangerous leveraging up in the global economy that has been almost constantly in place since The Great Decession of 2008-09. Higher inflation and interest rates bring the “bond vigilantes” out of their long hibernation. Stocks fall by -15% over the last six months of the year as price earnings multiples contract in the face of the highest level of corporate defaults in over a decade (led by companies in the retail space and others that were already struggling prior to the virus). Credit spreads (now at record lows), widen dramatically, the CLO market collapses and private equity companies are among the worst market performers of the year.

Doug’s comments about shortages touches on what has been missing from the whole inflation puzzle. Market prognosticators have been wrong about inflation for decades because they focus solely on the monetary aspect. Inflation is too much money chasing too few goods. The “too few goods” piece of the puzzle has been missing, since China has been producing cheap goods for decades. “Too much money” is a necessary, but not sufficient, condition for inflation.

One of the “tells” for higher inflation is higher capacity utilization. This is an indicator that factories are maxed out, and increasing demand will push up prices, not output. Take a look at capacity utilization over the past 50 years:

Compare capacity utilization rates in the 1970s versus today. If demand increases, there is plenty of slack in the system to meet it. Obviously COVID is adding some constraints, but that is a temporary phenomenon.

I do think Doug’s point about the Fed capping the Treasury yield is interesting, although I think with all of the deflationary forces around the world: Japan, Europe, it will be hard to create an inflationary cauldron in the US while the rest of the world struggles with deflation.

Filed under: Economy, Morning Report |