By Keith Black, PhD, CFA, CAIA, FDP As the COVID-19 lockdowns start to ease across the country, governmental entities often have phased approaches for opening. Smaller crowds, smaller businesses, and more socially distanced activities are the first to reopen. It may take until 2021, at the earliest, to return to live sports or concerts with thousands of spectators in the crowd. With 40% of those earning less than $40,000 per year now out of work, estimates are that as many as 40% of laid off employees will not be recalled. With the economic situation still in flux, perhaps between 10% and 30% of small businesses will close forever. Those businesses hoping to return will find their operations significantly impacted, at least in the short run. Those workers who are still earning a paycheck may think twice before spending that marginal dollar, preferring to rebuild their modest savings in case hard times with the economy or the virus make a return visit. One of the first things that people want to do when exiting the lockdown is to get a haircut. After 10 weeks indoors, the first newly reopened business that I visited was my next door neighbor’s hair salon. She had reconfigured her shop and bought some new equipment and supplies to keep things as clean and safe as possible. After waiting outdoors until the time of my appointment, I was allowed to enter wearing a mask and after submitting to a temperature check. After some conversation about reconfiguring her business, I thanked her for my long overdue haircut and prepared to pay. It turns out the price of my haircut had increased by over 42%. I guess that makes sense. If businesses are legally required to cut capacity by one-third or more, they need to raise prices by 50% in the hopes of earning the same monthly revenues. Inflation is not just limited to restaurants and haircuts. Grocery prices rose by a rate of 2.6% in April, the fastest rate since 1974 when CPI increased over 11%. Some of this price inflation can be traced back to issues of COVID-19 in meat packing plants, as reduced capacity in the meat industry has led to price inflation of over 4%. If a significant number of hair salons/restaurants/meat packing facilities close, competition declines and price increases start to stick, institutionalizing inflation even after virus protocols have expired. But what if consumer behavior has changed? What if people would rather save money than spend money? What if people learned to cook at home during the lockdown and now prefer exercising their new skill to visiting a restaurant? How many people learned to cut their own hair, or their children’s hair, three weeks after their missed salon appointment and liked the results? The question is the balance between supply and demand. It is clear that there will, or should, be fewer seats at restaurants, hair salons, and airplanes as health measures and bankruptcies reduce capacity. But, will the demand for those services fall more or less than the decline in supply? When supply declines faster than demand, prices are expected to increase. Add all of this to high levels of monetary and fiscal stimulus not seen in 200 years. Stimulus measures include the Fed purchasing high quality and junk bonds and reducing interest rates while the US Treasury provided direct stimulus of over $3 trillion. Tim Congdon in the Wall Street Journal estimates that the quantity of money supply in the US could rise by over 15% by spring 2021. Monetarist theory tells us that money supply growth in excess of GDP growth goes directly to inflation. If GDP growth is negative, which is likely as long as unemployment stays above 10%, the inflation rate could exceed the rate of money supply growth. That is, it would not be surprising to see CPI increases of 5% to 15% over the next year. One way to place a lid on inflation is for businesses to renegotiate rates. If there is 20% unemployment and 20% vacant storefronts, businesses could reduce overhead by renegotiating rents or moving to cheaper real estate or by paying less to current or newly hired workers. Of course, this gives less income to workers and property owners which further reduces aggregate demand. Will record levels of government deficit and stimulus lead to higher tax burdens which further reduce consumer spending? The elections in November 2020 could usher in a Democratic regime anxious to roll back Trump’s tax cuts and increase social spending. While emerging from the global financial crisis of 2008-2009, the US Federal budget deficit increased to between $1.2 and $1.4 trillion from 2009 to 2011. These levels were unprecedented, as the deficit had never exceeded $460 billion in the history of the United States. Not even a decade later, the current administration has dealt with COVID by expanding the 2020 US Federal budget deficit to an astounding $3.7 trillion, which could be followed by another deficit exceeding $2 trillion in 2021. In 2005, our national debt stood at $7.9 trillion, or 60% of GDP. By the end of 2020, the debt may exceed over $26 trillion, or 110% of GDP. The last time debt/GDP reached these levels, the US was emerging from World War II. However, it was short-lived, as debt/GDP fell to 68% by 1953 and 35% by 1970. The final driver of a potential spike in inflation is modern monetary theory (MMT). MMT proponents believe that the money supply is not finite, as long as a country (like the US) that can issue their own currency can simply print more or transfer funds digitally without limit. If an incoming Democratic regime further acts on the belief that spending can increase without worrying about taxes and deficits, the demand for goods and services like education and health care can increase substantially. Too much money (after MMT) chasing too few goods (with high unemployment and socially distanced production of goods and services) is the definition of inflation. As inflation increases, interest rates typically increase as well, leading to rising debt service on the accumulated national debt. The 10-year US Treasury Inflation Protection Securities (TIPS) market currently projects a breakeven inflation rate of 1.5% over the next 10 years, the difference between the 10-year yield of 0.7% and the real yield on the 10-year TIPS issue of -0.8%. I’ll take the over.
Interested in contributing to Portfolio for the Future? Drop us a line at firstname.lastname@example.org