Has Inflation Already Arrived?
For almost the entirety of the 20th century, the most essential decision posed upon the U.S. investor was that between the purchase of common stock in publicly held corporations and of fixed income securities, namely corporate and government bonds. The widely acknowledged dean of security analysis, Benjamin Graham, devoted an entire textbook, and in fact an entire life’s work, to intelligently deciding between these two investment vehicles.
What Graham could not have reasonably foreseen was the estranged world of the financial markets that have sustained themselves over the past two decades. Not long after entering the 21st century, the U.S. equities market suffered from the burst of a speculation infused bubble, brought on by an inordinate level of excitement about technology based companies. While somewhat mild compared to previous bursts, the popping of the dot com bubble served as a sufficient precursor to yet another panic that took over corporate America in September of 2008.
After years of increasingly risky financial products being adopted as safe-havens for pension funds, hedge funds, and bankers, the world financial markets were finally pushed to their knees when on September 15th Lehman Brothers — an investment bank with over $600 billion in assets on its balance sheet — declared bankruptcy, sending a tidal wave of shock throughout the canyon of Wall Street.
The economic impact of the mortgage market meltdown, however, spread far beyond the speculative crowd of the financial world. As bank after bank succumbed to the peril of Chapter 11 Bankruptcy, credit across the whole world economy practically disappeared, causing firms as large as General Electric and American Insurance Group to seek out funding from investors such as Warren Buffett’s Berkshire Hathaway.
By December of that same year, U.S. unemployment began to verge on levels of 7%, rising from 4.9% at the beginning of the year. Realizing governmental policy would inevitably be needed to give oxygen back to the suffocating economy, Ben Bernanke — the George Bush nominated chairman of the Fed — cut the U.S. federal funds rate to below 1%.
Alongside the lowering of interest rates was the Troubled Asset Relief Program, a bill signed into law on October 3rd to help in providing additional liquidity to financial institutions by purchasing low grade securities, particularly residential and commercial mortgage obligations.
The ensuing result of the fiscal and monetary measures taken by Congress and the Federal Reserve was a drop in nationwide interest rates on fixed income securities. With the central bank keeping rates near zero, and therefore putting the cost of money at virtually nothing, bonds quickly rose to a level at which they yielded a fraction of their previous rates.
As is the basic principle of all asset valuation, the lowering of the risk-free interest rate, expressly a U.S. Government Bond, brings a perfectly correlated rise to the value of all other assets. Warren Buffett’s elegantly simple definition, put at the back of every Berkshire Hathaway annual report, gives understanding of this all important concept to even the most elementary of financial professionals:
“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”
The crucial element here of that statement being “discounted valued.” If at a given time a risk free government bond is yielding 7%, and a business owner controls a 100% interest in a corporation set to go extinct in 10 years, and which is certain to pay out $100,000 each year, the intrinsic value can be easily determined as $702,358. That is, the present value of 10 annual cash flows of $100,000, each discounted at 7%. If, however, we calculate the value based on a discount rate of 1%, we see the value of our mythical corporation rise to $947,130.
Put on a level of the entire U.S. equities market, the sustained lowering of the risk-free interest rate brings about a prolonged rise in the price of asset classes, as we have seen over the past 12 years.
Only after the world had seen a bull market progress to a level that eclipsed all other prosperous periods before it, did we see actions from the Federal Reserve to start increasing rates at moderate levels. However, these rate hikes, as it would be imagined are obvious reasons to anyone, were not continued into 2020.
Beginning, supposedly, with a man in his mid-thirties landing at a Washington-State airport after a family visit to Wuhan China, the coronavirus brought not only an epidemic of disease throughout the country, but one of panic and fear as well. It was in late March that enough panic had spread throughout the conflicted corridors of Washington D.C. and state capitals, that officials began encouraging citizens to stay home, and eventually put in place stay-at-home orders.
