First Forward Podcasts

Everyone's Talking About Inflation (November 1, 2021)

Episode Summary

First American Bank's David Lackmann, Director of Investments, and Kurt Funderburg, Director of Equity & Economic Research, discuss inflation's impact on today's market and what we can expect in the upcoming year.

Episode Transcription

SUMMARY KEYWORDS

inflation, economy, year, interest rates, fed, bonds, transitory, pandemic, impact, consumer, supply, higher, prices, spending, period, demand, people, spend, tend, increase

00:30

You're listening to First Forward Podcasts by First American Bank, where we bring you business and investment insights designed by our team of experts to help you meet your financial goals. Here's our host for today's episode.

00:48

Hi everyone, thanks for tuning in. I'm David Lackmann, Director of Investments for First American Bank.

00:53

And I'm Kurt Funderburg, Director of Equity and Economic Research for First American Bank.

00:59

Today we're going to talk about what we've all been feeling and seeing so much and that's the topic of inflation. We're here to answer some of the most common questions that we've been given and some questions that we've seen out in the marketplace about inflation and we're going to provide you with some clarity so let's jump right in and ask Kurt. Hey, Kurt, so the Fed is saying that there's little to no inflation. When you know, I live in Florida, I know you're up in Illinois, I mean, prices seem to be going up. All around you know, whether it's a visit to the store or whether it's a visit to a restaurant. So how can the Fed be saying that? 

01:37

Well, I think it's basically a measurement problem, David. The statistics that the Fed talks about, or that you see quoted on the evening news or in the newspaper, usually the consumer price index CPI or the personal consumption expenditure index, the PCE, those are basically statistical averages of what consumer prices do over an extended period of time. They don't really on a month-to-month basis necessarily match up well with what a consumer faces when he fills his gas tank, when he goes to the grocery store, when he pays his cable TV bill. They may have very little resemblance to each other in short periods of time, like a month, or a period of several months. Over the longer term, I think they do a better job. But there's certainly a big mismatch on a month-to-month basis between what those averages report and what the typical consumer will actually experience.

02:36

Yeah, I didn't you know, it doesn't feel good. Everywhere we go, you know, prices seem to be going up and you know, the paycheck doesn't seem to go as far as to budgets have to change at least household budget. My household budget has to change a little bit so it doesn't feel good. And I saw today where Social Security, I guess the cost of living for Social Security payments, rose pretty significantly. I think it was 5.8%. I think it was the highest rate increase in the last forty years. Is that a product of the Fed or the official seeing this inflation in the marketplace? Is that why they rose? You know, this cost-of-living increase for Social Security?

03:19

Well, David, I think that basically is governed by the statute. So, I believe the social security laws that are on the books state that the Social Security Administration has to look at these indexes that government follows to measure inflation. And when they show that inflation or prices have moved higher, the Social Security checks must move to address that basically, because if you're on Social Security, you have a fixed income. This is basically to keep those on Social Security, from being overwhelmed by increases in prices, because if inflation goes up 6% and your charge goes up too, your purchasing power has gone down by 4%. So, I think this is designed by statute to offset those increases and that's why we're seeing that at number.

04:06

Okay, so it's kind of indirectly related, but it is related because it's cost, I mean, it's what people were having to pay and like you said, if your check only goes up 2% but everything around you is going up 6% you know, you're going to be short and shorter. And most people on social security are kind of on fixed incomes anyway. So, it's incredibly important for them, you know, to get that cost of living. Okay, I appreciate that. Hey, another term I've seen thrown around quite a bit…I've heard Janet Yellen say it, I've heard economists say it, you know either on TV, social media, is something you read somewhere, and it's this term of transitory. What does transitory really mean? And where do you fall on that, you know, as far as this inflation that we're seeing in the marketplace or in the economy right now, is it transitory and what do you think?

04:54

Well, I think going to first concepts I mean, if you look at Webster's, they define transitory as something of a brief duration or not permanent. So, in other words, the way I think of it is temporary. So if you say inflation is transitory, you're saying this rate of inflation we're seeing now and have so far this year, is only going to last for a certain period of time, and then we'll go back to the more normal historical pattern of inflation at or below 2%. If someone tells you they know how long this type of inflation is going to last, how high it's going to go, how low it's going to go, when will it end? Don't listen to them because this is a highly uncertain and dynamic topic. There are lots of different things in the economy and even outside of the economy they've impacted, so, very hard to say how long this current bout of inflation will last. I'm in the camp that if you think transitory means inflation will be, this higher inflation, will be over by the end of 2021, I think you'll be disappointed. If you're more in the camp of this period of inflation probably peters out sometime late next year or in the first half of 2023, he may be closer to the truth there. There are lots of different things going on. I don't think, at least currently, that we're in for permanently higher inflation. But transitory feels a lot different if transitory is two years, versus two or three months.

