Co-produced by Austin Rogers for High Yield Landlord
The Story of Inflation Up To Today
Austin here. I hate to admit it, but I haven’t exactly been spot on about inflation over the last year.
Around May, I argued that heightened rates of inflation would be transitory, probably only to last a few months and that they were mostly a result of base effects – that is, year-over-year comparisons in 2021 to strongly deflationary periods in 2020.
By “deflation,” I’m referring to the dirt-cheap plane tickets, ultra-low price of oil, and ability to buy out entire movie theaters for $99. What else do you call that besides “deflation?” When prices just returned to normal levels in 2021, the YoY comparisons would make it look like high rates of inflation.
That did happen. But then prices kept going up. The prices of almost everything kept going up.
- Semiconductor shortages (apparently microchip factories can’t just ramp up production at the snap of one’s fingers) led to surging prices of new and used cars.
- Lumber and other materials’ prices soared as depressed mortgage rates fueled a buying frenzy in the housing market, pushing up home values faster than any time since the housing bubble of the mid-2000s.
- Supply chain bottlenecks like container ship congestion at ports diminished inventories of consumer products as well as raw materials and intermediate products, making everything available more valuable.
This past fall, when I understood better how messed up the economy had become, rates of inflation in the 5% range began to make more sense. But I reassured anyone who cared to listen that inflation remained transitory. Supply chain breakdowns would be resolved in a matter of time because that’s what they do in a market economy. High prices are the cure for high prices.
I’ve also written extensively (see here) about the Five Horsemen of Disinflation (i.e. falling growth rates of inflation):
- Demographics. Aging populations and falling birth rates put downward pressure on economic and labor force growth.
- Technology. Technological innovation is inherently deflationary.
- Inequality. A smaller portion of money in the pockets of those with a higher propensity to spend translates into relatively lower aggregate demand.
- Globalization. International trade puts downward pressure on consumer prices and domestic wages.
- Over Indebtedness. Debt levels above certain thresholds have been demonstrated by numerous academic studies to weigh down economic growth.
These major macroeconomic forces are still at play, virtually assuring that the current bout of inflation will prove temporary. Hence why I thought this past Fall that high rates of inflation would soon come to an end.
Then the CPI surged further to 7% YoY in December:
The producer price index, measuring prices on the business-facing side, surged even higher to 9.6% YoY.
Now even Federal Reserve Chairman Jay Powell, who made “transitory” his catchphrase for most of 2021, has decided to retire that word and get serious about fighting inflation. As such, the Fed is aggressively tapering its government bond purchases and expects to raise interest rates multiple times in 2022.
This caused a sell-off in nearly all stocks. The S&P 500 (SPY) is down nearly 10%. REITs (VNQ) also. And even worse, innovative tech stocks such as those owned by the ARK Innovation ETF (ARKK) are down 50%! Some tech stocks like DocuSign (DOCU) and Peloton (PTON) are down as much as 80%.
But could the reasoning behind the “transitory” narrative still be true, even if “transitory” is taking longer than anyone expected? I would argue that inflation is still likely to prove impermanent – by which I mean it should fizzle out over the next year or two – and for this reason, this is a buying opportunity. To understand the argument, one must first grasp the fundamental driver of inflation in 2021.
The Fundamental Driver Of Inflation
To be clear, some level of inflation is virtually assured in a fiat currency system, because the creation of new money happens so easily. From 1980 through 2019, for instance, the growth of the money supply has dramatically outpaced population growth.
When the money supply increases faster than the economy can absorb it, prices tend to rise. With more dollars circulating in an economy with the same amount of goods and services, inflation is a natural consequence.
But then came the pandemic and the government’s response to a locked-down economy was to enact the biggest stimulus program in the nation’s history. Through direct stimulus checks and other means, the money supply exploded by around 40% in two years.
From 1980 to 2019, the money supply grew ~20x faster than the US population. But in 2020 and 2021, the money supply grew about 40x faster than the US population.
You can see the stimulus checks, sent out to hundreds of millions of Americans simultaneously, showing up in real (adjusted for inflation) disposable personal income as three massive spikes:
Real Disposable Personal Income:
Since the last round of stimulus, however, real disposable personal income has slid back toward its pre-pandemic level. It was only 2.0% higher in late 2021 than in February 2020.
