Below is the transcript from a recent podcast: "A Conversation on Inflation," featuring Senior Managing Director Jarett Levitsky, CFP®, and Director and Economic Strategist Brandon Zureick, CFA.
To listen to the audio recording, click here.
Jarett Levitsky & Brandon Zureick
Jarett
Hello and welcome to this Johnson Investment Council conversation on inflation. My name is Jarett Levitsky. I serve as a senior managing director in Johnson Wealth Management, and I'm joined today by my distinguished colleague, Brandon Zureick. Brandon is a Director and Economic Strategist within Johnson Asset Management. For those who might not be aware, Johnson Asset Management is a division of our firm that houses all of our economic and market analysis and research, our various investment strategies, and ultimately how topics, like inflation, apply to investment portfolios.
Now, whether you're someone who's remodeling your home and in the market for two by fours and plywood or whether you're in the market for a new or used car or simply going to the grocery store and buying a nice steak to throw on the grill, we've all been facing higher prices and that's caused a lot of concern. And frankly, there's a ton of articles and newscasts that talk about inflation and that has the tendency to maybe undermine confidence and undermine peace of mind.
What we aim to do today is maybe dispel some of the myths that might be out there. We also want to bring perspective and our thoughts on this topic and how much concern there should be at this point in time.
So, I was a history major in school. I love to look at things through a historical perspective. So, maybe what you can do to start off with is set the stage on this topic. As we look over the last 10 to 15 years, what was the inflationary environment like?
Brandon
There have been some really powerful, structural forces that have weighed heavily on inflation for the better part of 10 or 15 years- most notably about things like demographics. We've got relatively subdued population growth. The population that we do have in the United States is beginning to age. That tends to act as an inhibitor to faster inflation. Debt levels coming out of the financial crisis were obviously very elevated which weighs on economic activity and inflation.
Those things are not only still in place today but many of them have actually worsened since that point in time. So, you're right to say that inflation has been very modest for quite some time, and as a result of that inflation and a lot of these secular trends, we've seen a pretty low, pretty modest growth environment as well.
Jarett
As I think back a little bit, it seems like there were conversations about the Fed actually wanting to spur inflation a little bit. It's almost like it was too low.
Brandon
That's right. Be careful what you wish for sometimes. Right?
Jarett
Exactly. So, with that in mind, what brought us to where we are today, with all of these articles and every conversation is about inflation?
Brandon
This year has been the perfect storm for inflation concerns. Policymakers have poured trillions of dollars in stimulus, not just fiscal stimulus, but monetary stimulus into the economy. As we sit here today, we're debating the prospects of an additional infrastructure bill. So, there is possibly more spending on the horizon. Meanwhile, vaccinations are broadening, and economies are reopening. Quite frankly, the combination of those two things is leading to a boom in economic activity, primarily within consumers who have a lot of pent-up demand to do the types of things that they haven't been able to do for some time throughout covid. It’s the perfect storm of stimulus combining with acceleration in economic activity, which is leading to concern that demand is now exceeding supply. The old Econ 101 that prices will rise as a result.
Jarett
So, let’s talk about some examples. I mentioned, plywood, lumber, used car prices, and new car prices. Maybe break down some of those and give an example of how that supply/demand imbalance is causing higher prices.
Brandon
With any economic data, I always like to urge caution. It's not always what meets the eye. So, I think we need to take a step back for a minute and think about just what's going on underneath the hood with regards to recent inflation data.
We just got the April Consumer Price Index report, referred to as the CPI. The headline inflation number in April rose 4.15% year over year. That sounds like a pretty sizable increase, and I think it caught investors’ attention. In fact, that's the largest jump on that measure that we've seen going back to 2008. However, there are a couple of things going on underneath the surface here. The first is that any time you use year over year comparisons, and you're comparing a period of time today to a similar period of time last year, remember, last March, April, and May were severely impacted by COVID lockdowns. So specifically, we actually saw inflation fall. We had negative inflation in those months. So naturally, any stabilization that we're seeing this year leads to a mathematical increase in that inflation index. That's the first mathematical quirk of inflation data when you're comparing a period that was so disrupted. Now, the second is that you have to dive underneath that number and think about the types of industries that have driven the increase in prices, which are a very narrow set of industries.