06:25

One thing that I've never quite understood, and I've been doing this a long time and I know you have too, why does the Fed exclude food and energy from all the inflation statistics? You know, those two things are really important. But why do they exclude food and energy from all the inflation statistics?

06:43

Well, David, the short answer is that food and energy are two categories within the economy that tend to, in and of themselves, be very volatile, really independent of what is going on in the rest of the economy. So, think about those two areas: food, you can have major weather impacts on that, you can have a freeze of the citrus crop in Florida, which causes the shortage of citrus in the United States. Supply and demand says that's going to make citrus prices go up. And we've seen that happen again and again. But at the end of the year, the next year, unless we have another freeze, which statistically doesn't happen that often, we're going to be back to a more normal crop and the supply will get back to its where it normally has been and that means prices should come back down as supply and demand or more balance. Same thing in the energy markets. You could have weather impacts. You had the hurricanes earlier this year that knocked oil production off in the Gulf for a period of time, right? That meant supply of oil went down. So, guess what? The price of oil and, as a derivative, the price of gasoline went up as a result of that. With energy, you also have the fact that a lot of the world's energy still comes from the Middle East, a very politically volatile environment. And every year or two, it seems like there's a conflict of some sort or other that threatens to limit the capacity of energy that can be produced in that area of the world, and therefore threatens to reduce the supply of energy for the entire globe. And again, supply and demand, the way it works is if supply goes down, prices are going to go up. So those two areas, regardless of whether you're in a boom in the economy or a bust in the economy, tend to be volatile and tend to be independent of what's going on in the rest of the economic world. So those are why they're considered separately. The core inflation rate, which is what the Fed normally talks about, which is inflation, excluding food and energy, is more responsive to what's going on. In the economy. And so, since it's more responsive to what's going on in the economy, it's more responsive to what the Federal Reserve does with interest rates or other moves they may take to either heat the economy up or cool the economy down. So, those are more long-term trends that the Fed feels that they can appropriately address, while food and energy basically act independently and there's not a whole lot that the Fed can do. If you lower interest rates, it doesn't turn the oil wells back on in the Gulf of Mexico. If you lower interest rates or pump liquidity in the economy, it doesn't make more oranges grow in Florida. 

09:13

That’s a great explanation. And I think it'll help our listeners to understand a little bit more. Switching gears just a little bit during COVID…you know, a lot happened, obviously, but I think one of the silver linings that has come from this entire pandemic has been the fact that consumers have saved $5.4 trillion dollars in savings or money market accounts. So, consumers seem to be flushed with cash. I know corporate America is but even consumers seem to be incredibly, incredibly, you know, flushed with savings. With all that money sitting there and all the pent-up demand, is that going to lead to higher inflation too?

09:54

Well, David, I think it already has. The federal government, as the pandemic began back in March + April of 2020, correctly observed that if you shut down the economy, as we did to try to fight the disease, that's going to impact the economic well-being of virtually every American in one form or another. So, with all these people being thrown out of work, with factories shut down, restaurants shut down, schools, everyone's sort of locked in their homes trying to avoid getting sick, they correctly surmised that we need to do something to offset this pain in the economy, or we're going to be faced with something that probably looks at least as bad as the Great Depression, if not worse, and I don't think any of us want to find out what that was like. There are still a few people who are around who lived through it and can tell you it was not a very pleasant experience. But I think we don't want to plumb those depths again and see what that would be like. So, the government between April of 2020 and I believe, March of this year, pumped something in excess of $5 trillion into the economy. So even unemployed people, in many cases. Now we're getting a check every week, that was bigger than the check that they would have gotten if they had remained employed. And they didn't ever overspend. They had nowhere to spend it because we were all locked in our homes. So, we couldn't go on vacation. We couldn't go to a restaurant. We couldn't go to a movie. We couldn't go to a concert. And so, a lot of the things that we normally spend money on we couldn't get any more. So, what do we do? We either saved it in many cases, or we spent more on the things we could do which is buy goods. So, we have a consumer that was really in not bad shape coming into the pandemic, levels were relatively low, employment had been good, people were making money. They weren't stressed coming in and the government, through its fiscal stimulus, made sure that they weren't stressed during the pandemic, and they're not stressed coming out. So again, going back to supply and demand, there is a wall of money out there. And especially in the times we're in now where supply chains are snarled and supply is having a hard time getting back to where it was before the pandemic, that means more supply is chasing less demand. And that means inflation, typically, prices are going to go up until those supply and demand factors equal out which takes time to work through.

