An Alternative View of the World

The consensus view on Wall Street is that the Fed is dovish and economic growth is robust and both will remain so. That view is supportive of additional stock market gains in 2022. We’ve been around long enough to know that the consensus never sees the market top coming. With that in mind, we thought we’d play devil’s advocate and talk about where the holes in this theory might be.

The Wall St. consensus concludes

The Fed will remain dovish and the interest rate increases that are already priced into markets are the maximum that we will see (implying that the worst case is already being discounted).
Economic growth will remain strong – Part A. The consumer is in good financial shape with plenty of cash on hand and plenty of credit after years of deleveraging.
Economic growth will remain strong – Part B. Capital goods orders are high which is highly correlated with increased capital investment (i.e., investment in plant and equipment)
Stocks can continue to march higher in 2022.

Let’s take an alternate view on each of these:

The Fed mandate from Congress says it should “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. The goals of maximum employment and stable prices are fundamentally at odds with each other. Maximum employment would logically promote inflation, or unstable prices, so this mandate is a really balancing act. Right now, the Fed is under some pressure because prices are anything but stable and employment has not yet recovered to pre-pandemic levels. So, to encourage more employment would encourage more inflation.

The confusing factor here is that during the pandemic and recovery, work has changed. Many have apparently left the workforce, either permanently or temporarily. As a result, we may have an unrealistic view of what full employment really looks like. Initial unemployment claims reported on 12/09 totaled 184,000, a level we have not seen since 1969, when the U.S. population was only 61% of what it is today! In the same report, the unemployment rate dropped to 4.2%. Unemployment did not get back to a new low, but it is very close, especially considering the changes due to the pandemic. Some examples:

Nov. 2021 Feb. 2020

African Americans 6.7% 6.0%

Men Age 20-24 8.2% 6.8%

Women Age 20-24 6.8% 6.2%

We are close enough to consider that under the current circumstances, we are indeed at, or very close to, full employment. In fact, just this week, speaking on Bloomberg TV, Brian Moynahan, the CEO of Bank of America stated exactly that. It is a point that is hard to argue when labor shortages are so pronounced.

The consumer, on an aggregate basis is in very good shape. However, the aggregate numbers don’t give a complete picture. The income inequality we see today carries over to net worth as well. Most of this wealth (almost 70%) resides with the top 10% of households. The share for the bottom 90% continues to diminish. The bottom line is that most of America is not in the best of financial shape. This is also borne out by the increase in revolving debt (i.e., credit card debt). If you have the means, and half a brain, you are not carrying credit card debt, which is among the costliest, if not the costliest! The increasing use of credit card debt, which some view as a positive, can also be viewed as a negative. With the fiscal stimulus for the last 18 months now ended and largely spent by the masses, there is an increasing need to use credit card debt to maintain spending levels. That trend is not a sign of financial health.

As we have discussed on these pages before, the extraordinary increase in the demand for goods, driven by changing lifestyles during and after the pandemic, has been unprecedented. To put that statement into perspective, we looked at personal expenditures on durable goods. From the trough in 2008, during the Great Financial Crisis to the beginning of the pandemic, a period of 10 years and 10 months, durable goods expenditures rose 58.4%. From the pandemic trough to the most current data, a period of 18 months, these expenditures rose 73.4%. In short, we far exceeded in 18 months, what took almost 11 years after the GFC.

There is no doubt that demand has been and continues to be strong, however, to expect the current trend to continue for an extended period seems highly unlikely. From our perspective, it is more likely that the pandemic has caused demand to be pulled forward. With money in their pocket, and a general inability to spend on services, demand for goods sky rocketed. Rather than keep that older 65” TV for a few more years, why not buy the 85” unit right now?

Manufacturers need to respond to this demand and expand capacity, which works for a while, but when demand normalizes, we would expect excess capacity to be the norm. That would serve to keep prices down and create a need for manufacturers to rationalize capacity (i.e., a recession).

The bottom line:

With an assessment that max employment has been reached, there is ample reason to expect that Fed might be more hawkish (i.e., raise rates more and sooner) as it responds to the current inflation. Certainly, there will be political pressure to ‘do something’ about inflation with midterms less than a year away. This risks a ‘policy error’ where the Fed tightens policy into a weakening economy (due to the factors below), causing a recession.
The cash/wealth on the sidelines could be a figment of our imagination. Most of the country has lost ground to the elites and the elites are not spending that much more.
The current economic strength could be transitory (apologies for using that word) as economic conditions normalize.
There is plenty of room for disappointment in 2022. Understand that is not a prediction, but we always think it best to be well aware of both sides of any story and that is primary reason for staying diversified and making all risks.

Build Back Better Could Cost $3 Trillion

The GOP asked the Congressional Budget Office to take a second look at the Build Back Better plan under the assumption that all of the proposed programs were in place for the full ten years.

In a letter to ranking members Budget Committee members, Lindsey Graham, Senate and Jason Smith, House of Representatives, the CBO wrote:

“This letter responds to your request for a projection of the budgetary effects, including the effects on interest costs, of a modified version of H.R. 5376, the Build Back Better Act. You specified modifications that would make various policies permanent rather than temporary.”

“The Congressional Budget Office and the staff of the Joint Committee on Taxation project that a version of the bill modified as you have specified would increase the deficit by $3.0 trillion over the 2022–2031 period.”

Milton Friedman once said “there is nothing so permanent as a temporary government program.” We can’t help but wonder how this analysis might impact the votes of Senators Manchin and Sinema and therefore the viability of Build back Better.

Inflation Close to a Peak?

We came across this chart this week and we thought it quite interesting. The three lines show the course of inflation next year assuming constant monthly changes of 0.2%, 0.3% and 0.4%. Even under the worst scenario, inflation peaks in the first quarter of 2022. We appear to have a few more months of bad inflation news, but after that, inflation appears ready to come back down due to base effects.