You mentioned used cars specifically. In April, used car and truck prices jumped 10% in one month. That's a hundred and twenty percent annualized increase. It is almost inconceivable how that might happen. In fact, used car and truck prices accounted for a third of the increase in the overall CPI in April. So, there are some really quirky things going on with the data, both from a calculation perspective and from some subindustries that have been pretty heavily impacted going all the way back to covid.
Jarett
So, let's talk about a term that people hear a lot, supply chain imbalances. How does that play into this?
Brandon
I'm going to go back to the used car price example, because I think this is a great corollary for what's going on in other industries as well. Think about rental car companies back in last March, April, and May. Obviously, demand for rental cars fell off the earth. There was essentially no demand for rental cars. Rental car companies were faced with some pretty tough choices. In order to adapt and ultimately survive, a lot of those companies sold their fleets.
All of the sudden, vaccinations have crept up on us more quickly than many have expected. And we're faced with a situation where demand for things like rental cars has come back much more quickly than supply has. Add into that things in the used car market that have been disrupted, particularly shortages within the microchip sector, and used car companies or rental car companies are paying whatever price they need to in order to restock their fleets. It’s a good example of demand cratering companies adjusting to that environment of very little consumer demand or business demand, and then demand roaring back much more quickly recently, which has left companies with no other option than simply to pay higher prices in order to get production or supply.
I think this is a story and a narrative that we're hearing echoed across many other industries as well. The good news is that these probably aren't long term things. As you know, companies adapt and any time they can charge higher prices, there's a rush to production. We think that companies are probably in the midst of making the adjustments and that supply chains are naturally starting to heal as time goes by.
Jarett
Right. I've seen articles more recently talking about how some of those prices are already starting to ease. We're already seeing some of the supply chain issues heal. Are there any examples of that that you can think of?
Brandon
Yes, certainly in the commodity price sector you've seen it. This is not just a U.S. issue. This is a global issue. The whole world was impacted by covid, and particularly China has taken a couple of steps to pull back on some of the easiness of credit within the country, which has, in turn, led to some softening of demand in some of these areas and has directly resulted in lower commodity prices. Think of things like lumber and corn.
They're not back to where they were, but they are off of the ultimate highs. You are starting to see some early signs of this perhaps beginning to correct. If you listen to companies and you hear what corporate management has to say, they're making every effort to ramp up production to meet these short-term shortages. Another thing we haven't really talked about, it's not just a supply of goods. It's actually a supply of labor. It’s a difficult environment to attract workers back who may still be collecting unemployment benefits. So, it's the supply of labor that's also somewhat constrained. But again, we're hearing signs and seeing signs that that's beginning to start to correct as well.
I'll give you an example. I went to Chipotle the other day, and there was a sign on the door that said “we're closed. We don't have enough people here”. I'm sure other people have similar stories where it's hard to really fathom. There's a line outside the door, but the doors are closed.
Jarett
Yes, the demand for burritos is rather high, exactly as it always is, at least for me every time I go to lunch. Let's talk about another headline that has been out there. It’s one of these scary ones that people tend to latch ahold of. For those who have been on the Earth a bit longer than the two of us, some may remember the 1970s, early 1980s environment of stagflation. People are talking about whether we are in that new long term, “stag-flationary” cycle.
What perspective can you lend towards that?
Brandon
I think that's the number one concern we hear. There are maybe some echoes or similarities to that environment. For those who lived through that period of time, there's a real concern that this is the early stages of returning to that time period. There are a couple of things we can point to that would lead us to believe that maybe we're not ready to repeat the 70s and the 80s.
