What I Care About This Week | 2021 May 3

by Franklin J. Parker, CFA

The Summary

• The Purchasing Manufacturer’s Index (PMI) posts today, Non-Manufacturing PMI posts Wednesday, and unemployment posts Friday. PMIs are a measure of business activity, and while manufacturing is only about 10% of the US economy, it has been used as a bellwether. Since the Covid lockdowns, Non-Manufacturing PMI is arguably more important as it measures the services sector. Of course, the headline unemployment rate is both an important measure of the recovery and an important data point for the Federal Reserve.
  
  
• Speaking of the Federal Reserve, the Federal Open Market Committee (FOMC) met last week. They kept current policy going, of course. Chairman Powell’s press conference was more of the same: current policy of low interest rates and quantitative easing (QE) will remain in place until “substantial further progress has been made.” According to Powell, the Fed needs to see “a string” of positive data before they are sure that the economy is on proper footing. With $120 billion per month at stake, what is “a string”? More than one—beyond that Powell declined to comment. Markets have priced-in a beginning to the end of QE in Q3 or Q4 of this year, and an interest rate hike in Q2 to Q3 of next year. Substantial change to that outlook—either from the data or the Fed—would likely move markets.
  
  
• Earnings season continues apace! 60% of the S&P 500 companies have reported, and they are reporting earnings about 23% above expectations—the highest since at least 2008, according to FactSet. The S&P 500’s blended earnings growth rate stands at 46% for Q1, though much of that can be attributed to poor earnings posted in Q1 of last year due to Covid. This is encouraging, however, as it appears companies are recovering quite well. If/when the Fed backs away, it will be on companies to grow earnings to keep markets going. A signal that they can do that bolsters market confidence!
  
  

The Details

Where is inflation?

Any traditional economic theory would suggest that a serious inflation problem is on the horizon. In its simplest form, inflation is the Price Level in this equation:

Amount of Money x Velocity of Money = Price Level x Real GDP

We know that the Amount of Money variable has increased by about 28% over the past year (the most on record), and Real GDP, year-over-year, is about the same. Yet the price level has only increased about 2%. According to our formula, our price level should be about 25% higher—so where is inflation?

The answer is that the Velocity of Money has cratered. Because money is changing hands less often, inflation has remained muted. Even more fascinating: the velocity of money has decreased from about 1.6 to about 1.15—down 28% over the past year, which is almost exactly equal to the expansion of the supply of money over the past year. In other words, no matter how much cash the Fed prints it gets saved and not spent (given the size of the figures, the word “hoarded” comes to mind).

But why? Why is all of this cash being hoarded? This is the $10 trillion question!

In my view, investors are hoarding cash because there is no opportunity cost to holding it. Rather than invest in a bond at 1.5%, investors are more willing to simply hold the cash because it gives future optionality (we can do something with it tomorrow). Because interest rates are so low, the weighted average cost of capital (WACC) of companies is much lower than it has been historically. Because the WACC is the minimum rate any corporate investment must earn, companies are not punished for holding cash, either. Finally, banks don’t want to lend because they make very little profit on loans under 4%, so they end up holding cash, as well.

All of this cash, then, is getting “stuck” on the balance sheets of investors, companies, and banks. It will continue to be “stuck” until the opportunity cost of holding cash comes back. Only when investors, companies, and banks, are paid to put it to use will cash actually get put to use!

Counterintuitively, cash gets put to use when interest rates rise. When we can invest in bonds at 4%+, investors can no longer afford to hold cash because they are missing out on real return. This also increases the WACC of companies making cash drag unaffordable. Finally, at higher rates, banks miss out on real profits when if they hold cash rather than lend it. When interest rates meaningfully rise, then, everyone responds to that incentive simultaneously: investors deploy cash into financial instruments, companies spend their cash on employees, R&D, Capital Expenditures; banks begin to lend to everyone they can. Suddenly the velocity of money begins to increase quickly!

And that is when inflation rears its ugly head.

In the end, the Fed must decrease the supply of money before they raise interest rates meaningfully. Historically, of course, higher interest rates is how the Fed fought inflation. In this environment, higher rates cause inflation.

I assume that the Fed has read much of the same research I have (this framework was put together by a Fed economist back in 2014, in fact). Even so, investors must watch both the Fed and the data closely to ensure that (1) this framework is a correct assessment of the current environment, and (2) that the Fed is managing their transition to “normal” policy effectively.

As we bring this unprecedented economic experiment to a close—at least ostensibly—investors must remain vigilant to the big forces affecting their portfolios. Inflation is a macro force that we have had the luxury of ignoring for the past several decades. Given the current environment, however, inflation could very quickly become an investor’s #1 risk.

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