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Inflation: Demand Destruction and Wealth Erosion Trump Money Growth

A major logical error that humans can make is to draw a conclusion from an observation without considering the bigger picture.  These days, as folks can clearly see a rise in money supply and deficit spending by the federal government, they quickly jump to the conclusion that we are headed for rampant inflation, with many invoking analogies to Zimbabwe or post WWI Germany.  While we could certainly be setting up for an inflationary period once we get through this economic crisis, I believe that it is extremely premature to bet that way.

When one looks at recent money supply growth, it has indeed been strong.  I say thank God!  It is one of the natural responses of the Federal Reserve to counter the prevailing deflationary headwinds.  As you can see in the chart below, the year-over-year growth is about 10%.  While this level is high, it is in no way a major aberration.

This is a pretty long-term chart, and it is clear that similar spikes over the past 28 years (when the data starts, at least on my source) haven't led to high levels of inflation.  I believe that a look at nominal GDP helps explain the issue as well.  Most of the spikes in growth in the money supply occur as the GDP is decelerating, as it is now.  I would argue, though, that this time is indeed very different.  Not only is GDP in quarterly and soon annual decline (here and around the world), but we have had enormous destruction of wealth, including equity, debt and real estate values as well as many other types of assets from commodities to fine art.  Below are the levels rather than the growth rates:

Several observations:

• M2 and Nominal GDP have tracked well over the longer-term
• CPI (and Core CPI) have been consistently lower (real growth is the difference)
• Folks are concerned about a $700 billion increase in M2 over the past year

There are several things going on that I believe those who fear inflation don't fully incorporate, including the velocity of money and the destruction of wealth and diminishment of credit.  The absolute dollars of wealth destruction and credit contraction significantly outweigh the expansionary potential of the money supply's recent growth.  The irony is that the government isn't doing (and can't do) enough to stop this downward spiral.  Those who fear inflation imminently seem to have confidence that they can somehow stave off what I expect will be a year of GDP growth lower than -5%.

I have been in the "no inflation" since June, a time that wasn't exactly as easy to say that in my opinion as now.  I have shared my thoughts about the impossibility of getting out of this mess by "saving and spending simultaneously".  Clearly, spending will be muted for quite some time.  Government spending and debt creation will be more than offset by less spending and debt creation by individuals, companies and state/local governments.

One final chart.  I wish I had data going back further, but, quite frankly, I would perhaps question the quality and relevance.  Still, this period had some very high inflation at times, but note that it always occurred with strong economic growth.  While we can have weak economic growth with above-average inflation (stagflation), I don't see a single example of an "inflationary recession".  I conclude that many believe that the patient is going to die from the chemo, while I am worried that the chemo won't stop the cancer.  To bet on inflation is to bet that the government can revive the GDP at a time that spending pressures will be intense on the consumer and on businesses and our export growth will be swinging from +10% to -10%.  Additionally, state and local governments and not-for-profits will face tighter budgets as well.  The growth in the money supply and the expansion of the federal spending are clearly observable, but I recommend that investors consider that they aren't even sufficient to offset the headwinds that we clearly face. There will be a time for inflation, but it is down the road after considerable excess capacity has been wiped out around the world and our savings rate has returned to sustainable levels.

Disclosure:  None

Data Distortion: Retail Sales Plunged!

Complete and utter shock yesterday morning when Retail Sales rose 1% instead of declining 0.8%.  Let's put this into perspective:

• These are seasonally adjusted numbers
• The government statisticians put them together
• They are highly revised

• A little perspective - this was a monthly change (annual decline was 9.7%)

Here is a chart of the data series since inception.  Notice anything that looks bullish?

This chart is log-scale, so there aren't any optical illusions here.  The decline has been unprecedented.  Another way of looking at it is through the annual rate of change.  In the last recession (after 9/11), the series never really even went negative.  For anyone who thinks this is just a blip, take a look:

 

So, I have to conclude that the "jump" yesterday was noise at best.  These declines aren't restricted to our country, and they cross all sorts of categories that many seem to be finding somewhat surprising (PG, KFT, etc.).  Buckle up, as the comps are going to be tough for a few more months.  We had lots of years of above-trend growth (thanks to the piggy-bank effect of home equity extraction and the belief that savings aren't important), and we should expect years of slow/no/whoa.  As I wrote in December, we can't "save and spend" our way out of this.

Disclosure:  None 

Evaporating Exports: More Headwinds

Yesterday's improvement in the trade deficit to $40 billion from $57 billion a year ago would seem to be good news. Alas, it isn't, as it is being driven by a decline in exports.  Year-over-year, the decline in exports accounts for 70% of the improvement.  Of course, lower energy costs have helped on the import side.  We have enjoyed an export boom, with growth in excess of 10% for the past 5 years.  It is over, though:

In the past 4 months, exports have declined by 21%, which annualizes to 47%.  Year-over-year growth in December was -8.5%.  The level of exports has reverted back to what we last experienced in May 2007.  We have some very tough comps ahead, and it isn't difficult to see that we will most likely endure a full year decline in excess of 10%.  This will create additional drag on the U.S. economy, especially given that it has been a source of strength for the past many years.

