The Dividend Cafe - Inflating Clarification on Inflation

Episode Date: July 29, 2022

I really did mean to write this entire piece last week but simply ran out of time and space. I will give you a recap today of last week’s takeaways but then make sure this week’s wraps a bow around our updated point of view on inflation. This is not merely a philosophical exercise. There is an abundance of empirical support provided for my position, and I think you will find a lot of the information about the present state of affairs surprising. You may draw a different conclusion on the matter than I do, but my conclusions on what this means for the decade ahead have profound implications for citizens and investors alike. Again, this can’t be armchair stuff for a real asset allocator; this is what we call fiduciary responsibility. So grab a cup of coffee and get comfortable. This is one of those truly Dividend Cafe editions. Jump on in… Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to another Dividend Cafe, one that I've actually been very excited about all week. Back here in Newport Beach in our studio after a lot of back and forth in different places and especially out in New York over the summer. But back here at Homebase right now to do part two of what we talked about last week regarding this whole subject of inflation, deflation, where we've been, where I see us now, Deflation, deflation, where we've been, where I see us now, and where I think we're going, and just kind of that review of what my take is on all these subjects.

I got a lot of feedback from last week's part one, and I very much want to kind of finish this thought today. The written Dividend Cafe is a long one, and I cannot tell you enough how much I hope you will read it, as opposed to only listening to the podcast or watching the video but nevertheless we're going to try to cover everything right now that we do in the written version. So let me do something I don't normally do. I'm going to actually use the Written Dividend Cafe because I want to walk through a few particular things that are listed out and first just review what we covered last week. My views on inflation, as we've been in obviously a very high period of price increases

for about a year and a half now, my views are the same now as they were before and during the inflation moment. And as I said last week, if I believed I had gotten this wrong, there would be no hesitation on my part whatsoever to admit so. The reason I'm not apologizing for being wrong is I don't believe we were wrong. If I believed we were wrong, it would be easy to apologize because we get things wrong all the time and we acknowledge it, move on, and so forth. In this particular case, it would be easy to apologize because we get things wrong all the time and we acknowledge it, move on and so forth. In this particular case, it's more important to me to give the right nuance as to what we are talking about. That there's been massive inflation over the last 18 months is undebatable.

What exactly has caused it is debatable, but it isn't necessarily provable. And so the causation is different than whether or not it exists. And we talked about that last week. I want to just continue hitting my point home that housing inflation is a bigger issue to me than a lot of other things, because I think housing inflation is very easy to establish causation. And when you can establish causation, you should be able to establish resolution. When you know what caused something, you ought to know what could resolve it.

But my view is that, first of all, housing inflation matters more because the denominator is bigger, right? If you're getting, I'm making up a number, but if you're getting 10% inflation on something that is 40% of your budget, that's a bigger deal than if you're getting 10% inflation on something that is 40% of your budget, that's a bigger deal than if you're getting 10% inflation on something that is 1% of your budget. So the size and significance of

housing makes it to me a more unforgivable aspect of current public policy. But when you look at the non-housing aspects, broader manifestations of inflation are, in my mind, almost across the board, primarily byproducts of supply side challenges, not monetary or fiscal decisions, where very well monetary fiscal decisions could have exacerbated or supplemented price pressures. But it is my belief that the primary causation is supply side. The bond market, of course, seems to be screaming in agreement with me. Short-term inflation is short-term. Long-term inflation doesn't exist, is the view of the bond market. And why I think this matters is not political to me, not something that is super focused on a given election cycle, but rather economic. And that's what I'm going to talk about more today. So why I care about this economically, before we get into the stuff that you care about from an investment standpoint.

