— 2021 Q2 UPDATE —

Summary:

The second quarter of 2021 was defined by a generation of investors worrying about an economic issue that was last a problem when disco was the music of choice. In other words, most investors today have never made investment decisions with inflationary concerns being on the forefront of their minds until this past quarter. The unknown can be a frightening place to make any decision, let alone financial ones. Therefore, it is important to analyze inflation from a few different angles to gain a thorough understanding of the environment we may find ourselves in. This market update is going to attempt to do that by exploring the following:

• Second quarter returns from major indices.

• Defining transitory & secular inflation, analysis of the macroeconomic landscape in Q2 and why this economic environment is causing transitory inflation.

• Examination of whether the fiscal standing of the United States will be the catalyst for secular inflation.

Read on for our full Q2 market update and how these factors could impact the economy and your investments…

Returns:

Current Macroeconomic Environment & Transitory Inflation:

The term “transitory inflation” has been repeatedly used by Treasury Secretary Janet Yellen and Federal Reserve chairman Jerome Powell to describe the surge in inflation during the second quarter [1]. According to Google Trends, this caused the interest in the word “Transitory” to spike, as shown by the chart below.

This spike in interest mainly resulted from the lack of a clear definition for the word transitory as applied to our current macroeconomic environment.  Webster’s dictionary defines the word “transitory” as simply, “not permanent”, which is ultimately as good as useless for our purposes.  The difference between rising inflation which lasts for 1 year versus rising inflation lasting for 5 years puts the economy in vastly different spots, yet both can be classified as transitory when using Webster’s dictionary.  Therefore, for our purpose of investigation, we will classify the word transitory as 1 year or less, and anything beyond that timeline we will classify as secular.

Transitory = 1 year or less

Secular = Beyond 1 year

With our terms defined, we can begin to analyze the macroeconomic environment of Q2.  Q2 was defined by the largest jumps in year-over-year % changes in CPI since before the financial crises of 2009.

This spike in inflation was the result of many different forces in the economy working together in synergistic fashion.  As with everything when analyzing the macroeconomy, it is important to narrow down the myriad factors down to the main drivers causing a phenomenon.  With this inflationary spike, there are 4 main factors that provided the type of environment to allow this to happen.

These four factors are:

• The economy reopening in rapid fashion due to widespread vaccinations.
• A supply-demand mismatch in the labor markets.
• Accommodative fiscal policy.
• Accommodative monetary policy.

The first two factors are short term factors that are being pointed to as the reasoning for some to call this inflationary spike “transitory” in nature and the last two factors are the reasoning for some to call inflation “secular”.  Ultimately, these semantic games obfuscate the nature of these issues because they are all causing the same phenomenon.  However, for purposes of classification, we will consider factors 1 & 2 as transitory in nature and factors 3 & 4 as secular in nature.

Factors 1 & 2:

During the second quarter, the majority of adults in the United States were vaccinated against Covid-19 which was the basis for the economy to be reopened from the artificial slumber it was put in.  This reopening caused a surge in demand for goods and services which was enhanced by the fact that on average Americans had more money in savings than at any point in history, even when adjusted for inflation.

These factors are synergistic because one of the main reasons that many American citizens had this level of savings was from the direct and indirect payments from the federal government during the lockdowns.  Americans had the largest % of their savings come directly from government transfer payments since the statistic began to be reported.  With the most recent data showing at 39.4% of gross private savings coming directly from the government.

Therefore, with the reopening of the economy combined with the excess in saving coming in large part in government transfer payments, it primed the economy for a surge in demand for goods and services.  Normally, this would be great for an economy reopening from an artificially induced recession (when we say artificial, we simply mean exogenous factors outside of normal economic conditions induced the recession).  However, the labor market supply-demand mismatch is where the transitory inflationary pressures began to rear its ugly head because this pent-up demand was met with a reduced supply because the labor force was not ready to properly meet supply. 

