Can the Fed keep a lid on inflation?

Jeremy Siegel, Wharton finance professor, says the Fed has poured a tremendous amount of money into the economy in response to the pandemic, which will eventually cause higher inflation. David Rosenberg of Rosenberg Research argues that velocity of money is declining and the US economy has a large output gap so inflation is unlikely to materialize.

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Both are right, just in different time frames.

Putting the cart before the horse

The velocity of money is simply the ratio of GDP to the money supply. Fluctuations in the velocity of money have more to do with fluctuations in GDP than in the money supply. If GDP recovers, so will the velocity of money. Equating velocity of money with inflation is putting the cart before the horse. Contractions in GDP coincide with low/negative inflation while rapid expansions in GDP are normally accompanied, after a lag, by rising inflation.

CPI & GDP

Money supply and interest rates

Inflation is likely to rise when consumption grows at a faster rate than output. Prices rise when supply is scarce — when we consume more than we produce. Interest rates play a key role in this.

Low interest rates mean cheap credit, making it easy for people to borrow and consume more than they earn. Low rates also boost the stock market, raising corporate earnings because of lower interest costs, but most importantly, raising earnings multiples as the cost of capital falls. Speculators also take advantage of low interest rates to leverage their investments, driving up prices.

S&P 500

In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.

Housing: Building Starts & Permits

Wealth effect

Higher stock and house prices create a wealth effect. Consumers are more ready to borrow and spend when they feel wealthier.

High interest rates, on the other hand, have the exact opposite effect. Credit is expensive and consumption falls. Speculation fades as stock earnings multiples fall and housing buyers are scarce.

Money supply is only a factor in inflation to the extent that it affects interest rates. There is also a lag between lower interest rates and rising consumption. It takes time for consumers and investors to rebuild confidence after an economic contraction.

The role of the Fed

Fed Chairman, William McChesney Martin, described the role of the Federal Reserve as:

“…..to take away the punch bowl just as the party gets going.”

In other words, to raise interest rates just as the economic recovery starts to build up steam — to avoid a build up of inflationary pressures.

The Fed’s mandate is to maintain stable prices but there are times, like the present, when their hands are tied.

Federal government debt is currently above 120% of GDP.

Federal Debt/GDP

GDP is likely to rise as the economy recovers but so is federal debt as the government injects more stimulus and embarks on an infrastructure program to lift the economy.

With federal debt at record levels of GDP, raising interest rates could blow the federal deficit wide open as the cost of servicing Treasury debt threatens to overtake tax revenues.

Conclusion

Inflation is likely to remain low until GDP recovers. But the need to maintain low interest rates — to support Treasury markets and keep a lid on the federal deficit — will then hamper the Fed’s ability to contain a buildup of inflationary pressure.

S&P 500 bubble risk

S&P 500 valuations are higher than the 1929 (Black Friday) Wall Street crash and the October 1987 (Black Monday) crash. The Dotcom bubble is the only time in the last 120 years that the ratio between Price and highest trailing earnings (PEmax) was higher.

S&P 500 PE of Highest Trailing Earnings (PEmax)

PEmax eliminates distortions in the price/earnings multiple caused by sharp falls in earnings during recessions. The current multiple of 26.93 compares the index at December 31, 2020 to highest trailing earnings of 139.47 (for the 12 months ended December 2019) rather than expected earnings of 95.22 for the 12 months ended December 2020. Highest trailing earnings in such a case are a far better reflection of future earnings potential than more recent results.

Payback model

Using our payback valuation model, we arrive at a fair value estimate of 2331 for the S&P 500 based on:

  • highest trailing earnings of 139.47;
  • a long-term growth rate of 5% (the highest nominal GDP growth achieved in recent years was 6.0% in Q2 2018); and
  • a payback period of 12 years — normally only used for stable companies with a strong defensive market position.

The LT growth rate required to match the current index value (3851) is 12.0%. The only time such a growth rate was achieved, post WWII, is in the 1980s, when inflation was in double-digits.

Nominal GDP & Inflation (CPI)

Conclusion

Stock prices are in a bubble of epic proportions. Risk of a major collapse remains elevated.

Luke Gromen: Bitcoin alarm

“We do not think BTC is a bubble; we think BTC is the last remaining functioning fire alarm that has not been disabled by policymakers, and it is issuing an increasingly shrill alarm about the USD and fiat currencies more broadly. We have little doubt that policymakers will attempt to disable BTC as a functioning fire alarm as well, but its traits make that far more difficult to do to BTC than they have thus far done with gold.”

~ Luke Gromen, Treerings.com

The Battle for Democracy

“Democracy isn’t liberal or conservative, not left or right — at least it isn’t supposed to be. Millions of Americans currently believe that democracy isn’t working, or even that it isn’t worth saving. The battle to prove them wrong isn’t over, it’s just begun.” ~ Garry Kasparov

Markets that are likely to outperform in 2021

There is no reliable benchmark for assessing performance of different markets (stocks, bonds, precious metals, commodities, etc.) since central banks have flooded financial markets with more than $8 trillion in freshly printed currency since the start of 2020. The chart below from Ed Yardeni shows total assets of the five major central banks (Fed, ECB, BOC, BOE and BOJ) expanded to $27.9T at the end of November 2020, from below $20T at the start of the year.

Central Banks: Total Assets

With no convenient benchmark, the best way to measure performance is using relative strength between two prices/indices.