But as an economist, I believe that economics is how human beings act in their God-given nature to allocate scarce resources, to create abundance out of scarcity, to meet their own needs by meeting the needs of others. I think that when you suffocate growth, you stunt this entire process. And so economically, this bothers me because I think that the suffocation of growth that I'm going to argue to you today is the environment we're in made worse by both monetary and fiscal policy, that growth suffocation impedes this cause of what we're fundamentally here to do economically. Why I care as an investment professional is, I guess, different, but not particularly complicated. If you believe that a passive, simple, easy index investing will get people to where they need to be for the purpose of attaining financial goals in their life, whether they're accumulating or withdrawing from assets. You very likely use historical rates of return that are deeply wedded to historical rates of economic growth.

to historical rates of economic growth. And if that real economic growth is structurally different, it sure seems as if the structural return expectations of indexes will be different. And so because we lived for 60 years with 3.1% real GDP growth. And for well more than that, we have had an average of certain returns in the S&P 500, in the bond aggregate index, things of that nature. And so many investment professionals, the vast majority, have formulated a very passive, very turnkey, very model-driven approach to how they invest client capital to go about meeting needs around passivity. And the passivity is linked to economic history. And it's my belief that we very likely are facing a prolonged period of distortion in what to expect from economic growth.

We say, well, Dave, that's a pretty wild prediction. Well, not really, since it's been 15 years already of that being true. 3.1% real GDP growth for 60 years and now 15 years of 1.6, 1.7, basically half. To the extent that one believes you can have that kind of reduction economic growth. And maybe you believe it's just going to bounce back. Maybe you believe it's even getting worse. Maybe you believe it's going to stay the same. But you could also believe one of those things and then believe it won't impact index returns. And so that's fine. I don't happen to share that belief. But my point is,

I don't think anyone's even thought through that, let alone drawn that rather erroneous conclusion. My belief is that if I'm right that we are in a fiscal monetary environment that is fostering prolonged period of suppressed growth, I probably want to think differently about index returns than I do. Okay, so where are we now? Let's get into this. Let's start with obvious. I acknowledged last week. Write this down if you haven't heard it in the media. Inflation right now is high. Okay, you got that? Inflation's high. We already are aware the consumer price index in July, 9.1%, where it's inclusive of food and energy. When you take out food and energy, it was up 5.9%. Energy was up 41.6% from June of last year to June of this year. Okay, so that probably didn't help much. Food prices were

up 10%. So you have high headline inflation, largely driven by energy, secondarily by food. Core inflation, which doesn't include food or energy, is still high, but much less. So it is not hard to say that right now the rate of growth of inflation has been very high. But here's the thing, and this is why I have to bring my notes with me because I have like eight things I want to go through real quick. Very quickly though, my contention is that the inflation rate, the rate of inflation, the rate of growth of inflation, you follow me, is going lower. First of all, just fact-based descriptive stuff more than forecasting. Goods inflation has already gone down four months in a row. Used car prices were such a hefty source of the CPI increase we saw last year.

They had been going up 40%. They're now going up 7%. Well, 7 is a lot, but 40 is six times that much, and that's how much it's come down. So you start getting disinflation just from things like that. But it isn't just goods inflation, used cars. It's come way, way down. Agricultural commodity prices are actually now down to pre-Ukraine-Russia levels. Corn and wheat down 30%, 40%, 50%.

Huge drops in agricultural commodities. Oil prices were at 122. They came down to 92. As I'm writing right now, they're about 100. They're down 20% from June highs. Now think about that. I'm talking about $100 oil, and I'm talking about it being down 18% to 20%. That's an extremely high oil price,

and I don't have any reason to believe it's going much lower anytime soon. I'm only telling you that it's disinflated from its peak. That will put downward pressure on headline inflation unless it goes and makes new highs. If any commodity is going to break through its peak level, I don't think it's going to be copper or wheat. I think it would be oil. But at this time, I think that you're going to need real supply solutions to bring oil down to a place that helps clear demand in the market. And 100 is very high.

I don't want to get into the weeds on this, but owner's equivalent rent is the metric that is used to feed CPI to somehow try to account for housing expenses. And the lagging effect of the way they calculate owner's equivalent rent means that where it was at its peak is sort of catching in now. And so we know those things are starting to deteriorate. The rate of growth of housing prices and rent prices, they're actually coming down significantly. I think they're going to go into negative growth by the end of this year. And so that will end up catching up as well. And that puts a lot of downward pressure on services inflation.