Only 2%! The money supply is nearly 40% higher. Nominal GDP is 8% higher. But the vast majority of that nominal GDP growth comes from rising prices. The CPI today is 7.75% higher than in Q1 2020.
Worse, the private economy on its own, excluding government transfer payments such as Social Security and unemployment benefits, has generated even lower real income growth since the onset of COVID-19.
Real Personal Income Ex. Transfer Payments:
Compare the general trajectory of the period from 2015 through 2019 to the period from late 2020 to now. Notice the flattening?
From 2009 through February 2020, real personal income ex. transfer payments (“RPIxTP”) increased at a rate of 2.9% per year. As of November 2021, RPIxTP is up a mere 0.57% over its pre-pandemic peak in February 2020. That is 0.57% growth in RPIxTP over a span of 21 months, or 0.33% annualized.
Most of the 2% gain in real disposable personal income has come from government transfer payments, which in Q3 2021 were still 29.7% higher than their level in Q1 2020 (before any COVID relief had been sent out).
It should be noted, however, that government transfer payments have been falling since the big spikes when stimulus checks were sent out.
Government Transfer Payments:
So, if most of the gain in real personal income came from transfer payments, and transfer payments are now declining back to more normal levels as emergency government spending plans fade to the background, what will fund further growth in consumer spending?
Notice below that real PCE was 4.4% higher in November 2021 than February 2020.
Real Personal Consumption Expenditures:
However, nominal PCE was 11.1% higher in late 2021 than in February 2020.
In other words, while consumers collectively spent 11.1% more money on goods and services in November 2021 than in February 2020, we only purchased 4.4% more actual stuff (goods and services). The rest of the additional money spent came from price hikes.
When we look at real (again, meaning “inflation-adjusted”) retail sales YoY, we find base effects spurring a big spike in Spring 2021 corresponding with the dip in Spring 2020. Even so, real retail sales growth remains higher today than it was before the pandemic.
If real disposable income is up only 2% from before the pandemic while real personal consumption is 4.4% higher and real retail sales are increasing 8-9% YoY, what exactly has fueled this growth in consumer spending?
Answer: Mostly savings.
The bad news on this front is that the massive amount of cash stashed in bank accounts from stimulus checks during the pandemic is now all but depleted.
This is perhaps the most important chart in this article:
Government stimulus-fueled consumer spending caused a huge mismatch between supply of and demand for physical goods during the pandemic. Thus, the depletion of excessive, pandemic-era savings should dampen demand for physical goods. This removal of artificially high demand for goods should then allow supply and demand to rebalance, thereby ending the fundamental driver of inflation.
Going forward, real consumption growth will have to rely on wage growth above and beyond the rate of inflation – or else it will have to come from credit card debt.
Again, I have bad news to deliver: real (after inflation) wage growth has been falling quarter after quarter since Q2 2020, the first three months of the pandemic.
Real Wages and Salaries For Full-Time Workers:
In fact, as we can see above, real wages are nearly back to the level where they were just prior to the pandemic. This does not mean that nominal wages have not risen; they have. It means that inflation has risen faster than the average worker’s wages.
And the situation around real wages is actually worse than it initially appears. Consider this: Having a larger than usual amount of savings gives workers options. It gives them the option to quit a job they don’t like and to hold out longer than they otherwise would for the best possible new job.
The depletion of savings, then, may very well translate into less negotiating power over employers and thus less wage growth.
And after a brief period of paying down credit card debt during the pandemic (largely using stimulus check money), it appears that credit card debt is on the rise once again.
The reason consumers are building up balances on their credit cards again is almost certainly that their savings have been depleted and their wages haven’t kept up with prices.
This is not a sustainable situation.
It’s especially unsustainable given the gradual return of workers to the workforce.
Total Nonfarm Employment:
The total labor force remained 2.5% lower in late 2021 than in February 2020.
Much of that diminished labor force, though, is due to early retirements. The labor force participation rate (“LFPR”) among those aged 55+ has dropped by about 200 basis points from before the pandemic and has not rebounded. Many workers in their 70s, 60s, and upper 50s probably checked their 401k accounts and stock portfolios and realized they had more than enough to retire.