Measured in Gold (rather than Dollars) the S&P 500 iShares ETF (IVV) has underperformed since mid-2019. Respect of the red descending trendline would confirm further weakness ahead (or outperformance for Gold).

S&P 500 iShares ETF/Gold

But if we take a broad basket of commodities, stocks are still outperforming. Reversal of the current up-trend would signal that he global economy is recovering, with rising demand for commodities as manufacturing output increases. Breach of the latest, sharply rising trendline would warn of a correction to the long-term rising trendline and, most likely, even further.

S&P 500 iShares ETF/DJ-UBS Commodity Index

Commodities

There are pockets of rising prices in commodities but the broader indices remain weak.

Copper shows signs of a recovery. Breakout above -0.5 would signal outperformance relative to Gold.

Copper/Gold

Brent crude shows a similar rally. Breakout above the declining red trendline would suggest outperformance ahead.

Brent Crude/Gold

But the broad basket of commodities measured by the DJ-UBS Commodity Index is still in a down-trend.

DJ-UBS Commodity Index/Gold

Precious Metals

Silver broke out of its downward trend channel relative to Gold. Completion of the recent pullback (at zero) confirms the breakout and signals future outperformance.

Silver/Gold

Stock Markets

Comparing major stock indices, the S&P 500 has outperformed the DJ Stoxx Euro 600 since 2010. Lately the up-trend has accelerated and breach of the latest rising trendline would warn of reversion to at least the long-term trendline. More likely even further.

S&P 500 iShares ETF/Euro Stoxx 600

The S&P 500 shows a similar accelerating up-trend relative to the ASX 200. Breach of the latest trendline would similarly signal reversion to the LT trendline and most likely further.

S&P 500 iShares ETF/ASX 200

Reversion is already under way with India’s Nifty 50 (NSX), now outperforming the S&P 500.

S&P 500 iShares ETF/Nifty 50

S&P 500 performance relative to the Shanghai Composite plateaued at around +0.4. Breakout would signal further gains but respect of resistance is as likely.

S&P 500 iShares ETF/Shanghai Composite

Growth/Value

Looking within the Russell 1000 large caps index, Growth stocks (IWF) have clearly outperformed Value (IWD) since 2006. Breach of the latest, incredibly steep trendline, however, warns of reversion to the mean. We are likely to see Value outperform Growth in 2021.

Russell 1000 Value/Growth

Bonds

The S&P 500 has made strong gains against Treasury bonds since March (iShares 20+ Year Treasury Bond ETF [TLT]) but is expected to run into resistance between 1.3 and 1.4. Rising inflation fears, however, may lower bond prices, spurring further outperformance by stocks.

S&P 500 iShares ETF/Long_term Bond ETF (TLT)

Currencies

The US Dollar is weakening against a basket of major currencies. Euro breakout above resistance at $1.25 would signal a long-term up-trend.

Euro/Dollar

China’s Yuan has already broken resistance at 14.6 US cents, signaling a long-term up-trend.

Yuan/Dollar

India’s Rupee remains sluggish.

Indian Rupee/Dollar

But the Australian Dollar is surging. The recent correction that respected support at 70 US cents suggests an advance to at least 80 cents.

Australian Dollar/Dollar

Gold, surprisingly, retraced over the last few months despite the weakening US Dollar. But respect of support at $1800/ounce would signal another primary advance.

Spot Gold/Dollar

Conclusion

Silver is expected to outperform Gold.
Gold is expected to outperform stocks.
Value stocks are expected to outperform Growth.
India’s Nifty 50 is expected to outperform other major indices. This is likely to be followed by the Stoxx Euro 600 and ASX 200 but only if they break their latest, sharply rising trendlines. That leaves the S&P 500 and Shanghai Composite filling the minor placings.
Copper and Crude show signs of a recovery but the broad basket of currencies is expected to underperform stocks and precious metals.
The Greenback is expected to weaken against most major currencies, while rising inflation is likely to leave bond investors holding the wooden spoon.

Jim Bianco forecasts higher inflation in 2021

Jim Bianco from Bianco Research:

“The problem the stock market has in 2021 is by most standard metrics (P/E, Market Cap/GDP, etc.) it’s overvalued. Now a lot of people expect it to stay that way for another year. If we don’t get inflation, that can actually happen and you could actually have the market stay at these elevated levels. But if you do get rising interest rates on inflation……that will frip earnings, make mortgage rates go up and lift interest rates. That has historically not been good for risk assets….”

The problem if we don’t get inflation will be far worse. MMT theorists will take this as validation and we are likely to see more calls for far higher stimulus checks. Why not $200,000 stimulus checks someone on Twitter asked. The bubble will keep expanding without any visible effect …..until it bursts.

Perth Mint Gold (PMGOLD)

Not to be confused with the ETF (AAAU) listed on NYSE Arca — which went by a similar name — Perth Mint Gold (PMGOLD) is a call option listed on the ASX that entitles the holder to delivery of 1/100th of a troy ounce of fine gold held at the Perth Mint.

Liabilities of Gold Corporation are guaranteed by the West Australian state government under section 22 of the Gold Corporation Act 1987, an Act of the WA Parliament.

Management fees of 0.15% p.a. are paid in physical gold.

Gold holdings of Gold Corporation are unallocated.

Further details regarding fees, custody and delivery are set out in their Product Disclosure Statement.