The COVID-related elements are already coming down. Some of the kind of reopening inflation. There's a chart at Dividend Cafe that speaks to this. Future prices paid and future prices received is a big part of the Empire Manufacturing Survey. The most recent one last week saw a huge collapse in both of those elements. That's a leading indicator. The cash-to-supply spread, this is an old Milton Friedman concept, deposits at commercial banks with business inventory divided into deposits of commercial banks. This is the lowest it's been since the pandemic began. And there's a real leading indicator around inflation in that metric. The China lockdowns, I think they're reopening. Certainly marginally, it's

been more reopened. I would like to think they're not so stupid as to double down on this insanity, but perhaps I'm wrong. But whether it is in one minute or one year, China is going to be reopened more than it is now. And that obviously becomes disinflationary in its impact in supply chains. Could a peace settlement come with Russia and Ukraine? I don't know. I know the chances aren't 100%, but I also know they're not 0%. Maybe it's 5%, maybe it's 10%, maybe it's 20%, but whatever it is, I suspect is higher than what's been priced in right now into expectations. Do you get some sort of peace settlement, ceasefire, some agreement that regardless of what it may or may

not mean to foreign policy and geopolitics does have a disinflationary impact. I think it's entirely possible. I certainly would hope for it for a lot of other reasons. Do I want to get into velocity right now or not? It's a good question. Here here let me just say this not so much to the velocity of money just basic m2 money supply i have a chart at divin cafe about this too it is um completely totally collapsed and and we definitely saw a massive spike out of covid but right now you more or less have the lowest money supply change in a three-month period that we've had since 2003. And by the way, that's a negative growth. And it's the most negative growth since 2003.

The tips market, trillions of dollars of people transacting in the inflation-protected bond market, Opting in the inflation-protected bond market, government treasuries, where you get implied inflation expectations by what people are paying for given yields, has come down from a 3% 10-year expectation to 2.3%. Pretty close to what the Fed's target is anyways of 2%. Are investors wrong? Maybe they are. ways of 2%. Are investors wrong? Maybe they are. My point is that this is what investors in the bond market are now buying, and this is a real price discovery. This is not an illiquid or idiosyncratic measurement. This is trillions of dollars of heavily liquid pricing power, trillions of dollars of heavily liquid pricing power, or price discovery rather. So my bottom line across commodities, housing, potentially energy, food, general goods, inflation rates have peaked. In some cases, they're coming down slowly. Other cases are coming down quickly. We talked

about wheat and corn and used cars. But to speak to some cooling of the present inflation narrative is pretty fair at this point. If the counter is going to be, well, you're talking about going from 9% to 6% and 6% is still very high, I don't disagree. My point is that when you start getting a declining rate of inflation, it is a very different economic context than a continually growing rate of inflation. And certainly Chairman Powell feels the same. inflation's here and it's only a matter of time until it goes back into a sort of pre-inflation cycle period where we're back to the whole issue that I more or less fall asleep every night thinking about. Low, slow, and no growth. That's the issue I'm most concerned about and I've argued for some time and this becomes a bit more ideological but it's ideology that comes out of economics and that is that the cause of it is excessive indebtedness and then excessive monetary interventions that make matters worse. The proposed solutions for low, slow, and no growth are more indebtedness at a governmental sovereign level and more monetary invention. And the cause of that low, slow, and no growth is excessive

indebtedness and monetary intervention. So this negative feedback loop, this spiral, is the issue that I remain most concerned about. The challenge becomes when you ask the Fed to take on the role of monitoring the whole economy to begin with. I made clear in Dividend Cafe written today that something I want to put on the record in the video and podcast right now. I make clear in Dividend Cafe written today that something I want to put on the record in the video and podcast right now. I'm not against having a central bank. A lot of people that agree with me on other elements of my political and economic philosophy are against having a Fed at all, do not believe we need one. And I believe that there is an importance in a lender of last resort in our complex economy. And I think the late 19th century and early 20th century bore