Meanwhile, as you can see in the second panel above, the LFPR among the prime working-age population (age 25 to 54) is making a slow but steady comeback. As of November, it was down only 120 basis points from its pre-pandemic level, up from a low of about 300 basis points.
Early retirements have been a boon to prime-age workers as the departure of older, more experienced (and perhaps higher-paid) workers up the food chain has made room for younger workers to earn promotions and move up.
This results in a positive trickle-down effect, as the entry- or mid-level professional jobs those younger workers once filled become vacant, allowing the many college-educated but underemployed workers to move into those professional jobs.
During the 2010s, it became commonplace to hear stories of the college graduate who worked as a barista. In 2016, The Atlantic reported that around half of recent college graduates between age 22 and 27 were underemployed – i.e. working in a job that doesn’t require a college degree. Today, with job openings left and right, many of those college-educated baristas and bartenders are moving into professional (requiring a college degree) jobs.
As many have noticed, though, this has left many restaurants, bars, and retailers unable to remain fully staffed. “Now Hiring” signs hang in the windows of countless establishments across the country. But recently, this seems to have led to a further trickle-down effect, giving teenagers and early twenty-somethings the chance to get their foot in the door of employment.
Though a far cry from the ~70% peak LFPR for 16-24 year-olds in the late 1980s, participation in the workforce has surged among this age group in recent months. Indeed, this is the only age group in which the LFPR is already back to its pre-pandemic level.
Given the depletion of savings, rising credit card debt, wage growth unable to keep up with inflation, and the ~11 million job openings (about 50% more than the highest number of job openings at any point in the last 20 years), I would expect to see employment growth for the prime working-age group as well as for younger workers accelerate from here.
This should dampen wage growth as employers become less desperate for workers over time. And, in turn, lower wage growth should then result in lower demand for consumer goods, thereby allowing inflation to cool down.
Bottom Line
The root cause of the Great Inflation of 2021 was a massive supply-demand imbalance created by two events:
- Economic lockdowns that reduced productive capacity and funneled consumer spending toward goods and away from services.
- Unprecedented amounts of government stimulus money artificially boosted consumers’ ability to spend when it would normally be diminished.
We’re still living in the midst of this supply-demand imbalance, but depleted savings and rising credit card debt signify that consumers have burned through the stimulus money. Moreover, even as consumer capacity to spend decreases going forward, supply chains should be steadily strengthened and bottlenecks eliminated.
As of October 2021, a survey of business owners shows that about 60% believe the supply-chain disruption should end by or before sometime in Q3 2022. About 85% believe it should be resolved by or before the end of 2022.
It appears that the bond market, which is often called the “smart money,” is convinced of the “transitory” narrative. If the bond market believed that inflation would continue to run hot at its current high rates, then the spread between the 10-year and 2-year Treasury yields should have continued to expand. Instead, it has contracted since mid-Spring 2021:
Moreover, the five-year, five-year forward inflation expectations (what the market expects inflation to average in the five-year period beginning five years from today) remain muted at 2.3%.
5-Year, 5-Year Forward Inflation Expectation Rate:
And the Cleveland Fed’s 10-year inflation expectation (where they expect consumer inflation to be 10 years from now) likewise remains under control – no higher than it was immediately before the pandemic.
In short, then, it still appears as though we are in a disinflationary environment in the long run, despite the wild economic environment we are living through today.
As such, we are not fundamentally changing our investment approach to adapt to what we believe will ultimately prove a temporary phenomenon.
We hold REITs with long-term leases and fixed rent bumps, but we also hold six residential REITs (or REITs with significant residential exposure), a farmland REIT, and retail REITs that hedge against inflation almost by definition.
So we feel that our current portfolio is well-protected from inflation for as long as it remains elevated. But, at the same time, we’re also happy to continue holding net lease REITs like Realty Income (O) and National Retail Properties (NNN) with long lease terms and contractually fixed rent increases of around 1-2% per year. These more bond-like REITs are today undervalued and should outperform if our “transitory inflation” thesis plays out as we expect it eventually will.
We continue to buy the dips and let others panic. This served us very well in 2020, 2021, and we expect more of the same in 2022: