by the Asset Allocation Committee | PDF

Every quarter, the Federal Reserve publishes the Financial Accounts of the U.S., previously referred to as the Flow of Funds report.  The report is huge and provides a balance sheet and income statement of sorts for the economy.  The data offer interesting insights into the financial situation of the economy.  In this week’s report, we will highlight some of our favorite charts.

This first chart shows net saving for the economy.

Net saving is a balance sheet concept; saving in one sector must, by design, be offset by dissaving in another.  The pandemic has clearly led to a historic accumulation of household saving, mostly created by a similar increase in government dissaving.  How these household savings are used will be the key to the economy and markets for the next few years.  If it goes to consumption, inflation will likely accelerate.  It could also go toward debt reduction, which would lead to slower immediate growth but lay the groundwork for better future consumption.  It could also go to financial assets; later this month, the Fed will update the distribution data and we will update the allocation of this saving by income group.  Although the household saving and government dissaving does dominate the chart, the foreign and business saving data are also important.  Foreign saving is the inverse of the current account; since the U.S. runs a current account deficit, essentially, it is acquiring foreign saving.  That number has started to rise as well.  On the other hand, business saving has turned negative, which often supports increases in business investment.

This chart shows the shares of national income by capital and labor as a percentage of national income.   Since 1990, when communism fell, we have seen capital income rising against labor in each business cycle.  There is a tendency for labor to gain on capital during recessions, mostly because capital income tends to fall more than wages during recessions.  At some point, we suspect this trend will be reversed as it isn’t politically sustainable.  But that change probably won’t occur until much later this decade.

Finally, the last chart that caught our attention was one that shows we are nearing a normalization of housing finance.

This chart shows home mortgages as a percentage of the value of real estate.  At the peak of the housing crisis, home mortgages were more than 50% of the value of housing.  This was partly due to leverage and partly due to falling home prices.  The combination of conservative housing finance and rising home prices has led to rising home equity (and, consequently, lower leverage as this chart shows).  We are not at the level of the mid-1980s, but we are approaching it.  As home finance improves, it should bolster further expansion in the housing sector.

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by the Asset Allocation Committee | PDF

As the global economy begins to recover from the coronavirus, we’ve been warning that the apparent surge in price inflation may not be all that it seems.  Inflation is usually calculated as the percentage change over one year.  Since many consumer prices stagnated or fell at the start of the pandemic a year ago and only recently started to recover, “base effects” alone make it look like inflation is extraordinarily high.  In fact, the May consumer price index (CPI) was up 5.0% from one year earlier, marking its biggest annual gain since mid-2008.  To look through the unusual pandemic distortions and see where the trends really are, we’ve begun to focus more on the two-year rate of change.  As shown in the chart below, a comparison of the CPI in May 2021 versus the CPI in May 2019 would imply an average annual rise of just 2.5% over the last two years.  That’s still elevated compared with the recent past, but it’s only half as big as the inflation rate calculated over one year.

We’ve been arguing that these base effects will drop out of the calculation and result in more moderate inflation readings later this year, but the same can be said for many other economic indicators, even if they aren’t typically calculated on a year-over-year basis.  For example, the Federal Reserve’s index of manufacturing production for April (latest available data) was up an astounding 22.8% from April 2020.  However, that largely reflects base effects related to last spring’s sharp drop in output followed by a more recent recovery in production.  If we compare output in April 2021 to the output in April 2019, the average annual increase over the last two years comes to -0.9%.  In other words, factory production these days is actually a bit less than it was before the pandemic.

The concept of base effects may be especially important for stock investors as they look at corporate earnings.  In the first quarter of 2021, earnings per share (EPS) on the S&P 500 index will be up approximately 288.1% year-over-year, but that’s only because of the sharp drop in profits at the outset of the pandemic followed by a recovery in recent quarters.  As shown in the chart below, the expected EPS of $46.10 would only represent an average annual gain of about 14.7% over the last two years.  That’s better than the average annual EPS growth of about 8.4% over the last couple of decades, but it’s still weaker than the average gain of 16.2% over the most recent five years.  In sum, investors should be mindful of the big distortions that the pandemic has caused in all kinds of economic and financial data.  Looking at the two-year average changes may help investors gauge the true state of affairs more accurately.  While we still think equities can perform well in the near term, the gains may be much less dramatic than might be implied by just the year-over-year earnings growth.

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by the Asset Allocation Committee | PDF

In May, respondents to the University of Michigan’s monthly Consumer Sentiment Survey said they expect consumer prices to rise at an average rate of 4.6% per year over the next half-decade—the highest level of inflation expectations in 12 years. In this report, we discuss why inflation expectations are rising, what the rise might mean for future inflation, and the impact it may be having on financial markets.

Inflation expectations are the proverbial boogie man of economics. Rising inflation expectations can put upward pressure on interest rates and prices, and they can cause consumer confidence to plummet. In the 1970s, rising inflation expectations became a self-fulfilling prophecy. Fearing higher prices, consumers would stock up on goods, which led to persistent inventory shortages. The lack of inventory induced firms to raise prices. The rise in prices increased the cost of living, which encouraged workers to demand more pay. This increase in pay would then be used to stock up on goods, thereby restarting the cycle. This phenomenon is often referred to as the wage-price spiral.