that out. However, when I talk about that, it's really a stretch to say it's a defense of today's Fed. Because in what universe does anyone think this Fed is merely a lender of last resort? I stole it from my friend Lacey Hunt, who's one of the great economists living today. But Lacey says they become the spender of last resort. And he does it for the fun benefit of the rhyme, but quite technically, of course, Congress is the spender and the Fed is merely facilitating it. But the point being the same, they've expanded this notion of lender of last resort in ways that are so imaginative it's insane. And I think they become a facilitator of excessive spending, which is to say excessive indebtedness.

And all we end up doing in that environment is whatever intervention the Fed may be doing that is supposedly stimulative or useful, it goes in one side of the pool as you're draining it out the other side of the pool because of the downward pressure of growth that excess spending and debt is creating. So this is, I want to move into an area that I think is kind of the heart of this matter, and I think for a lot of people from what I read in the correspondence I received, this is what they're trying to get to. What is it I'm actually saying here? What do I mean?

Is the Fed creating inflation or deflation? My answer is yes. And I don't want us to think about it as the Fed creates inflation or the Fed creates deflation. The Fed creates monetary instability, which by its very definition means at some points inflation, at some points deflation. When we say, look what the Fed did, they created inflation, we are denying the role of the Fed in doing something far worse, which is destabilizing the price level. Okay? I think that distortions in financial markets are extremely problematic.

That the low cost of capital they facilitated for virtually 15 years uninterrupted, with just a couple little periods of trying to get a normal cost of capital that was very, very short-lived, a few quarters out of 15 years we're talking about, that more or less this period of time has facilitated distortions in financial markets. And as an investment advisor, I want distortion-free markets. financial markets. And as an investment advisor, I want distortion-free markets. So if one wants to analyze monetary growth, I believe very much that the money supply ought to grow in line with population, with the economy. You can account for certain you know technological uh constructs i am not against

having a money supply that grows and those who are i think underestimate how bad deflation can be to the cause of economic growth to the cause of economic calculation i do not believe the problem here is a fed that has grown money supply. I think it's growing money supply purely on discretion. That whether you like the way Milton Friedman wanted to grow money supply or Scott Sumner now today with nominal GDP targeting or John Taylor with his Taylor rule, there's competing theories. And that's not what I want to get into right now. One of the reasons, by the way, is I'm not decided on it. I've read, I'm guessing, 50 books on these different things that I remain undecided,

and I generally don't stay undecided on things very long. This is a tough subject, but what is not tough for me is to say that having a rules-based means of administering monetary policy is superior to having no rules at all, no guidelines, no measurements. And that's the world we live in, is granting total discretion to a Fed, which may very well be the most well-meaning folks in the world. I think that fosters instability, and I think instability is bad for growth. And I do believe in the long run what we need more than anything else is growth. I poke at John Maynard Keynes in Dividend Cafe today because his famous line about in the long run we're all dead, it's not funny.

I get that it's true that you and I will be dead in the long run, we're all dead. It's not funny. I get that it's true that you and I will be dead in the long run. And yet I do not believe that has any relevance to what we want for our society by way of economic growth for the next 10 years, 20 years, 30 years, 40 years. For a lot of you listening, you would fit into all of those timelines. For some of you, maybe not 40, but 30. Some are not 30, but 20. But for all of you, I hope 10 years. And for the vast majority, 20, 30, and 40.

