This paper is fairly technical, my apologies. Additionally, there is content that you may find alarming. It is not there to scare you because this could be a long way off. It is meant to bring things to forefront as we navigate high asset prices and may leave gains on table in the short run because of “irrational exuberance” (Greenspan in 1996)
Inflation and interest rates are getting the headlines while the stock market continues to rise. Inflation has been sticky, but I do not see it accelerating much from here. Commodities have taken off over the last 60 days with gold and silver catching front-page press. I have mentioned that for inflation to meet the Fed targets wage inflation must go well below the current 4% level. This still holds true but labor growth is set to weaken in the last part 0f 2024. The issue in this cycle has been labor supply, not demand. Job openings have declined markedly from COVID, slowing from 13 million to 9 million. Labor has exceeded supply for the last couple of years but that is eroding as more have reentered the workforce. (Search Civilian Labor Participation Rate)
Here is the issue – Headwinds are facing the consumer which represents about 70% of the economy. As the consumer becomes pinched, job openings will diminish further as supply continues to rise. The result will be higher unemployment. This is what will be needed to get inflation down to close to target levels. Credit card delinquencies are rising in conjunction with balances.
Finally, savings from the pandemic have all but vanished leaving little cushion for the average consumer.
Let us talk about money for a bit. This is the biggest long-term issue facing the US. I will not dive too deeply into the larger ramifications of the fiat money system, but I do want you to know why it is important and what has happened over the last 25 years.
There are three basic ways the Fed manages the economy.
- Interest rates – raising and lowering short term rates.
- Open market operations – expanding and contracting the money supply.
- Changing reserve requirements- making banks hold more in reserves restricting the bank from doing more lending.
The headlines have been when will the Fed lower rates. The only thing I will mention here is that moving rates around has a lagging effect on the economy. Rising rates are just now being felt in the economy and will be more so over the coming months. I expect more commercial loan defaults and potential bank failures.
Open Market Operations
Every dollar we print is associated with a dollar of debt just to be clear. There are four measures of money I will mention:
Monetary Base – Currency in circulation
Monetary Base Total – Currency in circulation and treasuries held in reserves. (Usually assets at commercial banks)
M1 – Monetary Base Total and all demand deposits and small savings
M2 – The broader money supply (include M1 plus time deposits and retail money market funds)
Monetary Base Currency – $ 2.3 trillion
Monetary Base Total – $ 5.8 trillion
M1 – $ 18 trillion
M2 – $ 21 trillion
Here is the important stuff! Currency has averaged about 7% growth since 1960 through 2024. Monetary base growth rate was about 6% until 2008. Since then, it has been about 13%. M1 and M2 growth rates have been about 7% (there were adjustments for money market funds and seasonality). GDP growth before adjustment for inflation (known as nominal GDP growth) has been about 6.4. This is not a coincidence by the way.
The monetary base total growth rate exceeding the long-term average was all quantitative easing. Printing money and issuing associated debt. In the period, 2008 through 2015 the monetary base had a 23% growth rate. It declined from 2015 to early 2020 and then from 2020 to 2022 another 23% annual growth rate. From 2008 until 2022, it was 13% compounded annually.
Now why is all of that important?
There are a couple of theories on modern monetary theory. There are primarily two different schools of thought. I am a monetarist. The other is a Keynesian approach. The former believes in managing the money supply and interest rates. The latter believes in fiscal policy – using government spending and taxation in conjunction with monetary policy.
The issue I have with the latter is that they are a bit freewheeling ever expanding the money supply and debt as needed as opposed to maintaining a balance. In addition, they resolve economic downturns by turning on the printing press whenever markets turn done and increase government spending. (The last 16 years) This builds up excesses and the markets are not allowed to adjust on their own. It creates ever increasing pressure after each rescue. This acting much like a pressure cooker.
The important part is inflation is and always will be a money supply issue. Shove enough money into system and it finds its way into the consumer and poof! Spending starts and you have inflation. This is where the Fed is behind the curve but only time will tell.
This is where the Fed is behind the curve but only time will tell.
The last point I will make here is we have a contracting M2. The last time M2 contracted like this was 1929. Today after 16 years of an economic boom, Americans are once again faced with a political elite that wants to monkey around with ever increasing rescues of economic cycles. It wants to raise taxes, restrict trade and ever-increasing fiscal stimulus (government spending). I did not include the Congressional Budget Office 10-year forecast. The problem is it has 10 years of consistently running deficits. Under current law and policies, the CBO projects the budget deficit will fall from $1.7 trillion to $1.5 trillion in 2024 before rising to $1.8 trillion in 2025 climbing to $2.6 trillion by 2034, amassing another $20 trillion in debt by 2034. Both parties are to blame. It is time to look back and remind us how it came to be, starting in 1929, when America got stuck on stupid.
What do we do from here? First, we always keep a level head knowing that markets can stay irrational longer than we think. The Fed and the politicians can keep the train running for a long time. Be aware of what is happening but not overreacting . Be mindful of valuations because in the end terrible downturns start from overpriced assets. Patience is particularly important.
I am not sure exactly where we fall in these scenarios except to say equites are not cheap and tech stocks have continued to rally. Now on a value basis tech is 1.4 times the value of the S & P 500. At its peak in 2000, it reached 2.8. It feels like 1999 and early 2000 where the NASDAQ was up close to 75% in 1999 and then moved another 36% higher in about 3 months to peak in March 2000. All that being said, some economists are equating this environment to the 1970s. Stagflation and ever rising interest rates cycles. No two periods are exactly alike, for sure. Enthusiasm for stocks, as represented by the percentage ownership of households, is still close to an all-time high. The peak in December 2021 was about 42% versus about 40% now. In 1969, it was 30% and in 2000 38%.
A decade plus of easy money have led investors to the idea of an ever-rising business cycle and no recessions. Though markets are off peak valuation levels. Conclude, there is room to run if the current thought on Fed policy is interest rate cuts and soft landing in 2024. Markets are pricing perfection on Fed policy.
Below are charts on valuations. They are pretty self-explanatory. In a recession, markets will be priced at lower valuations due to a contraction in earnings. Equites are set up for around a 30% downturn. (2025) What have we done? We hold cash!
I also believe that rates will drop (Fed policy) and the longer-term bond will get close to 3%. We want to hold more and longer maturity debt. I prefer treasuries. We will overweight bonds in the coming weeks.
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