During extended bull markets it becomes easy to believe the path of least resistance is up, and harder to see the risks that could whipsaw stocks. Take January 2020, when investors remained confident even as stock valuations were already being viewed as stretched. That was right before reports about a virus in China began to surface. This month, the path of least resistance again seemed up, until Reddit and Robinhood and GameStop gave the market its latest example of a black swan reminder that there is always something out there you won’t see coming.
What’s not a surprise is that investors panicked. Sophisticated Wall Street trading instruments that are opaque to the investing masses and risk of hedge fund failures rippling through the market are flash points for past crashes, from Long-Term Capital Management to the subprime mortgage crisis.
There will always be new market risks. Others, though, should be easier to spot coming. Inflation, for example, which is a classic market bogeyman.
“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures,” Warren Buffett once wrote. “The inflation tax has a fantastic ability to simply consume capital. … If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker — but not your partner.”
Warren Buffett and the worst inflation
Buffett lived and invested through some of the worst inflation ever in the 1970s. And before the 2008 crash, he warned that $4 gasoline was a not a good sign for anyone. But he also warned that the Fed’s printing of unlimited money after the crash would have unintended consequences. One has been maybe an inflated stock market, but actual inflation has remained low and Buffett has more recently said, no economics textbook of the past 100 years can explain this market.
As GameStop makes investors fear that there is a new normal in the market with unknown consequences, is inflation a classic market bogeyman that no longer has the power it once had? It would have been easy to miss Federal Reserve chair Jerome Powell this past week on inflation, but he was talking it up — and at the same time, sort of talking it down.
“Frankly we welcome slightly higher, somewhat higher inflation. The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in for some time,” Powell said after the Fed’s most recent FOMC meeting.
Though inflation remains low, investors worry that the Fed could start to taper its market purchases unexpectedly should conditions change and that could cause another period of market tumult. Even if the GameStop shock goes away, will there be a more classic factor for investors to worry about?
Powell pledged that the market will get plenty of guidance before any tapering actually happens. “When we see ourselves getting to that point, we’ll community that clearly to the public so nobody will be surprised when the time comes,” he said on Jan. 27.
The Fed has been signalling for some time that its policy on rates and inflation is part of a new policy normal, and it will tolerate higher levels even as employment rises and the economy runs hotter. The truth is that inflation has been in secular decline for decades, says Nicholas Colas, co-founder of DataTrek Research, and even all the money printing post-financial crisis failed to spark it. Inflation seems to retain more power as a political sound bite, especially among Republicans, than as a market force.
As Colas likes to point out, using a visual aid, if the following chart were a stock chart, would you buy it?
The Federal Reserve Bank of St. Louis charts the year over year change in headline CPI, and it has been declining.
Federal Reserve Bank of St. Louis
“Most answer ‘no,'” Colas said.
And Colas says it is hard to imagine rampant inflation with an aging, low growth population. “The experience in Europe and Japan sort of says no. U.S. population growth down to 0.3%. Average age rising. And China actually has worse demographics than the U.S. on this count. How do we get global inflation with slower household formation and overall pop growth?”
That doesn’t mean investors won’t continue to worry. The older and more conservative an investor is, the the more this issue may stay in focus whenever markets get back to more traditional worries — not pandemics and trading revolutions born on Reddit.
But Colas says that investors should understand a few important things about the new world and inflation. For starters, an inflated stock market does not mean there is financial inflation.
“Lots of people think goods inflation (CPI, PCE) has been replaced by financial asset inflation;” Colas wrote in a recent research report. “Is that really a thing? Not really. Financial assets are priced on expected future cash flows and discount rates. CPI/PCE measure the prices of things that get consumed (no cash flows to discount). You can think the stock market is overvalued, but calling that inflation is wrong. In fact, inflation can help future earnings and make stocks more valuable.”
The Fed says expect inflation, but don’t worry about it
Inflation is coming.
“We will see higher comps soon,” Colas said. “Powell talked about how a resurgence in consumer spending might drive inflation. The back half of the year we will see consumer inflation higher. … Powell acknowledged that.”
And in some ways, the setup for inflation is similar to that dark period of the 1970s when Buffett and so many other investors of older generations became permanently afraid of its power. Colas noted that during the fiscal spending of the Great Society and Vietnam War era the Fed did not want to pursue any policy that seemed to be at odds with either social progress or a war, which can be compared to the present war against the Covid-19 virus and the government spending on it amid rising economic inequality and concerns about social justice.
The Fed predictions market doesn’t expect the central bank to soon get any more brave about taking on that environment. The Fed funds rate tracker has the chance of a rate increase by 2022 recently pegged between zero and 10%, Colas said.
An initial phase of inflation could even be good for stocks, giving companies more pricing power and as a result better earnings. Between the current Fed outlook and that initial inflation influence on the market, Colas says that if GameStop turns out to be a “footnote” — though all bets are off on that for the moment for those who don’t want to be on the wrong side of the market’s most powerful current force — then stocks should be able to continue up.
Inflation indicators to watch
There are some inflation indicators that investors should keep in mind.
Gold demand is one. Flows into gold funds went negative in Q4 2020 after peaking in Q2 and Q3 2020. According to Colas, “If funds flow go positive in gold funds again, maybe that would mean inflation. … but there’s not much happening now.”
Bitcoin is the “new gold” to watch, but its meteoric rise last year and into this year was more a function of institutional buyers buying into the cryptocurrency than inflation fears, he surmises.
Traditional currency markets are also to be watched. In the 1970s, the German and Japanese currencies rallied every year of the decade. “The yen and the deutschmark rallied all the way through. Marginal global investors were saying inflation is too high in the U.S. and we are not getting paid for risk,” Colas explained.
The analog now is the Chinese yuan. It is in the middle of its 10-year band now, but if the yuan were to move up a lot, say 10% to 20%, that would suggest that global investors are worried about the medium- term outlook for U.S. inflation.
The Fed’s power will be key as well. When the 10-year yield rises even when “the Fed is putting its finger on the scale,” that’s a danger sign.
“Stock valuations are a function of cash flows and rates and that’s it. So if rates go up, stocks go down, unless the earnings growth rate is faster than the risk free rate,” Colas said.
Some market experts say the current Gamestop panic has been spurred by a Federal Reserve policy that has provided too much support for stocks, and too little opportunity for savers given low rates, while stimulus checks have led more stuck-at-home, and unemployed, Americans to day trade on their futures. The current market battle is about much more than just that, though it is true that the high-yield online savings accounts that attracted a lot of attention in recent years have seen their rates sink. As inflation stays low, it’s high short interest on stocks that you could say — to use a term often associated with inflation — has spiked. The subreddit WSB (wallstreetbets) group has passed 7 million subscribers. If actual inflation is next, there are reasons to believe that investors should at least be able to have a better handle on it.