But here's the thing. Even if every single person listening right now is 80 years old, you still have kids and grandkids. Of course, economic growth matters longer than Keynes is lying about in the long run, we're all dead. We want multi-generational opportunities because we care about our family. We care about the future of the country. We care about humanity. And I think that economic growth in that construct becomes an entirely moral issue, not merely financial and investment. But what we're talking about right now, and I'm going to talk much more next week on this whole recession stuff and the fact that we came out today with the technical recession and the second quarter GDP contraction, I'll unpack more of that. But my point is simply

longer term than where we are right now this quarter, that we are living in a period of lower growth. And I think that we are going to be living in a period of compressed growth because the things that we have turned to to address the challenges of growth, monetary discretion and fiscal spending, ongoing running up of debt. Those instruments are, A, in my opinion, taking dollars out of the private sector of the economy. That means you have less dollars available for the production of goods and services, but then also impacting the incentives and the actions and the risk taking and the decision making of economic actors who know what I just said before. to go towards greater and greater and greater coverage of debt. And so that net national income, our gross receipts minus debt expenditures, the net national income continues to decline. How do you get an acceleration of rate of growth with decelerated national income? Go home and talk to your spouse about how you're going to be growing financially as your income is declining. This is not a very complicated idea.

But what we have decided is that greater use of debt and spending combined with greater use of Federal Reserve creativity are solutions to what we view as economic problems. our solutions to what we view as economic problems. And in so doing that, the two-headed monster solution is feeding on itself and putting us into what we're at risk of, a real debt deflation cycle. I loathe fear-mongering and melodrama and the use of exaggerative language so much that I'm very happy to give a caveat. When Irving Fisher first taught us about debt deflation cycles, we were in the Great Depression.

And I think the Great Recession, the great financial crisis in my adult lifetime, was a debt deflation cycle. And I most certainly believe that Japan has been living in one, but I'm not suggesting that we're in a period where our debt level is so high that as people are panicking to reduce debt, that they are lowering the size of the economy so much that their total output divided by size of economy is actually already underwater. That's what Fisher was referring to. So hear me out on this. All a debt deflation cycle means, for those who are not familiar with this terminology and would like to get a little economic vocabulary and education today, is that you can increase your indebtedness by reducing debt when you are panicking to sell so you're selling away assets from the economy in order to reduce

debt and yet you can't possibly reduce debt quickly enough relative to how much you're reducing the assets okay so there's a math equation in there when output reduces so much more than the rate at which you're reducing debt that you end up with a worse ratio after you've paid down debt. And that negative feedback loop is what Fisher referred to. And that's the inevitable consequence. It's just a matter of the speed in which it comes. Thank God it's coming very, very slowly for us. We're not feeling it quickly, but that dynamic is what happens in excessive indebtedness, and it is awful for output. And by output, I mean the greater production of goods and services that are contributing to the meeting of human needs in a society. So this is why I care about the issue,

that profoundly changes investment expectations, and it profoundly changes what I believe can work to drive economic prosperity and a higher quality of life. You combine that with what is happening in demographics and you can get a kind of flavor for what my 10-year, 20-year, 50-year outlook may be. That I start with the very basic formula that economic growth is population growth combined with productivity growth. And I've explained why I'm concerned about productivity growth because of the downward pressure that monetary and fiscal interventions are creating. But then the population growth side has been a deficit for Japan and a deficit for Europe for some time. It's been about a break even for America, thank God, and it's now turned into a deficit for America. But let's just look big picture here at the largest country on earth. China, 1.4 billion people,

17% of the world's population, has doubled its population since Ronald Reagan was elected, doubled its population. Okay? And they have averaged a fertility rate of 2.6 kids per household throughout this period,

and they currently are averaging, and have been for several years 1.1. They've been below the replacement rate for the last 20 years. 1.1 right now in China, 1.3 in Japan, 1.6 in America. The estimates that I provide in Devon Cafe are that China's population will go down to less than 600 million in 75 years. That's a long time from now. There's a lot of variables along with it, but that's an incredibly conservative, reasonable projection. So I just ask you, I'm not using America where our population is only 330 million. I'm not using Japan, which is much, much smaller. Globally, when we talk about

inflation versus deflation, if you believe over 75 years that just from peer demography, which I don't know how in the world anyone debates these statistics, that China is going to go from 1.4 billion people to 600 million, I ask you, is that inflationary or deflationary? It's wildly deflationary. So we are dealing with both population growth and productivity growth working against the cause of economic growth. I leave you very quickly with eight quick conclusions. I want you to understand exactly what I'm saying as we navigate this period. Number one, the monetary instability that Fed policy has created, and I should say when I talk about Fed policy creating