The first is the environment of that time period. Particularly with the Fed, they had just come off of the gold standard. There was an early adjustment to the way they were thinking about monetary policy. Not to get too far in the weeds there, but it was a whole new era for the Fed and perhaps they made some mistakes through that time period. That's kind of a unique aspect of the 70s and 80s.
The second is that it was very clearly a demand driven inflation. You had robust population growth. You had the beginning stages of the baby boomer population. You had women beginning to enter the workforce. You had all of these demographic tailwinds during that time period that led to a very strong environment for growth and a demand increase. A legitimate, sustainable, and secular demand increase. Now, if we compare that to today's environment, I think a lot of those things are quite the contrary, particularly with regard to demographics.
I already referenced this, but it's hard to overemphasize how important demographics are from a long-term perspective. Population growth and fertility rates here in the U.S. and around the globe remain subdued and depressed. You've got aging populations and all of that tends to lead to a very modest economic growth environment and in turn low inflation and low interest rates. Maybe a good example of a playbook in this area would be Japan.
Jarett
I remember you bringing this up when we had a conversation last week. That's a great example.
Brandon
If you rewind the clock 20 or 30 years, we're in the midst of what Japan was experiencing back then. If we take a look at what's happened in Japan, the fear that we hear from folks a lot is that all of this debt and that all of this Fed easing and money printing are going to lead to a weak dollar or fast inflation and that sounds threatening. And Japan is again, this is the playbook is set.
All the things that we're doing today, higher deficits, higher debt levels, super low interest rates: Japanese interest rates have been near zero now for many, many years. They have, in fact, struggled to actually get inflation. So, it's exactly the opposite of the scenario that many folks fear that all this debt and money printing might lead to might lead to faster inflation and higher interest rates. I think quite the contrary. And again, I tie it back to demographics. The poster child of demographic headwinds would be Japan, with an aging population and very low population growth. Those things are very powerful, long term drivers of things like economic growth and inflation. Near term, it's difficult to segregate what's going on today from what might drive these types of things over the next five or ten years. The number one thing we would urge is segregating what's happening today during this cyclical, very strange rebound coming out of covid to what the longer term economic and inflation trends are going to look like once the world normalizes.
Jarett
We've talked about monetary policy a little bit. Let's unpack that a little bit more, because I think there is that element where people say that all this money creation has to result in higher inflation. Maybe talk a bit about how that translates to the money that's created actually getting into the system.
Brandon
Absolutely. When you start to trace where the money is going, the Fed has printed trillions of dollars in stimulus. I don't want to make it sound like it wasn't warranted. Obviously, the economy and the market needed that. When we were back in March, April, and May of last year, the world was a much different place at that point in time. The Fed balance sheet is now about to exceed a trillion dollars. That's a lot of money. Again, there's a very real concern that all this money printing is going to damage the status of the dollar, and it's going to lead to inflation. However, when you look at the banking system, there's some things going on that that might lead you to believe different. Think back to the financial crisis. It really all goes back to the financial crisis coming out of 2007, 2008, and 2009.
Regulators forced banks to become far more regulated and far more responsible with their lending. So, there's a lot of constraints on banks to do things like keep capital ratios in line and lend much more responsibly than they were prior. All of this liquidity has been pumped into the system, but I don't think that there's a robust enough lending environment to lead to that money being recirculated, lent out and ultimately leading to a much more robust demand for loans, lending, and spending.
Instead, a lot of that money that has been printed is trapped in the financial system, either in the form of bank balance sheets or investing in things like Treasury bills or even in the personal side of things. I don't think it's a coincidence that you're seeing elevated valuations in everything from investment grade corporate bonds to plain old vanilla, large cap equities. There’s something to that. All of this liquidity sloshing around in the system has perhaps manufactured asset price inflation because of the nature of it being saved, recycled, and invested versus being lent over and creating economic inflation.
Jarett
That makes sense. Maybe we transition from here: what are the key indicators or measures? I think bank lending is one of them. You explained that. What are other things that you look at when you're sniffing out inflation? And what would cause you concern that this is not a transitory process, but that it's longer term?