To bring down inflation and inflation expectations, Federal Reserve Chair Paul Volcker set short-term rates so high that they caused a double-dip recession in 1980 and 1981. Although Volcker was successful, the memory of what it took to control inflation expectations remains forever ingrained in the minds of those who had to live through the process. Keeping inflation expectations anchored is therefore considered critical to the Federal Reserve’s mandate of maintaining inflation at around 2% annually.

One reason for optimism regarding inflation expectations today is that they have historically fluctuated in line with the Consumer Price Index (CPI), as shown in the chart below. Inflation expectations can act more like a gauge of consumers’ present experience of inflation than a predictor of future inflation. In April, the two most important U.S. inflation gauges were both showing price increases well above the Fed’s target and far in excess of the average experience in recent years. The CPI was up 4.2% year-over-year, and the price index for personal consumption expenditures was up 3.6%. However, this high level of inflation is largely related to the recovery in prices from their early-pandemic lows one year ago. It can also be attributed to several other factors, such as pent up consumer demand, supply chain disruptions, and unprecedented fiscal stimulus. Importantly, all these factors are likely to be transitory, so today’s inflation and inflation expectations will probably moderate over time.

Furthermore, over the last 10 years, inflation expectations have routinely overshot actual realized inflation, sometimes by more than 2%. This upward bias may be due to a few survey respondents having a disproportionate impact on the overall report. In the latest surveys, for example, inflation expectations surged among those in the 75^th percentile (i.e., the 25% of respondents with the highest expectations). As shown in the chart below, expectations rose more modestly among those in the 50^th and 25^th percentiles, suggesting that realized inflation in the next few years may not be as bad as some consumers fear.

That being said, high inflation expectations have shown up in the financial markets. The yield spread between the nominal five-year Treasury note and the five-year Treasury inflation-protected security (TIPS), also referred to as the five-year breakeven rate, has widened to a 16-year high. Although the spread has eased over the last few days, it does show that investors have begun pricing in higher inflation. Of course, economic theory would suggest that unanchored inflation expectations should result in rising yields of longer-duration bonds. However, this time around, yields are likely to be capped by factors such as the high level of household saving. This large holding of savings has also pushed down the velocity of money, thus reducing inflationary pressure on the economy. As a result, we suspect the rise in the breakeven rate may be an overreaction to recent reports and would caution against hastily jumping to conclusions regarding inflation. Although inflation expectations are a concern, it is important to note that these expectations need to be sustained over a long period of time before they translate into actual inflation.

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by the Asset Allocation Committee | PDF

(Due to staff vacation schedules, there will not be an accompanying podcast and chart book this week. The multimedia offerings associated with this report will resume next week, June 11.)

Over the past five years, the United Kingdom has been the backwater of investment attraction.  Much of the investor indifference originally stemmed from Brexit and the ensuing drama that unfolded.  Recent issues associated with COVID-19, particularly the error-plagued early responses, have depressed asset flows further.  As evidence, among developed countries, the United Kingdom registered the lowest five-year annualized return through the end of last year.  Investor indifference has led to attractive fundamentals for British companies relative to those in the rest of the world, particularly versus U.S. counterparts.  The operative question, therefore, is whether the U.K. will continue to be an investment pariah, or will the conclusion of the Brexit saga soothe investor concerns?

The first issue is obviously the current status of Brexit.  While we have written on issues faced by the United Kingdom as an outgrowth of Brexit, we note that these will be borne out over an extended period of time.  The recent approval of the EU-U.K. Trade and Cooperation Agreement (TCA) by the European Parliament, while still requiring further details between the two sides, sets an essential framework for business practices.  Though the TCA doesn’t place Brexit fully in the rearview mirror, the ring fence is now narrower than at any point since the vote in June 2016.

Combined with the resolution of trade, U.K consumer demand is expected to bounce back in the second quarter.  Such demand expectations have driven the IMF to upgrade its growth forecast for the U.K. to 5.3% this year and 5.1% in 2022.  Adding credence to the argument for strong growth is progress registered against COVID-19.  Although Britain blundered in its early response to COVID-19, as noted previously, recent data are much more optimistic for the British populace.

A further attraction for U.S.-based investors is the valuation of the British pound versus the U.S. dollar.  Our estimates of fair value place the pound at more than one standard deviation below parity.  An increase in the value of the pound would be a tailwind for U.S.-based investors.

Although there is uncertainty surrounding the long-term fallout from Brexit, the prospects for the U.K. over the next few years appear favorable and valuations among the unloved U.K. equities are certainly less stretched than their U.S. counterparts.  While we find U.K. large cap stocks to hold appeal for more moderate risk thresholds, U.K. small cap stocks hold even more appeal for aggressive investors on a range of valuation measures relative to small cap U.S. equities.  Since small cap companies are often less integrated into the global economy, they should be less adversely affected by a strengthening pound.

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