it, it's really our political and societal demands of the Fed. The monetary instability is a contributor to downward pressure on growth. The excessive indebtedness, number two, that we face as a nation is contributing to a downward pressure on economic growth. Number three, the problem I identify in number one and number two is so far treated with actions that exacerbate monetary instability and exacerbate excessive indebtedness. I'm worried about the impact of growth for monetary instability, and so therefore we're going to have more monetary instability. I'm worried about the impact of excessive debt on economic growth, and so therefore we're going to have more excessive spending. This is a negative feedback loop, self-reinforcing downward pressure on growth that can only be countered by a commitment to a stable price level and an end to the ditch digging of this ongoing fiscal indebtedness. Well, number four, investors have got to understand that my proposed solutions

in the end of number three, they're not the most likely thing that's going to happen. You have to assume that what will happen is that there will be more monetary policy creativity, more government excess, more instability. This creates both a temptation to be drawn into bubbles, but also the risk of severe pain from the bubble bursting. Number five, economists predict now that certain things will play out in a certain way and they will be wrong. Economist A says this. Economist B says this. Nobody can actually say with any certainty, certainly including myself, though I wouldn't dare try. It's riddled with incomplete aggregates that are the variables and calculations susceptible to surprises and to shocks along the way. It just simply makes the prediction business impossible. So number six,

what am I saying we ought to do here? Invest in productivity because it will carry a return premium for the rest of your life. When you're struggling with low productivity, invest in things providing high productivity. It may not be a shiny object. It may not be part of the boom cycles, but it's needed in a way that I think we've never quite seen before. Number seven, invest in stability.

Instability is going to rule the most and stability will carry a massive return premium. And then finally, number eight, reread six and seven. Invest in productivity and invest in stability because those things essentially are at the heart of dividend growth over shiny objects of really understanding the environment we're in.

Instrumentation right now that is subject to the policy regime of the Fed or central planners, I believe, should not be factors in how we formulate investment policy. That favoring productivity and stability in an economy desperate for growth is treating its deficit with more instability. When all, excuse me, I'm saying this wrong. Nothing can be done infallibly. But as a general direction, you want to emphasize, you want the trend, you want your criteria to favor productivity and stability, because right now the economy is doing the exact opposite.

There's a big deficit on productivity. There's a deficit on stability. There's a big deficit on productivity. There's a deficit on stability. So I hope that all of this economic talk, all of this jargon has helped bring us to a place of understanding what it means practically, what it means in not only my care economically, but my care from a portfolio management standpoint. If one were to say, oh, I agree with a lot of it. There's some things I don't agree with, but at the end of the day, I just kind of think that passivity will still work and we're going to stay with an index-oriented strategy or something like that.

Well, that's fine. I am just telling you why I disagree. I disagree because I believe that we are struggling with problems of productivity and problems of stability and we are treating them with things that exacerbate both the same and therefore it causes me to be much more proactive and serious and contemplative about how we address those issues. I hope this Dividend Cafe two-parter has not overwhelmed you. I hope it hasn't discouraged you. There are plenty of good things that can happen.

Maybe I ought to write a Dividend Cafe about that. If I were a king for a day, what would I do? The reason I probably don't write a Dividend Cafe like that is I'm not going to be king for a day. I'm very serious about using Dividend Cafe to talk about what is, not just what I want to be. This is not meant to be prescriptive, but descriptive. We have to invest for the world we live in. That's our aim here at the Bonson Group. I'm going to continue to do the very best analysis I can with humility and conviction as we go about dealing with what has so far been unsettling times this century, both in terms of productivity

and stability. We'll continue working. We hope you'll continue watching and listening to The Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free of risk. There is no guarantee that the investment process or investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced Thank you. information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only. The opinions

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