Three weeks into 2020 and things continue apace. The world has been to the brink of war and back (remember that?), the impeachment trial is finally underway, and now there’s fears of a new global pandemic. Meanwhile, markets are up over 2% on the month, which annualizes to another 30% year. Which is absurd, so don’t get your hopes up.
As for the “why”, well it’s certainly not due to fundamentals. Global trade (as measured by the Baltic Dry Index) is at a 9-month low and falling, and the IMF has cut their global growth forecast to 2.9%, which is the lowest since the financial crisis...and those forecasts tend to be optimistic. But thankfully the Fed shows no signs of slowing their repo operations, so the market has the green light to keep going higher. The Fed even - get this - floated the idea of lending directly to hedge funds during the next liquidity crisis.
So, we’d say investing thesis solidly intact to start the year. But there is a little hiccup at the moment that has us slightly concerned. A hiccup called the Wuhan coronavirus. As of writing, China has quarantined seven cities (about 23 million people) (ed. note - now 11 cities and 40 million people, one day later) in an effort to stop the spread. They are literally building a 1,000-bed hospital in the next 5 days on the outskirts of Wuhan because their current hospitals are full. There are over 600 confirmed cases (ed. note - over 900), with 18 (ed. note - 26) fatalities. Cases have already been reported in Hong Kong, Singapore, Japan, South Korea, Thailand, Taiwan, Vietnam and the US, and are suspected in Saudi Arabia, Russia, Scotland, Nepal, and India.
Markets - mostly Asian markets - are taking a bit of a hit on fears that the virus will affect the actual economy. While a distinct possibility, we’re not anywhere close to that yet, and especially not to any kind of impact to the US economy. The more worrying issue is that something like this is one of those rare exogenous shocks to the financial system. There’s a central bank backstop in play right now that has supported markets for the last...let’s call it decade. As long as people hold that belief in the power of central banks, all is well. It’s what has let the markets shrug off (or even embrace!) bad economic fundamental news, because it just means the Fed will get more involved.
But a virus is clearly outside the Fed’s purview (pending ECB strategy review notwithstanding). Something non-financial, that the Fed has no control over, is a big risk exactly because it falls outside the monetary-cum-belief system that has been built up over the last decade. If something like that causes investors to once again look at fundamentals absent a Fed-supported framework, there is the possibility for a rather sudden repricing of risk, to put it euphemistically.
Having said that, however, we are assuming that this will be more of a temporarily volatile period and not the start of the next great financial crisis. As such, we’ll keep an eye on it and probably play the Pandemic board game a little more than usual over the next couple months, but for now let’s revisit last month’s newsletter and unpack some of our comments about inflation.
We wrote a "What is...?" newsletter on inflation back in 2018, with the focus more on what is it and wage inflation. Last month, we brought up inflation vis a vis the Fed and easy money policies. Here’s the quote in context:
"At the time QE was implemented, the expectation was that you’d get rampant inflation. More money chasing the same amount of goods and services equals inflation; that’s econ 101. Except it didn’t happen. Or did it? We’d argue that it did, just not in a way that the Fed measures. CPI hedonic adjustments and substitutions are crap. And it doesn’t take into account things like bananas taped to walls or...the stock market."
So to back things up, the Congressionally-mandated purpose of the Fed is to promote maximum employment and price stability. Somewhere along the way, it was decided that “price stability” meant “prices going up by 2% every year”. Thus, the 2% inflation “target” you may have heard of.
The Fed uses measures of inflation as an economic barometer that helps them decide what kind of monetary policy decisions to make. If inflation is below their 2% target, monetary policy will tend to be “loose” or “easy” - they’re trying to stimulate the economy to get prices to rise faster. If inflation is above their 2% target, monetary policy will tend to become “tighter” in an effort to slow the economy down.
Given that it’s so important, it’s a good thing that the Fed has a super-accurate way to measure inflation in the economy! Wait, what’s that? They don’t? Well...that’s awkward. Here’s how inflation gets measured, courtesy of the St. Louis Fed website:
About a decade ago, 28,000 consumers kept detailed spending diaries. This data was supplemented with 60,000 interviews (ed. note - That’s a grand total of 0.2% of the population). Then, a bunch of data collectors run around every month and record the prices of about 80,000 different things that make up the “market basket” of the average urban consumer. Differences in overall market basket price from one period to another gives you inflation.
If you think that’s a rather gross generalization of buying habits, you’re not wrong. Much like any average, it is likely not accurate for any one individual, but through the magic of statistics can be applied accurately to everyone at the same time. But wait, it gets better.
The prices of the goods in the market basket can receive “hedonic adjustments”. Bascially, technological innovations improve the utility and pleasure of an item, so its price needs to be adjusted. For example: TV screen picture quality improves (CRT, LCD, plasma, LED, OLED), but prices stay the same. The improved quality will actually result in a downward price adjustment for inflationary purposes. So while you the consumer are paying the same amount for a TV, the math says that the price actually went down. Take that example just a little bit further, and it’s not hard to imagine a world with “low inflation” where the cost of everything you buy continues to go up.
We can take it a step further. You can also adjust for “substitution effects”. This is the idea that as a product becomes more expensive, the average consumer substitutes it for a similar but cheaper product. So if you were going to grill burgers one weekend, but the price of beef was too high, you would instead grill chicken. Substitution. Personally, we don’t think that’s something that is remotely measurable for the population to any statistically significant degree. But it looks good on paper. To recap, here's how inflation gets measured, in cartoon form:
The Fed actually likes to use something called PCE instead of CPI to measure inflation. Very similar, just know that PCE includes those substitution effects. In other words, if prices for something go up too much (high inflation), your overall inflation measure replaces it by definition with something that has lower inflation. Meanwhile, you the consumer are still paying through the nose for your milk or your beef or whatever the math says you just stopped buying.
Another step! The Fed excludes “volatile” items like energy to arrive at a measure called Core PCE. Because sure, the price of gas at the pump has no bearing whatsoever on spending patterns.
So. The Fed makes policy decisions based on the level of inflation. “Inflation” as a single, nation-wide constant is an absurd concept, but we’ve come up with a way to measure it. And then we’ve gone about tweaking that definition from time to time. Is it a coincidence that every one of those tweaks serves to give a lower reading of inflation? Hedonic adjustments - lowers inflation. Substitution - lowers inflation. Excluding energy - (usually) lowers inflation (and we would probably argue always lowers inflation given governments’ propensity to increase the gas tax if prices drop).
Some among us might suggest that the government is intentionally lowering inflation measures so that entitlement spending comes down (social security and pensions have a cost-of-living adjustment based on inflation...if you can make inflation seem lower based on how you calculate it, you can get away with smaller cost-of-living adjustments). But it’s not yet April, so we’ll just gloss over that.
The point is, the Fed’s inflation measures seemed designed to intentionally lower inflation relative to what any actual consumer would experience. And since your “average urban consumer” isn’t dropping $100k on bananas duct taped to walls at Art Basel Miami, the Fed seems almost willfully blind to some of the excesses caused by all the money sloshing around in our system. Money that is there because of the Fed’s easy money policies, which themselves are in place because of low inflation. Oh the tangled webs we weave.
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