The reasonings behind why the labor market supply-demand mismatch happened is beyond the scope of this article but the excess in savings and extended unemployment insurance almost certainly has some role to play in this phenomenon.  Below is a graph comparing the amount of unemployed versus the amount of job openings over time.  At the end of Q2 there were around 9.4M unemployed citizens with around 9.3M job openings.

This mismatch is not relegated to one sector of the economy either, with 4 different sectors of the economy accounting for 15% or more of those 9.3 million job openings.

Overall, the combination of pent-up demand being unleashed from an excess of saving mainly from government transfer payments combined with employers being unable to meet this demand from the disequilibrium in the labor market caused a large part in the spike in inflation.  This will most likely be a transitory phenomenon because savings without salary can only last so long.  However, in the meantime, this has put upwards pressure on wages because employers are having to compete with the government transfer payments/extended unemployment benefits.

U.S. Wage Growth:

This wage growth provides a feedback loop for the inflationary pressures as well because these costs will inevitably be passed onto the consumers so that businesses can keep their profit margins relatively steady.  The problem with this wage growth is that it is coming from these transitory effects so it will most likely be temporary and we might see downward pressure on wages as the labor market returns to “normal” in the coming quarters. 

These outcomes are the transitory inflationary effects that Treasury sectary Janett Yellen and Fed Chairman Jerome Powell are referring to.  However, they are only one part of the equation because they are not addressing the longer-term inflationary risks that are derivatives of factors 3 & 4, which are accommodative fiscal and monetary policy working in tandem.  To properly analyze those aspects, it is important to understand why these policies might be in place for longer than these transitory effects are a factor.

United States Structural Economic Conditions & Secular Inflation:

Whether inflation will turn from transitory into secular will most likely be a result of the current financial standing of the United States.  Since World War II, there have been two periods where the United States experienced secular inflation.  The first time happened right after World War II and the second time happened in the 1970’s, however, both were brought about through very different circumstances.  For the sake of brevity, I will focus on the similarities between the United States current financial situation with the financial situation of the United States after World War II because if there will be secular inflation it will most likely come about through comparable mechanics to the post World War II secular inflation.

Main similarities between now and the U.S. after WWII are:

• Debt-GDP ratio
• Coordinated Monetary and Fiscal Policy
• Economic recovery from a world changing event.

Interestingly enough, the official end date of WWII is not universally agreed upon [4].  Different sources identify 3 separate end dates, May 8^th, May 9^th, and September 2^nd of 1945.  However, the national WWII museum says the official end date is September 2^nd, 1945, so I will take their word for it [5].  WWII required the United States to mobilize outsized financial resources and take on extraordinary levels of debt to fight the war, which makes perfect sense since it was an existential threat to the country.  In 1941, debt-GDP levels for the United States were 39%, and by 1946 they had reached 121%.  This level of government spending would have put the U.S. in a difficult spot to pay back all of debt they owed but they used a coordinated fiscal and monetary response to inflate the currency from 1941 until 1951, while keeping interest rates low.  When a country issues debt in their own sovereign currency, they can essentially default in “real” terms on their debt by inflating the currency.  From the period of 1941-1951, the average yearly inflation rate was 5.90%, while the T-bill rate was kept at an average of 0.68%. 

This means that investors in short term government debt lost an average of 5.22% of their purchasing power per year during this time.  However, this plan worked for the U.S. because they were able to reduce their debt to GDP ratio from the 121% in 1946, down to 74% by 1951 even though overall debt levels only dropped by 5.27% during that time period.

You may be asking, what would be the purpose of the government inflating their own currency?  One of the main reasons a sovereign government may do this is to give the central bank monetary flexibility.  When debt-GDP ratio is high it can make independent monetary policy very difficult because interest rate increases can cause an outsized effect on the level of interest payments the government has to pay on its debt.  It is much easier for a government that issues debt in its own sovereign currency to simply inflate the currency and default in “real” terms (i.e., non-inflation adjusted).

