Q4 2021: PFM Quarterly Commentary
The production of our quarterly market commentaries is beneficial for many reasons. Through these thought pieces, we can effectively communicate our viewpoints on various topics, events, and data germane to our efforts to fastidiously manage client portfolios. Forming a storehouse of sorts, the commentaries create a historical narrative, depicting the major tides responsible for the paths of markets, changes in economic activity, and shifts in fiscal and monetary policies. At times, this chronology runs the risk of sounding repetitive; however, the reality is that the large structural forces which pressure nearly all asset prices can span many years. Thus, understanding the contextual effects of these driving forces is imperative when forming reasonable inferences of the future. In fact, we find it invaluable to have past market commentaries to reference when discussing the current state of economic affairs.
Beginning late 2017, we have meticulously identified the conditions present for a structural change in the inflationary regime. Finally, we can document this change in real time. In our opinion, this resurgence of inflation may be the most impactful disruption to the macroeconomic environment since the Great Recession in 2008. Long anticipating this shift, Peak has been carefully making calculated adjustments within client portfolios to reflect that assessment. However, many investors were caught unaware. Economists, pundits, government officials, and investment managers obfuscated their inability to forecast the inflationary sea change by dismissing it as “transitory.” In our last letter, we were openly suspect of this characterization. It seemed nothing more than an attempt at rationalization for originally underappreciating inflation’s well-documented tendency to arise quickly and persist stubbornly.
On November 30th, testifying in front of Congress, Federal Reserve Chairman Jerome Powell finally acknowledged that inflation may stick around much longer than he had been publicly forecasting over the past year. Specifically, he said that it was probably a good time to “retire the word transitory regarding inflation” and went on to share concerns that higher prices run the risk of “becoming entrenched.” The sudden pivot toward enduring inflation was eventually recognized in late 2021 by Bank of America, JP Morgan, and other prominent financial institutions. Meanwhile, Fed members Thomas Barkin and Raphael Bostic, in addition to the European Central Bank’s Pablo Hernandez de Cos, publicly admitted the inaccuracy of their previous statements which had suggested any higher inflation would be short lived. It is both remarkable and disconcerting that these masters of monetary policy did not recognize their participation over the years in creating the inflationary impulses.
The fourth quarter provided ample evidence to support our prognosis that a new era of higher inflation was here. The Federal Reserve’s preferred measure of inflation, the Personal Consumption Expenditure (PCE) Deflator, clocked in at 5.7% year-over-year, the highest reading since June 1982. Also fueling the vicious cycle of inflation was consumer spending, rising an annualized 7.2%. All the while, the US domestic savings rate plunged to its lowest level since December 2017. Collectively this information lent credence to the conclusion that Americans spent at an elevated rate, possibly even by dipping into their savings, to preemptively purchase goods ahead of sharply rising prices.
Clearly, Americans were correct to buy in advance: consumer prices soared during this most recent quarter. Core CPI (Consumer Price Index) rose 6.8% on an annualized basis, notching a forty-year high. In that same New York Fed report, the public learned that annual prices of gasoline, food, medical care, college education, and rent rose 9.2%, 9.2%, 9.6%, 9.1%, and 10.0%, respectively. Moreover, the Fed’s survey of consumer inflation expectations showed that 25% of respondents see inflation rising another 9.7% over the next year. The famed University of Michigan Consumer Sentiment Survey also corroborated the Fed’s data, as their measure of expected inflation spiked to a thirteen-year high. As illustrated in our previous writings, inflation is in part a psychological phenomenon. The fear of rising prices pulls demand forward, thereby actually raising prices, and thus inciting even greater fear. In the scientific community this is known as a positive feedback loop. Clearly, to some extent, this has begun to play out.
Consumers’ fears of experiencing higher inflation are not unfounded. Empirically, changes in inflation at the producer level usually trickle down to the consumer with a lag. Producers will absorb some amount of inflation to stay competitive at the expense of lower profitability. Inevitably though, much of the rise in production input prices gets passed on to the consumer. Having described this methodology in previous letters as a way to forecast changes in consumer level inflation, we now highlight the change in last November’s Producer Price Index (PPI): a blistering annualized 9.6%. This quickly became headline news when the change far exceeded the preponderance of economists’ expectations. If what’s past is prologue, a majority of these higher costs will eventually trickle down to consumers.
Now that inflation has become impossible to ignore, curiously some in the mainstream financial media have introduced the idea that high inflation, somehow, is good. For sure, inflation benefits debtors, asset owners, and those earning an income that can keep pace. However, for the population at large, particularly lower income households and/or those impoverished, inflation is crippling at best and devastating at worst. Generally, inflation’s impact is measured by how quickly wages can adjust upward to price increases. Inflation is clearly less of a problem if wages grow at or quicker than the rate of price increases. Conversely, if wages grow at a rate slower than inflation, the standard of living, at least for most of us, declines. The good news is that a tight labor market has driven wages higher. In November, the Bureau of Labor Statistics (BLS) reported that average hourly earnings increased 4.8% on an annualized basis. The bad news is that headline inflation was 2.1% higher than that figure, resulting in negative real earnings growth. Unfortunately, real earnings growth has remained at a deficit for eight straight months.
A steadily declining standard of living for a large proportion of the population is untenable, so the resulting fiscal and monetary policy responses will likely determine the paths of markets in the coming quarters. However, with gross domestic product (GDP) already slowing dramatically in the third quarter to just an annualized 2.3% from loftier levels, traditional methods for abating inflation will most likely stymie growth even further. We’ll be watching with bated breath as fiscal and monetary policymakers navigate this paradigm of promoting growth while moderating inflation.
Owning risk assets is one traditional method to guard against inflation. 2021 offered robust evidence that this approach is still effective, as certain sectors demonstrated strong positive correlations with rising prices. Similarly, inflation-friendly bonds such as TIPS (Treasury Inflation Protected Securities) and high-yield debt also generated solid returns in an otherwise lackluster year for fixed income. Although equities generally performed well, domestic stocks outshined their international counterparts as they have for most of the past decade.
While 2021 proved a strong year for risk assets, not all asset classes joined the party. Bonds, aside from those mentioned above, clocked in with a largely negative year. With inflation soaring the poor bond performance was unsurprising, but the underperformance of precious metals was unusual given its well-earned reputation as an inflation hedge. Needless to say, we’ll be watching precious metals closely in 2022.
We wish everyone a Happy and Healthy New Year.
Peak Financial Management
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