Brandon
Yes, I think you nailed it there. Bank lending is one thing that we're watching pretty closely. Again, not to take it too technical, but the velocity of money, a measure of how many times a dollar gets lent and re-lent, is specifically the thing that we're keeping an eye on. That's at effectively all-time lows today. We're keeping an eye on that. If that were to increase, it might be a sign that some of this is easing. Another thing to think about from a longer-term perspective of an economist is that I try to always separate myself from the near-term noise.
Jarett
Which means the headlines and everything that's in the media?
Brandon
Absolutely. One piece of economic data in and of itself is almost meaningless. What we're trying to do is take a step back and try to see the forest instead of the trees, per se. One thing that has historically led to faster inflation, which we've referenced it back with the 70s and 80s conversation, is an environment where demand is sustainably increasing. I call it the “speed limit” of economic growth. If you think about it, it's generally population growth plus productivity equals how fast or slow the economy should be growing long term. Any sustainable increase above that speed limit, to use the analogy, generally lends itself to the economy getting a “ticket” in the form of inflation. For us, we're really thinking about what would cause that speed limit to increase or what would cause the economy on a longer-term, sustainable, secular basis to grow much more quickly than is implied by that measure? It's hard to think of something that would change the game that much. We talked about debt levels. Debt levels were high coming out of the financial crisis. If anything, they've been greatly exacerbated, and the nature of the last recession was so unique. Recessions are painful because they purge the economy of excesses. They purge the economy of companies that are unprofitable. None of that happened with the government’s covid response. If anything, we piled more debt into companies that perhaps are struggling in order to keep them afloat. All of those combine to probably lowering the speed limit, instead of increasing it. The velocity of money in this concept of the speed limit of economic growth are things that we're very much thinking about for signs that the game has changed.
Jarett
I think what's helpful about what you say there and lends itself to our process is that we take a mosaic approach, which is a term that's been used in the past. It's not just one indicator. I find some of the folly in the financial media when they take one indicator that looks really scary and then expand a whole article on it, which puts that out there for people to read and get really concerned about.
Brandon
The most dangerous headlines that I read are the ones that say “the worst ____ since ____”. Oftentimes, it's the worst consumption since two months ago. It's a way to sensationalize things. And again, one isolated economic data point is in and of itself almost meaningless. You really have to take a step back and think about the trend instead of just worrying about a single data point. People don't always realize that underneath the economic data are estimates, seasonal adjustments, revisions, and things like GDP that we get that move the market. They get heavily revised and often change. What moves the market is the initial release. It's nothing more than an estimate. So, be careful with the headlines with one piece of economic data. Take a step back. Think about the longer term and, again, the mosaic of data. Are things getting better or worse from a long-term perspective? Has the story changed? That's really how we try to think about things.
Jarett
Let's talk about investments. As consumers, we hate to see prices go up on the things that we consume, and we buy. We like to see that remain steady or maybe go down. However, on the ownership side and on the asset side, we love to see the things that we own go up in value: our homes, the stocks we own, the bonds we own. Is the market indicating that it is concerned about inflation right now?
Brandon
It certainly wouldn't seem so.
Jarett
What is the market saying about this topic?
Brandon
If you look at bond yields, while they have increased pretty significantly from the middle of last year, but the ten year US Treasury yield is sub two percent. That's certainly not an indicator that the market believes inflation over the next ten years is going to be very high.
Jarett
And we've seen those yields higher in years prior in a non-inflation concerned environment.
Brandon
You're exactly right. There are a lot of signs, at least in the bond market, that the inflation we're seeing is short term, instead of more long term in nature. Even in the equity market, the mechanics of how a stream of cash flows is valued depends heavily on the level of interest rates. To put things simply, if there were concerns that inflation would be rising significantly, and thereby interest rates would be rising, equity multiples, at least historically, would be coming down. Instead, we are still in this environment where, if you look at the valuation and the equity market, it's not what I want to call it stretched, but it's elevated. Some of that makes sense as earnings have rebounded very strongly and quickly. Some could be justified, and some may be a sign of enthusiasm in the equity market. I would say overall that the market is not behaving as though it's afraid of a hyperinflationary or sustainable higher inflation environment.