Moving to the present day, we find ourselves in familiar territory with our fiscal and monetary standing.  The U.S. currently has a higher debt-GDP ratio than it did at the end of WWII.  At the end of 2020, the debt-GDP ratio hit a high of 130% due to large budget deficits and a sharp drop in nominal GDP due to the Covid induced recession.  This has put Fed in a position where it must take a back seat to the fiscal situation of the United States because if they pursue independent monetary policy as stated by their dual mandate, they could potentially cause an outsized effect on the budget of the Treasury. 

It is likely that the Fed will continue to keep interest rates low irrespective of the inflationary pressures facing the economy and that congress will continue to pass omnibus stimulus packages to stimulate the economy from the lack of demand for loans from the private sector even with low interest rates.  This process is very similar to what happened after WWII with President Franklin D. Roosevelt’s “New Deal” [6].  According to the National Archives, “The “New Deal” aimed at promoting economic recovery and putting Americans back to work through Federal activism.  New Federal agencies attempted to control agricultural production, stabilize wages and prices, and create a vast public works program for the unemployed.”  We are in a very similar situation today with general public acceptance of federal work programs and an expansion of direct government transfer payments that it would be surprising to see that momentum shift in the near future.

Overall, the current economic situation, the political environment, and the recovery from a large exogenous economic shock is similar to the situation after WWII.  The period after WWII saw periods of high inflation mixed with periods of low inflation that correlated with government spending. 

After the transitory aspect of inflation passes and the labor market settles, we might see similar lumpiness in inflation that correlates with fiscal spending packages but that averages to an overall higher inflation rate than we have seen since the 1970’s.  If this plays out in this fashion, then I would expect to see this continue until the debt-GDP ratio gets to a low enough point that monetary authorities have the flexibility to pursue independent monetary policy without the worry of causing an outsized effect on the fiscal budget.

The main question is how long this will take to play out, which is an answer that will be highly dependent on how much fiscal spending the government can pass through budget reconciliation and what the political environment looks like after the 2022 midterm elections.  For these omnibus stimulus packages to be passed through congress, a simple majority will be needed by Democratic congress members.  If Republicans reclaim either the house or senate, it will be difficult for these packages to be passed and it could change the math of this whole situation.

Overall, the probability for secular inflation coming to fruition appears to be higher than the probability of the opposite.  There are many variables that could change over the course of the next couple of years that could run roughshod through this analysis, but the current trajectory appears to resemble post WWII America.  As the great Samuel Clemens (a.k.a. Mark Twain) once said, “History doesn’t repeat itself, but it often rhymes.” [7]

Conclusion:

Here at K2 Financial Partners, our main mission is to help you reach your financial goals. We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when inflationary pressures are coming to the forefront. Therefore, it is important to have a well-diversified portfolio and contact your advisor when you have questions, comments, or concerns. At the end of the day, we are here to help you!

SOURCES:

1. S. Treasury's Yellen tells G7 to keep spending, says inflation will pass | Reuters
   
2. Transitory | Definition of Transitory by Merriam-Webster
   
3. CDC COVID Data Tracker
   
4. When and How Did World War II End? (thoughtco.com)
   
5. The End of World War II 1945 | The National WWII Museum | New Orleans (nationalww2museum.org)
   
6. The Great Depression and the New Deal | National Archives
   
7. History Doesn't Repeat, But It Often Rhymes | HuffPost Australia Politics (huffingtonpost.com.au)
   
8. Federal Reserve Economic Data | FRED | St. Louis Fed (stlouisfed.org)
   
9. U.S. Bureau of Labor Statistics (bls.gov)
   
10. TRADING ECONOMICS | 20 million INDICATORS FROM 196 COUNTRIES
    

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. The material presented is provided for informational purposes only. Past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. Diversification does not guarantee a profit or protect against a loss.

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