As with any lack of human movement, a subsequent drop in consumer spending follows, henceforth slowing the flow of money needed to drive the economic machine. To offset a severe drop in spending, the Federal Reserve, for the third time this century, resorted to its two main economic tools to save the country from economic downfall. One of those tools, however, had been severely worn down.
Having kept interest rates at historically low levels since the aftermath of the financial crisis, the Federal Reserve had very little room to move rates lower when the pandemic started to batter the nationwide economy. The tool that the Federal Reserve, and its chairman Jerome Powell, were left with was an excessive use of money printing.
On April 9th, a Federal Reserve pressured by the country — and more specifically the executive branch — introduced a $2.3 trillion lending program, aiming to ease liquidity problems by the nation’s businesses, and backstop an economic freefall, which by many seemed close to rivaling the Great Depression. The only governmental assistance that approached the magnitude of the actions taken by the Federal Reserve was the Coronavirus Aid, Relief, and Economic Stimulus act, signed into law just two weeks earlier.
The cumulative amount of governmental stimulus devoted to combatting the world’s most economically painful pandemic is, at time of writing, upwards of 6 trillion dollars, posing severe questions in regards to the world’s economy. Insights from John Maynard Keynes or Milton Friedman are not needed to come to the conclusion that an additional 6 trillion dollars spewed into the economy may bring a level of inflation high enough to bring Paul Volker back from the grave.
Though, what may not be coming across the cognitive waves of many within the financial profession is that inflation, although in a different sense, has already arrived.
Conventional inflation, as usually measured by the consumer price index, involves the mass increase in prices of items most commonly purchased by the population (milk, gas, fast food, etc.) The most extreme case of U.S. inflation being the tumultuous period of the 1980s when, by the summer of 1980, inflation neared an annual rate of 15%; a gargantuan level compared to the 2% annual inflation most countries try to maintain.
What appears to be happening across the economy now is a much lesser talked about type of inflation, termed asset price inflation, involving an excess amount of capital flows through the economy, but with fewer adequate investments available to absorb the capital. The result, as the world is currently seeing, is a steep rise in the price of asset classes; the most dramatic example being the U.S. equities market.
After falling to multi-year lows in mid to late March, prices of U.S. equities have recovered to a level that, in relation to current earnings, is higher than almost any other time in American history. As indicated by quarterly figures from Standard and Poor's, operating earnings per share of the S&P 500 index fell almost 50% during the first quarter of 2020, and with unemployment at levels close to 11%, drastic improvements to those earnings are unlikely to come during the remainder of the year. Yet, despite these suppressed levels of income, the S&P 500 index has returned already to pre-virus levels.
Even with low interest rates and trillions pumped into the U.S. and global economy by central banks, the current multiples at which a large majority of equities are selling make sense only if their aggregate earnings return to previous levels within a modest amount of time. Given this improbability, the extreme rise in prices can only be attributed to an inflationary period of the world’s asset classes. After falling to a low of 226, the Dow Jones Real Estate Index has risen over 40% to 322. Similarly, the price for an ounce of gold has climbed from $1,580 in January to $1,947 in August, a 23% jump.
Whether these richly priced assets can sustain their current level, however, is still under scrutiny by the world’s investors. Some have taken an adamantly pessimistic view that the levels of excess within the country have reached all-time highs and asset prices are much too great given present situations to be rationally justified. Others, being ever bullish, believe current levels can only make sense given the lack of alternative investments; mainly a disappearance of adequately yielding bonds.
Such conflicting views in regards to market levels makes one reminiscent of Ben Graham’s 1955 testimony to congress regarding stock market excesses in which Graham, having a Yogi Berra-ish way with words, summarized his thinking with the comment “the market looks high; and it is high; but it’s not as high as it looks.”
Given the unprecedented situation the world now finds itself in, a clear understanding of the future economic impacts to come from such immense government intervention are widely unknown. What is known, and has been proven time and again, is that patience and rationality will successfully guide any investor through even the most ambivalent of times.