Disclosure:  None

Prepare for a 1mm Monthly Payroll Decline

When it comes to the over and under on unemployment, I'll take the over.  As I conveyed in January when I discussed some of the implications of a shrinking global economy, I believe it is a foregone conclusion that the rate of unemployment will climb towards 10% this year, but I am sticking to my suggestion that it actually hits 11-12%.  In terms of job loss, this implies that we will lose a total of 5-6mm jobs, or an average of about 500K per month.  Given that this process should be front-loaded to a great degree, we run the risk of a record monthly decline of 1mm jobs.  The forecast for January is for a decline of 500K.  I have no clue if it will be this month or next, but I don't think the market or our collective confidence are prepared for a headline like that. 

A few caveats:

• I am not an economist.  I have no fancy models, but I have been following the data closely now for 23 years
• The data is subject to revisions and new benchmarking and has substantial statistical margins of error

I see several factors suggesting a watershed event like a 1mm monthly job loss.

• Pent-up Supply of Pink Slips
• The Small Business Effect
• The Cycling of the Numbers
• Historical Precedent

I had a thesis last year that proved correct initially but that ultimately failed as the economy went over the cliff.  Looking back at the very tough times companies had finding qualified labor after they drastically cut payrolls following 9/11, I had expected that they would be very reticent to lay off during this downturn.  This proved to be the case until the fall.  While it's not especially clear in the chart below over the past 50 years, it wasn't until September that we had a monthly decline in excess of 127K.  The declines in the first 8 months of the year, well into the official "recession" that has now been dated, were, in fact, stunningly low.  Of course, the floodgates opened late in the year, and we have been running at a torrid pace now for what will be the 5th consecutive month.  I believe that we are seeing a proverbial throwing in of the towel by large companies who are in the process of evaluating the new economic environment and abandoning their desire to carry their workforce through the downturn.

 

When we read the papers or listen to the news, it is quite evident that large companies are laying off workers en masse.  A more subtle trend to detect is what the even larger overall employment providers, small and medium sized businesses, are doing.  I have encountered several anecdotal signs of a rapid retrenchment, and it makes sense.  As smaller companies see pressure on sales and margins, the owner is able to manage costs by working harder.  Additionally, spouses, family or friends who become unemployed or underemployed can help pick up the slack as the owner cuts the payroll.  Shrinking credit availability isn't helping make it any easier for these smaller businesses to hang onto employees.

As I mentioned above, I expect to see a total job loss of about 6mm this year, which equates to 500k per month or a continuation of the trend of the past 3 months as well as the expectation for this month.  I assume that a lot of this will be front-loaded and expect that at least half of the losses will occur in the first 4 months of the year, suggesting that the average will be 750k per month through April.  If the economists forecasting "just" 500k hit it right this month, that suggests the average over the next three months would be about 850K.  Clearly, we could hit 1mm in one of those months.  While we are hearing of the massive layoff announcements, it is hard to predict when they actually hit.  It would seem that the biggest headline risk would be in February.

My final basis for being open-minded regarding the potential for a month of 1mm jobs lost is looking at it as a percentage of the base rather than an absolute number.  In the chart above, we had an increase of 1.1mm jobs in September, 1983.  The largest decreases over the past 50 years have been 602K in December, 1974 and the recent 584K in November.  If, however, one looks at the data as a percentage of the base of employed non-farm workers, it is clear that there is precedent for a higher number.  There have been two instances of gains in excess of 1%, while there have been several instances of losses of .5% or more.  If one takes the current base of 135mm and assumes a 0.8% decline (like the worst print in 1974), we would see a loss of almost 1.1mm jobs.

 

The rapidly deteriorating employment situation is so powerful that it will be creating a negative feedback loop that will adversely impact the overall economy.  Many of our safety net programs are funded via payroll taxes (Social Security, Medicare) or through corporate payments to state governments (unemployment insurance).  Income taxes will also be impacted.  At the same time that government income is threatened, demand for services will be escalating.  As you can see in the chart below, the duration of unemployment has been increasingly longer and for more extended periods for quite some time, and we are risking leaving a large segment of our population as permanently unemployable.   The statistics cover up another ugly truth:  Many folks are underemployed.  We are beginning to see downward pressure on wages as well, and clearly the workweek is shrinking.  Clearly, consumption will be pressured for quite some time as unemployment rises and incomes stagnate due to either wages falling or fewer hours worked.

