Mike Lipper’s Monday Morning Musings
Debt, Inflation, and Markets
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
I. The Changing Value and Price of Money
As is often the case, when we speak of purchasing a good or service, we mention its cost in our local currency. We don’t view the purchase in terms of unrelated transactions, like a vacation vs. a month’s rent. If we were more intellectually rigorous, we would calibrate the purchase in terms of inflation and currency exchange rates. For those whose wealth is totally used up by spending, this thinking is understandable. However, for those who have savings/investments, this singular way of thinking reduces future wealth and spending power.
With the above predicate, all savers/investors should focus on prices and inflation. An agreed price is the result of supply meeting demand and the costs incurred in the present or future. As in a gunfight, don’t show up with only a knife. For serious purchases, don’t bargain without insight into the history of prices. In the modern world, where services are the largest part of an economy, we have difficulty grasping the costs driving prices. For manufactured goods, the costs of raw materials and industrial goods play a dominate role, excluding the cost of labor. That is why I pay attention to the weekly reading of JOC-ECRI Industrial Price Index, which saw a price rise of +44.83% year over year. Part of the price explosion is due to capital expenditures not keeping up with demand. For example, Goldman Sachs is warning of a copper scarcity in the coming months, leading to the largest deficit in ten years. A somewhat similar situation is occurring in the oil patch.
In analyzing inflation, it is useful to recognize who benefits, who hedges and who loses. The pure benefactors of rising inflation are the relatively few that gain from rising prices, due to it being the sole input to their financial well-being. Most people have a mix of prices received and prices paid. Some are naturally balanced, while others hedge offsets. Non-savers/investors who consume all their income are clear losers, as the losses created by the declining value of a currency are the equivalent of a tax.
The motivations of the Federal government are mixed. When governments pay off their debts with inflated dollars, they net the difference between the purchasing power of the dollar and its contractual payment value. In addition, personal income tax payments rise on the inflated income. (Since corporations pay taxes on their pretax income, which may be offset by inflated costs, their pain of inflation is less.)
From a political vantage point, the financial problems of the non-saving poor are intensified. However, for some politicians this problem has a “silver” lining, it encourages the redistribution of wealth through the socialization of the concern. In a healthy economy, increases in productivity often create gains that offset the pain of inflation, but US redistribution also leads to increases in jobs overseas and makes international investing more attractive. (The difference between international and global investing is that international investing excludes the home country, which global does not.)
Most investors ignore declines in purchasing power due to currency depreciation or inflation, if they are small. Due to current conditions and global political leadership, it may be prudent to adjust investments.
II. Breaking the “Bubble” Ahead?
Since the beginning of recorded history we have dealt with seasonal cycles and those that last longer. Trading markets adjust due to the relative strength of buyers and sellers, thus markets have they own cycles. Economic and market cycles do not always coincide, and when they don’t coincide the amplitude of the cycles is more limited. As long-term investors, we therefore need to examine the probability of the next declining phase, both in terms of economic and market cycles. In analyzing cycles it is useful to look at elements the popular media and marketers can spout quickly. You should also look for structural changes that can cause the foundation of the cycle to weaken to a point where it collapses. What are the signs I see?
Economic Structural Issues
Debt is a major accelerator of most economic collapses, distinct from those primarily caused by political, medical, or climate changes. Debt is already growing much faster than the economy, even before the full increase in debt at all levels of government globally is disclosed. Normally, the banking system controls the policing of debt. However, significant debt is being extended by non-bank credit groups in many countries, including China and the US. The problem with debt is that it replaces equity for temporary uses and speculative purposes, solving short-term needs, but doing little to generate long-term investment. While China and some other countries are spending on infrastructure to produce longer-term economic gains, it is not happening in the US. While both the past and current administration have discussed infrastructure programs, the private sector has not indicated a willingness to provide substantial equity. We don’t seem willing to get little or no cash return for a number of years, before the supposed gusher of profits arrive.
The steepening of the yield curve may be capturing this reluctance. There is great competition to supply short-term funds for margin debt and short-sales by brokerage firms and banks. Bank money market account interest rates dropped below 10 basis points this week, indicating banks have no need to attract new deposits to make additional loans, driving the front end of the yield curve even lower. On the other hand, interest rates at the long end of the curve are now higher than they were last year. One should remember that the published yield curve is for US Treasury paper and long rates for perceived lesser credit should be higher. This drives up the costs of long-term equity dollars, making them scarcer.
This week’s weather in Texas and the Midwest shows the need for much more capital spending on local infrastructure and power generation. The purported growth of electric vehicles will also shift energy needs from oil to natural gas, which should economically be distributed through pipelines, contrary to the present government’s wishes. The combination of new regulation and higher taxes means that many energy facilities will be taken off-line. Fitch believes the removal of these units for economic production will reduce the earnings of the energy companies, which in turn will lead to lower credit ratings that drive up their capital costs. Beyond the energy sector, the expected jump in taxes and regulation will reduce the ability of industry and individuals to generate capital for spending and investment.
Stock Market Structural Changes
Most of the time money follows performance. In the week ended Thursday, an index of the large S&P 500 index funds gained +4.47%. Five other equity fund indices were up at least twice as much:
Lipper Small Cap Value +13.13%
Lipper Pacific Ex Japan +13.10%
Lipper Global Natural Resources +11.66%
Lipper Science & Tech +11.48%
Lipper Financial Services +10.05%
There is no common denominator in the five leading groups, except they are not primarily large companies and the leading tech companies have less influence of in the portfolios of the largest funds.
The cash positions of many of the leading institutional investors are near a historic lows and the new speculators are heavy users of margin. The American Association of Individual Investors (AAII) weekly sample survey of bearish sentiment for the next six months has dropped 10.2% (25.4% vs 35.6%) in the last three weeks, with an almost concomitant rise in bullish sentiment (47.1% vs 37.4%). Professional market analysts view these as contrarian indicators and the combination of the three sentiment indicators could be significant.
Investment Conclusion
Rising stock markets have a habit of lasting longer than when structural problems are present, staying “bullish” until something changes mass opinion. I would use this enthusiasm to raise this year’s cash needs. I expect within two years we will have an opportunity to buy valuable investments with more knowledge and at better prices.
Important Note:
I always want to hear from our subscribers, but I particularly appreciate hearing from subscribers that can correct or disagree with what I have written. That is how I learn to do a better job. In response to last week’s blog, a long-time subscriber and investment professional with non-Us experience, correctly noted that the Declaration of War between Germany and the US was declared by Germany a few days after the December 7th attack on Pearl Harbor. It was followed by the US declaring war on Germany in a reciprocal move. This re-enforces my view that the main impact of an action is often the reactions of others to the event. In this case, if the move by the Germans was to support Japan, it had a different impact on both, as well as the US. In terms of Germany and the US, it led to a two-front war waged by the US, with the political decision to primarily focus on the European War. This in turn gave more force to the industrial mobilization of the US, which probably shortened the overall war effort, leading to the surrender of both Japan and Germany. One should think through the reactions of others to the moves you make.
Question of the Week: What is the worst for which you are prepared?
Did you miss my blog last week? Click here to read.
https://mikelipper.blogspot.com/2021/02/mike-lippers-monday-morning-musings.html
https://mikelipper.blogspot.com/2021/02/adjust-investment-tools-for-next-phase.html
https://mikelipper.blogspot.com/2021/01/is-gamestop-missing-event-weekly-blog.html
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