Q3 2021: PFM Quarterly Commentary
In the good old days, before the Great Recession of 2007, markets were primarily driven by fundamental measures related to the health and growth prospects of companies and the macroeconomic environment in which they operated. Legions of analysts would clinically dissect government reports and financial statements, hoping to glean some shred of information that would tip them off as to the future direction of stock and bond prices. This laborious process was time consuming, required an arcane knowledge of finance, and was fraught with peril given errors in judgement and/or analysis could yield substantial financial losses and damaged reputations.
Now sadly, the days of fundamental analysis, at least for the time being, are largely over. Having spent a lifetime learning the trade, it pains us to acknowledge that this skillset lacks the relevance it once had in high finance. That said, we also must recognize that markets constantly evolve and thus so too should the methodology used to analyze them. Adapting to this new normal became necessary once the world’s central banks undertook an interventionalist role in manipulating asset prices to help us exit the Great Recession. The recent Covid crisis only further solidified the existence and persistence of this relatively new paradigm. In fact, empirical evidence suggests that markets now seemingly move in lockstep with monetary policy; they rise when monetary conditions are loose and fall when monetary conditions are tight.
At first glance, forecasting the direction of markets should be simple; however, in reality this isn’t the case. Analysts may have adjusted their techniques, but the amount of information to gather and process is still immense: there are scores of central banks around the world which continuously release communiques and policy decisions. Take our very own Federal Reserve for example. It is comprised of twelve regional Reserve Banks, twenty-four individual branches, a Board of Governors, a Chair, and an Open Market Committee with rotating voting members. At any one time, there can be several Fed members commenting on policy, releasing esoteric monetary data, and/or addressing their particular visions on the future of our monetary system. The challenge then is to discern the meaningful signals the Fed offers from the background noise generated by the sheer volume of information it disseminates. Fortunately, we’ve been hard at work honing an important skill since the Great Recession: interpreting the Fed.
This discipline of professional Fedwatching was necessitated by the novel emergency programs it unveiled during the Great Recession. All eyes turned towards them as they reduced interest rates to zero and began directly purchasing Treasury Bonds and other government agency debt to inject liquidity into the financial system to encourage borrowing. Save for a short time, those emergency programs have largely remained in place, despite those born at the onset of the financial crisis now nearing high school age. As a result, a portion of the trillions of printed dollars not retained by commercial banks for reserve purposes must go somewhere; namely, markets large and liquid enough to accept such vast quantities of money (e.g., stocks, bonds, real estate, high-end collectables, and even the newcomer on the block, cryptocurrency).
Illustrating this point perfectly was an Institute of International Finance (IIF) report released in September. The IIF calculated that global debt had risen by $36 trillion in the eighteen months since governments began financial policy responses to Covid-19. Of this, $4.8 trillion was raised over the last three months alone. Presently, the combined government, household, corporate, and bank debt (excluding derivatives) of sixty-one countries stands at a whopping $300 trillion.
Considering that much of this mind-boggling sum of money eventually must be deployed in some fashion, to us it’s unsurprising that global equity markets rose sharply in the subsequent eighteen months following the Covid bottom in March of 2020. Additionally, this information also helps to explain the robust appreciation in other large, liquid markets such as real estate over that same time period. While few appeared to discern the interconnection between government spending, central bank debt monetization, and asset price increases (or decreases), we have repeatedly identified these factors as the main drivers behind market performance in recent years.
To date, these policies’ inflationary effects were primarily isolated to asset prices. However, in recent communications, we’ve noted that consumer prices are beginning to reflect more pervasive inflation. Given the $36 trillion of newly minted capital mentioned above, this outcome was all but assured. We can’t help but harken back to our 2020 Q3 letter which cautioned that: “The signal could not be clearer: the Fed and other global central banks are going to continue their experimental monetary policies in order to drive inflation higher.” Looks indeed like it is mission accomplished.
The data points released in the third quarter alone supporting this “accomplishment” are too numerous to list. However, if you’ve shopped for groceries, bought a car, sold a house, or purchased fuel, you don’t need us to tell you that prices for consumer and durable goods have moved sharply higher. For most of the summer, the Consumer Price Index (CPI) rose steadily, topping out at an annualized 5.4% in July with Core CPI (CPI excluding food and energy) rising at the highest annualized pace (4.5%) in three decades. Individual components of the index, such as used car and truck prices, increased at even greater rates. Month over month, buying a used car or truck today would cost you a staggering 10.5% more, the fastest price increase since 1953.
Even more alarming was the inflation data on the producer level (known as the Produce Price Index or PPI) which saw nine consecutive monthly increases. All summer, the PPI set impressive marks such as posting the highest annualized increase since 1982 in June, followed by hitting a new record of 7.8% in July, only to notch another record in August by rising 8.3%. The cause for concern with such high producer-level inflation is that companies will only absorb so much of the higher input costs before passing them on to consumers by raising prices. Fed officials tell us that this inflation is “transitory” or “temporary,” but given record government spending estimated by the Congressional Budget Office (CBO) for the next ten years and another multi-trillion dollar “infrastructure” deal currently under negotiation by lawmakers, we don’t share their confidence.
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Peak Financial Management
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