Jarett
So I think our general opinion is that this is more transitory inflation. It's not the secular inflationary trend of the 1970s, early 1980s. But what if we're wrong? In the portfolios that we manage, how are our clients being protected from inflation and can they actually benefit from it?
Brandon
We get a lot of questions about explicit ways to hedge against inflation. For example, things like TIPS (Treasury Inflation-Protected Securities) or commodities. Our general thinking is that a lot of those things have almost over-anticipated inflation at this point. Another way to say that is valuation in those explicit inflation hedges is pretty expensive. So, for the most part, we've avoided putting those types of things into asset allocations.
Jarett
Have you seen prices ease in some of the commodity complex?
Brandon
Yes, we talked about some things like the lumber and corn and some industrial metals on a select basis that have eased a little bit, but certainly not enough to be thinking this is a really attractive entry point there. Those are the explicit inflation hedges. There are some implicit asset classes that do benefit from a modest inflation environment. Things like equities generally rise as prices rise. There's a sweet spot here. If we get a little bit of inflation, corporate earnings tend to follow. That's a good thing for earnings, which in turn tends to be a good thing for the stock market. Inherently, the stock market is somewhat of a hedge to inflation to a point. If inflation were to cross the threshold, that's not good for equities. To take it to other, alternative areas, things like real estate or REITs tend to benefit from modestly rising inflation. Even infrastructure, which we've included in the portfolio, tends to do well as well. So, again, we are kind of avoiding the explicit inflation hedges because of the over anticipation of inflation. However, portfolios should be put together with some implicit things that do stand to benefit should the inflation environment be a little bit more persistent than what we're ultimately forecasting.
Jarett
Let's put a bow on things as you like to say. Maybe summarize your thoughts and package it together. If this is transitory, do you have any general sense of a timeframe?
Brandon
It’s hard to tell exactly. I do think there are some clues that later on this year, there are some restraints to some of the activity that we're seeing. So naturally this burst in consumer demand, I think will abate. Think of things like vacations and restaurant meals and concerts. Everyone wants to do those things now.
I use the analogy of a haircut. If you didn't get a haircut for six months, you don't then go get six haircuts. You get one and then you've satisfied the demand for that haircut unless your hair grows really fast. So, I don't necessarily think that this demand environment is going to continue to persist, especially as we get into the later months of this year. Additionally, we haven't talked about this, but the prospect of potentially higher taxes coming later this year or early next could act as an additional inhibitor or governor to economic growth. Then there’s the Fed policy. We've been nothing but easing for the better part of the past 12 or 18 months, but you're starting to hear some chatter from the Fed that they're talking about tapering. However, you can't talk about it until you've talked about tapering. We think that the Fed is gradually inching in the direction of potentially tightening monetary policy, which all of that would lead us to believe in the latter part of this year or early part of next, things are going to start settling down to what we would call a more normal economic growth environment.
So, to kind of put a bow on it, I would say really resist the urge to extrapolate what's going on in this very disrupted, very unusual, and strange environment to persist forever. This is highly unusual. Last March was highly unusual. This year is highly unusual as well. What we're seeking to do is find the middle ground. Where does the economy settle down ultimately? In the meantime, we are scrutinizing and studying and collaborating to try to figure out has that story changed? That's all we can do.
Jarett
And ultimately, if that's true, that will play into client portfolios. Those are things that will be addressed along the way with our portfolio management.
Brandon
Without question.
Jarett
Well, Brandon, thank you so much for your time and lending the expertise. I enjoy these conversations because I always learn a lot, and we hope that you have as well. Again, our goal here is to bring about peace of mind on this topic. If you have any questions or anything that you would like to ask, feel free. Always pick up the phone and give us a call. We're happy to have those conversations and be able to provide perspective along the way.
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