Some Thoughts on Inflation, Tax Reform and the Fed 1 st October 2017 Before this week s report, we wanted to draw your attention to the trade ideas section of the report we have run for the past few weeks. For administration and regulatory reasons, we would like all those who wish to receive these trade ideas to contact us or reply to this email and we will send separately. My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation but our understanding of the forces driving inflation is imperfect more broadly, the conventional framework for understanding inflation dynamics could be misspecified in some fundamental way [emphasis added] Janet Yellen 26 th September 2017 Janet Yellen explicitly said this past week that the Fed does not understand the fundamental forces driving inflation. Now, with price stability being one of the Fed s mandated goals, we would have thought that the Fed would need to have a pretty clear understanding of fundamental forces that drive inflation. In fact, we seem to hear an awful lot these days from the Fed (and all developed country central banks for that matter) about how they must get inflation back up to their 2% target; a target they set themselves in January 2012. It s as if inflation is THE most desirable economic outcome, over and above say productivity growth, wage growth and financial stability to name a few. How can they possibly have the right monetary policy setting when they are targeting a self-imposed target on an economic dynamic that they do not understand? Of course, the answer is that they cannot possibly have the correct monetary policy setting. Post GFC monetary policy has been a huge experiment conducted by central banks without any proof that it would help the real economy, nor a true understanding of what the negative consequences would be. We think it s correct to say that financial markets have benefitted from this grand experiment significantly more than the real economy, and that the unintended consequences are only likely to be seen once monetary policy has been normalised. We should note that we certainly have no better understanding of the fundamental forces driving inflation than the Fed does, but we do want to take issue with the almost maniacal desire on the part of central banks to keep inflation moving ever upwards. Chart 1 below, courtesy of Deutsche Bank, shows global inflation from an historic perspective and also over the last 100 or so years. Many of you will know that the Fed was created in 1913, which strangely coincides with the time when inflation became a permanent feature of developed countries. Furthermore, although we would have to expect periods of war to coincide with higher inflation, the persistence of inflation since the end of WWII is either a feature of the modern economy or an historical outlier. We ll go with it being a feature of the modern economy, and one that devalues the wealth of households slowly but persistently over time.
Chart 1 Global median inflation It s incredibly difficult to measure inflation as every household is a bit different, and experiences a different rate of annual price increases. Furthermore, deflation in some sectors is desirable as it is a sign that productivity and competition are healthy and consumers will be better off as prices decline (who doesn t want a cheaper TV or car?). Chart 2 below shows the cumulative inflation for selected goods and services between 1996 and 2016. In a modern economy dominated by services, it is notable that the largest price increases have been seen in these sectors. Also, we would point out that the forces of globalisation and technical advancement have supressed prices for many manufactured goods and in some cases, even lowered prices examples of good deflation. There is also a process known as hedonic adjustment (and other measuring gimmicks that we won t go into) that attempts to measure and adjust for a product s improvements so that even if the price for a car or TV remains static over time, with the technical and quality improvements seen, the price used to calculate the rate of inflation actually falls. We are pretty sure that the vast majority of consumers have no idea what hedonic adjustment is; all they know is how much income they have and how much they need to spend to maintain what they see as their standard of living.
Chart 2 Inflation of various goods & services 1996 to 2016 Accepting that it is impossible to produce one single inflation measure that is consistent with the experience of the vast majority of households, we do suspect that what many households experience is that their cost of living increases at more than the official figures suggest. The data is clear that those who hold a college degree earn more money, and so many households choose to pay ever increasing education costs, taking on huge debts along the way, in the hope of a better standard of living. Healthcare costs keep rising far faster than the official rate of inflation, and the failed healthcare reform is certainly not helping with stories that Obamacare premiums in Florida will rise by an average of 45% next year, for example. Even using official data from the Federal Reserve, most Americans are worse off now than they were before the financial crisis. Chart 3 shows the data for real growth of incomes and net worth, and unless you are in the top decile, you are worse off. Indeed, data for median household real income (not shown) illustrates that despite a large boost in
the last two years, the median household is barely better off than it was in 2000, and we suspect that many households remain worse off when we measure income versus their true cost of living. Chart 3 Real income and net worth growth 2007 to 2016 by percentile Many suspect that it is the plight of a large number of middle and lower income families that helped Donald Trump win last year s election; that much appears obvious. Trump is now trying to work with Republicans to pass a wide ranging tax reform that he claims will benefit everyone. As we only have a proposal at this stage, and we know that the final version that is signed into law will be different, it s difficult to predict exactly what the benefits to the economy and households will be. We will make a couple of observations though. First, although after tax income will increase for US workers, this does not guarantee that their standard of living will increase. As noted above, it is probable that most households have experienced faster price inflation than the official inflation rate would indicate. If this continues (and it certainly looks like the biggest expenditure for many households being healthcare will increase rapidly again next year), then this will swallow up some of the tax gain. Second, there is an enormous pensions problem affecting all