Here we are, December 2021 and the S&P 500 has just reached a new, all-time high. The latest run has overshadowed a noticeably volatile December month, with multiple spikes in both directions. However, the one negative theme that has come up regularly has been inflation, and where it is headed. High inflation would not be good for the stock market, so this latest rally may indicate that investors are not worried about ongoing inflation. But the narrative around inflation is starting to suggest inflation is, and will be, with us longer than originally thought. In today’s Financially Speaking I want to take a closer look at inflation and offer my sense of where it stands. As always, the team at Barron Financial Group are only a phone call or email away if you have further questions or prefer a personal discussion.
2021, The Year of Inflation
Inflation in February 2021, not quite a full year into the pandemic, measured about 1.8% in the Consumer Price Index (CPI). This value represents price increases over the previous 12 months. It also is an amount in-line with what we’ve seen for inflation over the last several years and is just shy of the Federal Reserve (Fed) inflation target of 2%. A month later in March 2021, the 12-month CPI went up to 2.7% and continued higher every month until June, where it remained flat until October. In November 2021, the 12-month CPI hit 6.8%, the highest inflation seen since 1982. However, it is important to not just look at the headline number, how each sector breaks down into the headline matters. For example, the energy sector is up 33.3% for the 12 months ending in November. And energy carries a 4.4% weighting in the CPI, so that means energy accounted for a full 1.5% of the 6.8% headline inflation. If we look at other sectors with higher inflation, we see new vehicles up 11.1% and used vehicles up 31.4% as of November. Given the CPI weighting of those two sectors, they contributed a total of about 1.3% to the headline amount. Thus, if we remove energy and new/used vehicles from the CPI, it comes in at a still high, but much less worrisome 4%. Looking a bit more closely at these sectors, we know the price of oil has gone from $59/barrel in February 2021 to a recent $76/barrel, a 29% increase. The increase can be mostly explained by the substantial recovery of energy use as we recover through the global pandemic, and the reduction in energy investment and exploration, which reduces overall supply. The past 9 months are a classic example of increasing demand, with no additional supply, which drives prices higher. Automobile price increases, on the other hand, seem to be driven by the pandemic induced global chip shortage, which has reduced the volume of cars being produced. Again, with sustained demand for new cars, and reduced supply due to chip shortages, comes higher prices. Used cars indirectly follow because if a buyer can’t find a new car, and they need a vehicle, they shift to the used car option. The supply of used cars has not gone up, so more demand without increased supply leads to higher prices.
The most reasonable counterargument I’ve seen for longer lasting inflation is the fact that our M2 money supply (cash, checking deposits and money markets) has grown by almost 40% since the onset of the pandemic. This, compared to the normal level of M2 growth of about 6% per year. This extra money sloshing around in our system is the result of stimulus checks, extended unemployment benefits, a halting of student loan payments and other government induced measures. Now, I’m not suggesting these measures were wrong. I am convinced if the government had not acted quickly and dramatically, the COVID recession could have been a depression. But, nonetheless, the extra cash is allowing people to spend at higher levels than pre-pandemic, and combined with pandemic induced supply chain disruptions, it’s a perfect recipe for inflation. More demand and less supply. Some economists suggest we may need years to pass to allow this extra M2 supply to work its way through the system. My belief is that the Fed can drain M2 money from the system and they will once we start the cycle of monetary tightening and raising interest rates. That is expected to happen around mid-2022. So, for me, this counterargument doesn’t hold in the longer term.
Now I want to shift to a term the Fed was using for a time but has recently stopped using. The term is “transitory” which they used to describe inflation and the idea that it was being driven by economic factors that would correct themselves as time passed. If we look at the two examples above, I think there is good reason to believe that those conditions; reduced energy exploration/less supply and the reduction of computer chip access will correct themselves in reasonable time. How long that takes is a fair question, but the idea that investors won’t explore for more energy (especially at now higher prices) or that the global chip industry won’t find a way to recover or increase production, seems unlikely. For me, those conditions are the definition of transitory. They will correct and prices will adjust, however long that takes.
From there we have other inflationary conditions to consider. One is food pricing. Food prices are up 6.1% for the 12 months ended in November. Almost as high as the headline number. Based on my research, much of this appears to be pandemic driven. As of November, we are still 3.9 million jobs short of the pre-pandemic level from February 2020. And that employment gap is affecting not only food, but other household items as well. Some of those workers were part of the supply chain that helps put those items on our store shelves, and those workers are not there to do it. Some have retired, some are caring for family, some just feel it’s not worth the risk to be in public with COVID. Here again, I feel as COVID becomes less of an issue, we will see employment recover along with many of the COVID induced supply chain issues. I feel much of this is also what I call transitory. The problem for the Fed is that transitory is a word that gives people the expectation the issues will be resolved quickly. And that has proven not to be the case. Maybe transitory is not the best word, but I do think it is an accurate description of what is happening.
My final point for today is to talk about the price increases we have seen, and what I expect as inflation comes back down toward the 2% level it used to be at. Will prices recover to pre-pandemic levels? I feel strongly the answer is No. At least part of the reason for that is that wages have risen by 5% over the 12 months ending in November. There’s no way those wages will be pulled back, meaning employer expenses are higher, and they will pass those costs along to consumers. Do I believe some items may drop from their peak pricing, such as lumber and building materials, yes I do. But for the most part higher prices are here to stay. The question becomes will they continue to go up in the same rapid way as we’ve seen since March? I believe they won’t as the “transitory” issues start to resolve themselves. My best guesstimate for this is sometime mid-2022 to start seeing some improvement.
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This newsletter is for general information only and should not be considered investment advice. Investors should consult with a trained investment professional to discuss their particular situation.