Market Commentary – February 2021
“Inflation is always and everywhere a monetary phenomenon, resulting from and accompanied by a rise in the quantity of money relative to output…. It follows that the only effective way to stop inflation is to restrain the rate of growth of the quantity of money.”
– Milton Friedman
It feels good to be back in the saddle writing the market commentary again. Not that I didn’t enjoy interacting over video and the webinar format in 2020 (the investment team will continue those quarterly), but there is something therapeutic about the writing process. Writing requires concerted effort, and there’s just something about taking the time to slow down that is appealing in a world full of headlines, tweets, and 30-second sound bites. Hopefully, there will be some value to you in the sharing of these ideas in the market commentary, which I’ll aim to contribute on a monthly basis. The topic of this month’s missive is inflation. While an acute rise in inflation has yet to show up in the official Consumer Price Index (CPI) data (January’s reading was a paltry 1.4% year-over-year increase), we think it is only a matter of time. A review of the intermarket linkages will guide the way. We’ll show how the massive increase in the money supply (M2) leads to a weakening of the currency, which in turn begets higher goods and commodity prices, finally pushing official inflation data higher, albeit on a lag. As one of the key inputs to our QUAD process, a forecast for the change in direction of CPI has significant implications for our investment portfolios.
Inflation, everywhere but the (official) data
Economist and Nobel laureate Milton Friedman, quoted above, is the father of the monetarist school of economics and a major proponent of free-market capitalism. His seminal book, A Monetary History of the United States illustrated the central role of monetary policy in creating and exacerbating the Great Depression, and how changes in money supply affect price levels ie inflation. For our purposes, the key takeaway is that Friedman argued that too large of an increase in the money supply, (M2) would eventually spur meaningful inflation.
I’ll invite the reader to look at the chart below, which plots M2 year-over-year percentage growth going back to 1960.
Prior to 2020 the largest increase to our money supply never eclipsed 15% growth. As we see over the last year M2 growth exploded to over 25% year-over-year driven by unprecedented levels of fiscal and monetary stimulus. The other aspect to consider is monetary velocity, or how quickly these dollars turnover, which has a multiplier effect on the economy. For now, velocity is extremely low. We’ll be watching this metric extremely closely as a small uptick in velocity on top of all these additional dollars in the system could be the spark that causes runaway inflation.
As we’ll see in the next chart, courtesy of BCA Research, the United States is set to lead the globe in fiscal stimulus as a percentage of GDP, after accounting for the CARES Act, the second round of stimulus checks, and the Biden administration’s plan for an additional $1.9T in the first half of 2021.
When looking at the relationship between money supply and the value of the U.S. dollar relative to other currencies, there’s no surprise that such a rapid increase in the supply of dollars, which began in earnest in March 2020 (green line), leads to a decrease in the value of the dollar (blue line) as the next chart highlights. As of this writing, the value of the Bloomberg Dollar Index is down over 12% from the peak in March of last year. In currency space, a 12% drop could be considered a crash!
As the world’s reserve currency, the U.S. dollar has an outsized impact on the prices of goods and services. The next chart illustrates the relationship between the rate of change in the value of the U.S. dollar and the price of non-durable goods. In the chart below the value of the dollar (blue line) is inverted, meaning that a rising blue line actually means that the value of the dollar is falling (left-hand axis). As the value of the U.S. dollar falls the price of non-durable goods rises, typically with some sort of a lag. We expect the prices of goods to “catch up” to the weakening dollar over the coming months.
Source: Daily Shot
Last but not least, it is important to understand the link between the rate of change in prices of goods, in this case, commodities, and the rate of change of inflation (CPI). We compare the value of the Bloomberg Commodity Index to the year-over-year rate of change in CPI with a one-month lag. The strength in commodity prices since March of 2020 indicates a high probability that sharp increases in inflation are just around the corner, which will likely exceed the consensus forecast of 2.2% for 2021. (Bloomberg)
A rise in inflation, especially when it exceeds expectations, has massive ramifications for asset markets, which is why it is a key input into our macro QUAD process. The forecast for at least the next two quarters is for rising inflation, along with rising GDP growth, which we refer to as QUAD 2. We’ve discussed the major investment implications most recently in our 2021 Market Kickoff video, which can be watched here. But I’ll leave some key takeaways for this market commentary:
1. Rising growth and inflation expectations typically cause Treasury yields to rise, which can be detrimental to Government bonds and high-growth sectors of the stock market.
2. Equity investors would do well to increase exposure to cyclical sectors of the market and away from rate-sensitive defensive sectors.
3. Commodities and commodity-linked stocks can add diversification and upside to traditional stock and bond portfolios in these macro environments.
We began making these pivots to our portfolios back in late-October and these exposures have served our clients well to begin the year. As always, we will strive to maintain our discipline, stick to the process, and stand ready to pivot as conditions change. Thanks for reading my market commentary for February 2021.
Cliff Hodge, CFA – Chief Investment Officer of Cornerstone Wealth
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