2nd Qtr. Newsletter-July 2021

Transitory or Sticky?  The Effect of Inflation on Interest Rates and the Economy

The charts below cover the last 67 years of the stock market and the interest rate of the 10-year Treasury bond. Interest rates were rising for the first 27 years and declining for the last 40 years. The stock market performed pretty well over the first 27 years, rising an average of 9% (including dividends). You must remember, however, inflation was rampant and dividend yields were around 5%, so stock market appreciation was only 4% annually.  On the other hand, the 40-year era of declining interest rates brought an average stock market return of 13% annually. Dividend yields pitched in 3% and inflation has been much lower than in the 1970s, leading to 10% annual stock price appreciation:

The Federal Reserve and the markets are wrestling with the question of rising inflation, and what should be the impact on interest rates. The Fed has a dual mandate to seek full employment and stable prices. Like most things in life, these are relative terms. If you are the guy trying to find employees, you might assume we are at full employment. If you look at the statistics, however, there are 7.6 million fewer people working today than before the pandemic.

Likewise, if you stopped by Home Depot to pick up a couple of 2×4’s and some copper wire, you might be surprised at how much they have gone up in price. The closing of the economy and the subsequent restarting have caused some temporary/permanent supply chain issues, restraining supply and driving prices up. Below is a graph of core CPI, the steadiest measure of inflation, going back to 1990.  Notice the recent uptick.

We appear to be at the place in the cycle where the Fed is still pumping in money, the federal government is spending money faster than you say “higher taxes,” and companies are increasing production with fewer employees. Profit margins are thus increasing and companies are handily beating earnings estimates. These are the best of times…or are they?

At the Fed meeting on June 16, 13 out of 18 Fed governors projected they will have begun increasing the Fed Funds rate by 2023, and 7 of those 13 by 2022. The Fed continues to have discussions about having discussions about slowing down their bond purchasing program. If they raise rates too high or too fast, they risk throwing the economy into a downturn. But if they are too late getting to the party, they risk an onset of inflation.

The Fed’s record of success is sketchy at best. While the Fed is independent, Chairman Powell is up for reappointment early next year. Needless to say, President Biden would prefer not to have the economy in a nasty recession as we head into the mid-term elections.

There is an almost 100-year-old economic argument which is still being fought today. I believe John Maynard Keynes to be closely aligned with today’s Democratic party, while Friederich Hayek would be a libertarian, or at least a Republican, today. Keynes believed the federal government should step in to help the economy when it had slowed and then retreat as it recovered. Hayek believed government should stay out of the argument and let the economy recover on its own, by letting the supply and demand be dictated by market participants (buyers and sellers).

Needless to say, you can see Keynes is alive and well in the White House and the Fed today.  The budget deficit has grown immensely and the Fed’s balance sheet has doubled since Powell began his tenure in 2018. That said, the government’s obsession with social engineering and its lack of patience with letting the market allocate capital properly has increasingly become a bipartisan position. 

From all I have read and studied, the government is doing exactly what it should do if they want to create inflation.  Presuming we have begun an upward bias for inflation and interest rates, how should we adjust our investment policy? The first would be to avoid long-term bonds. On the equity side, you may want to avoid capital-intensive industries. If a company’s cash flow is largely consumed by capital expenditures, there is less left for shareholders. Think about prices of steel, copper, vehicles, semiconductors… those are the guts of capital spending. 

We have been spending quite a bit of time thinking about pricing power and cost pressures, and which companies are better positioned than others. Companies that already have high labor costs, low turnover, and low capital spending needs earn a gold star on the cost side.  The pharma industry wins this battle over all comers. Med tech, financials and tech are close behind. On the pricing front, big pharma always seems to face a looming showdown with government bean counters, who want to intervene into the marketplace where prices are set.  This is especially true now that Congress is in search of “pay-fors,” which are ways to “pay for” the trillions of new programs they would like to create.  Higher taxes serve a political role, but are not universally seen as a great idea, even in Washington. That said, the industry has been waging these battles for decades and has not lost its ability to gradually raise prices on its proprietary products, once approved.

The market is not cheap today but corporate earnings should grow strongly for the next couple years. Perhaps we will have to aim our sights a little lower going forward, given valuations, but dividends and share buybacks should provide a decent return while the market finds its footing.

I believe it was President Reagan who said politicians do the right thing only after all other options have been exhausted.

  • Written by David Meyer