by Franklin J. Parker, CFA
The Summary
- The big news today is, obviously, the attack on Israel. The humanitarian crisis is top of mind and our hearts and prayers go out to all affected by this (and all) war. Oil was the first asset to move, jumping slightly higher on concerns that instability in the region would lead to curtailed supply. Gold also reacted as a safe haven, partly due to the closing of US bond markets for Columbus Day. This is a developing situation and investors should keep a close eye on it.
- Earnings season starts this week, with the major banks reporting. Factset has forecast a very slight contraction in earnings this quarter for S&P 500 companies, which would make the 4th quarter in a row of declining profits. The last time we had four quarters of earnings contractions was 2019. This week we also see the all-important inflation figures for September. Reuters polling expects inflation to post at 3.6% and core inflation (which factors out food and energy) at 4.1%. These figures will easily move markets as investors try to parse the path of the Fed’s rate policy.
- The fundamental economic data is not positive. Four quarters of earnings contractions, unemployment is moving higher, the manufacturing sector is in contraction (and services are breaking-even), borrowing costs have increased substantially, and more pressure is on consumers due to higher debt payments. Yet, despite all of this, the US economy has managed to hold on to expansions quarter after quarter. Spending and employment are holding the economy together, so watching those for signs of weakness will be key moving forward.
The Details
Where does inflation come from?
The classic view of inflation, spelled out by Nobel-laureate Milton Friedman, is that “inflation is always and everywhere a monetary phenomenon.” That is by printing money backed by nothing, central banks are the sole cause of inflation in the classic view.
A recent view, espoused by Modern Monetary theorists, suggests that inflation is one of many types of economic dislocations that can occur from imbalanced government spending. Unemployment may rise, or inflation may rise, or business activity may slow — these are all types of economic dislocations caused by government policy with respect to the balance between taxes, spending, and money printing.
My view is a bit nuanced on this topic. In my view, when government prints new money to then spend invest into the economy, it necessarily devalues its currency. However, that devaluation has a lag associated with it — it doesn’t happen immediately. If that currency is invested in projects that grow the value of the economy more than the money-printing devalued it, then there is no inflationary effect.
However, if the spending does not create more economic growth, then you do get inflation.
Just like any other organization of humans, governments can, of course, make productive investments in this way. The difference between government and other organizations is that the incentives to do so are not primary. Thus, governments tend to be less likely to invest in productive projects. Noone pays the cost of being wrong, and ideology (rather than an objective measure of success/failure) tends to dominate.
Identifying the source of inflation is key to defeating it and preventing it in the future. Because the discussion is so closely tied with politics, we struggle to communicate about it clearly and accurately.
We tend to all agree, however, that inflation is definitely a bad thing.
Chart of the Week
One of the many intangible things that policymakers attempt to manage is perception and outlooks. Interestingly, economic optimism has not been this low since the depths of the 2008 financial crisis. There tends to be some overlap between market performance and this indicator, but not as much as you might think. Politically, however, it is telling. When economic optimism has declined substantially, you tend to see a change in political leadership, as indicated in the chart below (red represents a Republican president, blue a Democrat president). As the US election comes upon us next year, it is likely to be a fight with economic optimism as low as it is.
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