This is the “extra late edition” of the “Macro Monday” column published Monday afternoon on Margin of Safety Investing.
Inflation is always and everywhere a monetary phenomenon.
– Milton Friedman
There are multiple factors and scenarios that could play out in the short term regarding the economy and markets. The intersection of oil, inflation, trade and Fed policy is set to determine the direction both go.
Ultimately, I believe that the tipping factor will be what the Fed decides to do in coming quarters. Too firm a policy will likely tilt the economy into recession and cause a bear market in stocks.
The two places to be overweight with our money is in cash and in certain energy investments that have firming fundamentals.
Inflation In America
By definition, inflation occurs when money is added to the money supply above the demand for money and generally when it causes an increase in the amount of money per capita. At least that’s my exam answer definition.
Consider that if money is “printed” into an economy, if the population is increasing, then there is some natural demand for more money. So, there is a natural amount of additional money supply needed from year to year.
If the money supply grows more than the demand from the population requires, then we will generally get inflation in prices.
In the past decade though, inflation in the prices of goods and services, and especially wages, has remained subdued in America despite massive amounts of Quantitative Easing (QE). This is similar to the experience in Japan and Europe as well. Why?
There are certainly several reasons. And we should think about this in light of the fact that asset prices have increased substantially.
The first reason is that the population of the United States has aged. People in retirement spend less than those working and raising families. This has put a crimp in demand for goods and services. With that crimping came a reduction in the velocity of money.
As we can see from this chart, the older age population is rising rapidly and there is a direct correlation to the velocity of money. Simply put, even though money supply increased, it’s not moving through the economy in a way that is driving prices of goods and services up.
Where we are seeing inflation, as I noted already, is in asset prices. Also, we are seeing inflation in healthcare, which makes some logical sense since not only is the population aging on the whole, but also the Millennial generation just started making babies.
Oil And The Trump Tax Cut
I have argued on several occasions that the main transitory factor suppressing inflation was the low price of oil the past few years. The oil price collapse acted as a defacto tax cut and enabled consumers to spend more than they otherwise would have.
Even with that “tax cut” inflation remained low. In my opinion, low oil prices prevented a shallow recession in the 2015-2016 time frame. Now that oil prices are rising, the impact on spending could put a dent in consumer spending.
To the rescue could be the Trump Tax Cut. The extra few dollars per week in employee wages from lower tax withholding should mostly offset the more expensive gasoline and diesel costs to the economy – if, in fact, I’m right about the “Oil Price’s Goldilocks” level getting to and staying around $80 per barrel.
The IMF studied the impact of oil on inflation in a report aptly titled: Oil Prices and Inflation Dynamics: Evidence from Advanced and Developing Economies. In it they observed that “a 10 percent increase in global oil inflation increases, on average, domestic inflation by about 0.4 percentage point on impact, with the effect vanishing after two years and being similar between advanced and developing economies. We also find that the effect is asymmetric, with positive oil price shocks having a larger effect than negative ones. The impact of oil price shocks, however, has declined over time due in large part to a better conduct of monetary policy.”
I would argue that the aging demographics, global debt (which is now at a record high again) is a larger factor on keeping inflation from rising the full .4% with each 10% increase in oil price. I think the past few years demonstrates that as the price of oil has plunged and then rebounded as there has been barely a budge of inflation despite a tightening labor market.
What this all points to of course is that the “slow growth forever” scenario based upon demographics, debt and technology is very real. Read these pieces for the big picture on why economic growth will be subdued a very long time.
In addition to the above, let’s not forget the impact that a trade war could have on economic growth and inflation. That is a known “black swan” at this point. I believe things will work out on the trade front as I described in:
It is important to keep in mind that if imports increase in price by any significant amount, that would drive inflation up on goods and service, and likely take away from asset price inflation. So, there is a trade off if there are unintended consequences from trade policy.
Could The Fed Tip America Into Stagflation
The scenario I am most concerned about is that I believe The Fed Is Making 2 Huge Mistakes that could slow down the economy. As I covered, I believe the Fed should stop raising interest rates and freeze the level of bonds being retired from the Fed balance sheet month to month.
If oil and a trade war also cause inflation into a slowing economy, then we would get the nightmare of stagflation. Let me stop here and say, I don’t think stagflation is likely, however, it is a possibility that should not be taken lightly.
In order to avoid stagflation, the first thing we need to ensure is that growth continues for the next few years. There’s no sure thing no matter what, but tightening up liquidity into “slow growth forever” factors is dicey at this point in the very mature economic expansion.
The Fed is seeking a soft landing, however, I do not believe based upon Chairman Powell’s testimony and first Fed statement that he fully grasps the “slow growth forever” reality.
Neel Kashkari, Minneapolis Fed President, whom I cited several times in the “2 Huge Mistakes” article has given several statements in the past week that the flattening yield curve is a “sign of caution.” In response, he said the bond market has “a yellow light flashing.“
The flattening yield curve is a bit surprising given the rolling off of the Fed balance sheet, suggested Kashkari. That would mean that the neutral interest rate is likely upon us or very nearly there.
I would suggest that the markets simply don’t care about the Fed balance sheet anymore than I do, which is very little. To me, when the next normal-ish recession comes, normal-ish policy, particularly fiscal policy will help smooth that out. I also believe that when, not if, the next crisis comes, helicopter money will become necessary (more on that soon).
So, the takeaway I have is that the Fed ought to slow down and let the economy play out a bit. If there is no trade war, oil finds Goldilocks and global growth continues around 3.9% as projected by the IMF, then the Fed can resume a bit of tightening. Until then, they ought to stand pat.
Where To Invest
I stand by the idea that investors ought to be overweight in two areas, cash holdings and energy-related investments, both in the 15-25% range for asset allocation.
Extra cash of course gives investors two things. First, more safety. Right now, with high valuations in general and the discussed uncertainties, this is the ideal time to increase cash holdings as discussed in The Intelligent Investor by Ben Graham – Warren Buffett’s mentor.
Second, extra cash gives an investor optionality to buy cheap assets as opportunities happen. This is the basic be prepared to “strike when the iron is hot” idea. I have already suggested that Millennials have an opportunity to save cash in preparation for a great investment opportunity in coming years – they should be hoping the next recession and stock market crash holds off for another year or two or three so they can save more cash.
That is not market timing. It is a realization that much of the stock market is overvalued and not worth owning right now, especially given uncertainties in oil, trade and at the Fed.
I have on several occasions, including way back last July in XLE And XOP: Comparing 2 Popular SPDR Oil Stock ETFs, recommended buying the SPDR S&P Oil and Gas Exploration and Production ETF (XOP).
Just this week at the Sohn Investment Conference, none other than Jeffrey Gundlach of Doubleline revealed he is long the fund. The falling oil inventories, firm economy he cited and value prices in U.S. oil producers must have caught his attention too.
Sign up for a free trial before the end of April to try Margin of Safety Investing on for size. The free trials go away come May flowers.
Disclosure: I am/we are long XOP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own a registered investment advisory but publish separately from that entity for self-directed investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.