The government can do very little to change the trends now firmly in place.  In the long run, it is crucial that we retrain those workers who no longer are able to work using the skills that they have acquired, but this takes a long time.  While it makes little sense to keep people on the job when the job isn't economically justifiable, it seems like many of the job losses in the coming year will be from viable companies just scaling back for an extremely weak economy.  It may make sense for the government to promote job retention by subsidizing it.  An easy way to do this would be to eliminate employer contributions to SS and Medicare, which would effectively lower the marginal cost of keeping employees.  Similarly, the government might consider subsidizing unemployment insurance and worker's compensation insurance that is paid by employers to the states.  These programs would effectively pay for themselves to the extent that they reduced the loss of payroll (employee contribution) and income taxes and served to improve corporate cashflows. 

While I could be wrong about actually getting a print of 1mm jobs lost in a single month, I think that the odds are pretty strong.  This economy is the worst since the 30s, and the data indicates that the monthly employment change can drop by as much as 0.8% in a given single month.  The more important issue is to understand that the deferral of layoffs last year will result in a continued near-term assault on the workforce.  The economic implications are extremely negative.  Until the market begins to better understand that unemployment will move into the double-digits, stocks are most likely not properly discounting the risks to even lower earnings.

Disclosure:  None

Fears of Inflation are Inflated

It wasn't that long ago that everyone was worried about deflation.  Now, with soaring commodity prices, especially the ones that are visible to consumers, the pendulum has swung the other way.  There is a mistaken assumption out there that commodity prices somehow influence the overall level of prices.  A look at historical data, though, shows that it just isn't necessarily the case:

Yes, it is true that the spikes in oil in the 70s did lead to inflation, but it was A cause not necessarily THE cause.   Clearly, our economy, which is so much more service-oriented than three decades ago, is less vulnerable to material costs. What's the big swing factor these days?  The cost of labor, which isn't budging:

Wages were a big big problem in prior inflationary periods, but there are absolutely no signs of wage inflation.  Don't believe me?  Try this:  Ask your boss for a pay hike, telling him or her that you need more money to pay for gasoline and food.  Please let me know how that goes.  Good luck with that.

There are several other things that encourage me on the inflation front.  Gold prices, usually a harbinger of inflation, are quite behaved:

Recall that in the early 70s, gold was allowed to float on the free market after having been set at a fixed price of $35.  Since peaking in March above $1000, gold has actually pulled back over 12%.  The dollar?  It has rallied sharply relative to the Yen and the Euro lately.  The Treasury market?  No signs of problems yet (4.5% 10yr would worry me):

When I was bearish earlier this year, I was concerned that the dollar would be the sacrificial lamb as the FED cut rates indefinitely.  Bernanke et al appears to be signalling that easing is done, and the dollar has responded quite well (108 yen after touching 96 in March, .65 Euro after touching .625 in April).

Hey, it's easy to be concerned about inflation when certain components are so obvious, but a deeper consideration of the facts shows that there is much more to the picture than the price of oil.  The dollar, interest rates and gold are all saying not to worry, and the real issue appears to be the potential for wage inflation (no sign at all for now).  I believe that the concern about inflation in the market is creating an opportunity not only in stocks, but also bonds.  I manage a foundation that is benchmarked against a blended index:  60% S&P 500 and 40% Lehman Aggregate Bond.  I have maintained my minimum exposure to bonds all year (10%), though I am considering moving some of the 15% currently in cash back into the bond market.

Disclosure:  None, though all of my holdings are posted to my website.

Consumer Confidence Plunges: Buy!

Falling consumer confidence tends to lead to a falling stock market, but once it is "low", it tends to signal a buy opportunity.  Take a look at the 30 year history of the Consumer Confidence Index.  You will see that yesterday's print of 57.2 is the lowest level since the early 90s and represents a decline of over 42% from a year ago.

The top panel is the index itself.  The middle panel is the one-year percentage change in the S&P 500.  It seems pretty clear to me that a year after a spike down in confidence, stocks have offered positive returns.  Note that the last big drop occurred after the bottom of the bear market bottom in late 2002.  Confidence was weak in the early 90s, but note that returns were positive shortly after the indicator first breached 60.  Looking back at the early 80s, confidence plunged in 1980 but didn't seem to hurt the market.  As the indicator fell in 1982, the market was crunched.  While I don't think we are sowing the seeds again for the greatest bull market in our lifetime (1982-2000), we all know that 1982 turned out to be a great time to buy.

I put the last panel on the chart to show how useless the index is:  It repeats the obvious.  Note the high correlation between the 1 year change in stock prices and the 1 year change in confidence.  Is it surprising that people lose confidence when stocks are declining?  It's not a perfect fit and certainly not the only factor to explain consumer sentiment, but stocks are a great leading indicator.