levels of Government. For the state and local governments, who have to balance their books by law each year, as these pension commitments become due either pensions will be reduced or taxes will have to rise. So, in the years ahead, the pensions crisis will at least offset some of the tax gain, perhaps eventually completely offsetting it. Third, although the administration will make many claims about how the tax reform will benefit everybody, the fact is we simply don t know what will happen. For the corporate sector, who seem to be quite large beneficiaries, it is hoped that companies will take the extra dollars they have available, and invest in new plant and equipment and create more jobs for Americans. This may well happen, however, we cannot assume this is a safe assumption as we need to understand the incentives involved here. We have been working with the assumption for the last two decades, that corporate America (especially the large quoted sector) have the wrong incentive structure. American executives compensation is dominated by share options,
and obviously the incentive is therefore to get the share price as high as possible. Although this seems to align management and shareholders interests, we do not think that all stakeholders are aligned. Rather than invest in new plant, equipment and worker training to try and boost their long term profit potential, quoted American companies have become much more focused on financial engineering. All too often, management choose to buy back shares rather than increase investment, sometimes increasing debt to do so. All too often when profits look to be falling short of estimates, companies will announce mass layoffs. And often, rather than investing for growth, companies will acquire growth through mergers and acquisitions. Sometimes, companies do all of these at the same time. So, if companies suddenly find themselves with more free cash available, will they invest and create jobs? Or will they simply engage in more financial engineering which may actually cost jobs? Even if they choose the invest and create jobs route, the US economic cycle is looking increasingly mature, and not in need of a massive fiscal boost. Some companies are already complaining that they cannot find skilled labour at the right price. Any fiscal boost now could tighten the labour market even further, thereby increasing the risks of a significant increase in the rate of inflation in the years ahead. The fact is that nobody knows what effect the tax proposals will have on the economy. However, claims made by the administration that the growth the tax plan will create will pay for the tax cuts is probably just wishful dogmatic thinking. The likelihood is that the tax plan will simply increase the Federal Government deficit. So let s try and bring these thoughts into some sort of conclusion here. Despite a still lacklustre GDP performance, it is clear from surveys that small businesses (the true job creators in America) and consumers appear pretty content with the current state of affairs. Perhaps Trump s deregulation drive and tax proposals are indeed just what the country needed unleashing the animal spirits. If so, then we would expect inflation to start rising and the Fed will most likely continue to tighten monetary policy, via both balance sheet reduction and rising rates. Chart 4 Small business and consumer sentiment
In fact, many economists expect to see a mini cycle low for inflation right about now, and for the Fed s 2% target to be reached in the first half of next year. We concur with this, and assuming a tax plan of sorts will be passed, the Fed will be tightening more than the markets are currently pricing. We can actually see an economic scenario in a few months where some economists will actually be getting quite excited about a real pick-up in growth. The rebuilding post two devastating hurricanes along with tax reform and a cyclical pick-up in inflation could make the data look pretty decent heading into the first half of next year. As far as our bigger picture view goes, we hold some reservations. We think that the Fed will continue to tighten. We worry that many households will see rising costs offset a good amount of the tax cut. We worry that the incentive structure of large quoted corporations is wrong and that they could choose to squander a large part of their tax gains on financial engineering. We think that the tax bill will only increase debt, which is already proving to be a headwind to growth, and just as off balance sheet liabilities are coming home to roost. So in short, we can see some short term excitement over the economy, but no major long term benefits, perhaps even rising costs and inequality. If the Fed do continue to tighten policy, they will simply keep going until something in the financial markets breaks a good old fashioned policy error. If the Fed are struggling to understand the fundamental drivers of one of their policy goals (and a price target they chose themselves only a few years ago), we can t really have faith that they really know what they are doing. Perhaps the policy error will be similar to 1999 and 2007 when they kept policy too easy for too long, and created financial bubbles that wreaked havoc on the real economy once they burst. Perhaps they think that asset prices are already too high and that they need to tighten more aggressively now so that when Yellen steps down early next year, she can say that she had put in place the correct normalisation policies. Our view remains that most market prices; bonds, credit and equities (as well as some property markets and crypto currencies) are in varying stages of bubbles that will burst at some point. We continue to believe that the Fed will
make a policy error, and currently our money is on them tightening policy too much until something in the financial markets breaks. Even if we are right, the timing of these events could take a lot longer than we imagine. Equity markets continue to make new highs, but there are now signs that bond yields are turning higher, and the Dollar is showing tentative signs of improvement. If yields and the Dollar continue to rise (which we expect), and the Fed continues to tighten policy on two fronts, then at some point we expect a sharp increase in volatility and lower prices for pretty much everything. In fact, we think there is a strong case to be made that cross asset correlations become more positive, in which case diversification may not be much help to investors. Remaining fully invested today (as many ETF investors are by the nature of the product) is a bet that the Fed, and the other major central banks, will not make a policy error in this cycle, when history shows that policy error is in fact to be expected. Stewart Richardson RMG Wealth Management