12:22

So essentially, Kurt, it sounds like you're saying that yeah, we got a lot of cash and it's all these lot of dollars out there fighting for less product if you will, because of the supply chain issues. And, you know, there's just not much, there's not enough product to meet the demand, if you will, for all the dollars that people want to spend. Is that fair to say?

12:48

Yes, that's completely fair to say.

12:49

Okay, here's another big number I'll throw at you. So Congress, Washington, our politicians, they're in the process right now trying to come up with this infrastructure bill, and the latest number was, I believe three and a half trillion. I know they're trying to trim some of that off anyway. It's a big number no matter what it is. You've got the infrastructure bill. We've got a spending bill out there, all that additional spending, that they're trying to legislate and pass. How does that impact or will that impact inflation as well? I mean, what are your thoughts on that?

13:23

Look, it certainly could. As we just stated, we already have an excess of savings in the economy. We already have too many dollars chasing too few goods and services. So, if we add on to this, I believe the figure is five and a half billion dollars over the past 18 months or so, if we add another three and a half or four and a half trillion onto that, the impact would tend to be even more inflationary. Now, the one saving grace in these bills currently being considered by Congress, if they pass, is that instead of being spent all at once, or in one or two years, as the five and a half trillion dollars we've already had has been spent in 18 months, instead of being an irrelevant spent in a relatively short period of time, these bills call for spending to be spread over five or ten years. So, the impact on any individual year will not be nearly as great as what we've seen over the last 18 months, with the fiscal stimulus, but it will still be stimulatory to the economy, it will still stimulate demand, and until supply can catch up with it, it will, I think, or it definitely has the potential to make the inflation problems incrementally worse on a year-to-year basis.

14:38

So, if I hear you right, it's not a huge impact on annual basis or not an immediate impact, but it is kind of spread out over 12 years. But nonetheless, there's got to be some kind of impact, right? Because corporations whether corporate taxes go up, which likely they will, those incremental revenue hits are probably going to be passed through somehow someway to the consumer, I'm guessing. So that's kind of inflationary to me as a consumer and to you as a consumer, and to all of our listeners, as a consumer. So, the spending that the government wants to do is somehow somebody is going to end up having to pay the piper so to speak, right? And, you know, so whether it's an increase in taxes, whether it's an increase in just the cost of goods, it's being passed through to the consumer. So you know, as I look at my pocketbook, as you look at your pocketbook, as we look at our budgets, you know, things are going to change, but to your point, it's going to change over a period of time, not just all in one, you know, one fail swoop, if you will, because the intent is to, to do it over a period of years. Is that an oversimplification? Or I kind of get what you were saying?

15:52

No, I think that's exactly what I was trying to say. I would add to that, that if you look at the pattern of our federal government over the last few decades, we're much better at producing spending bills, spending more money, than we are at offsetting that spending with increased taxes. I certainly am not advocating higher taxes for anyone, but to the extent that we keep spending more money, and we don't bring in more revenue to the government to offset that spending, that makes the inflationary impact even worse, if we're going to spend four and a half trillion dollars over the next decade, but we're going to recoup that in taxes both on businesses and consumers…yes, businesses will pass that cost increase onto consumers, consumers will face higher inflation, but if taxes are higher for the companies, they won't be able to reinvest as aggressively in their businesses. And so, growth will slow because of that, and you'll sort of have somewhat of an offset. But if we continue along this path that we've been on for the last few decades, and especially, I would say for the past five or six years, at least, of spending more but not really worrying about offsetting that spending with higher revenue that could make the inflationary impact even worse.

17:05

Yeah. So let me ask you this. What if the Feds are wrong? I mean, what if they're wrong about inflation? What if it does, you know, really rise much more sharply and last longer than, you know, they use that term transitory but what happens if they're wrong? I mean, how does that impact all the rest of us?

17:26

I think, unfortunately, the Fed has painted itself into a very difficult corner because the traditional way you deal with higher inflation, at least the Fed, is to raise interest rates, if you raise interest rates, you tend to cool down the economy, you tend to curb the level of demand in the economy, and going back to the supply and demand bar again, as demand is diminished, that means prices should go off a little bit, inflation should cool down. That's still the best way that the Fed can deal with this. But we're in a situation now coming out of the pandemic, where the economy hasn't fully recovered to where it was in February of 2020. The labor market has not fully recovered to where it was in February of 2020. So we're not fully recovered, yet. So, if the Fed feels compelled to raise interest rates, because inflation is persistent, and or getting higher, that's going to have second order effects on the economy. I mean, the old saying is, economic expansions don't die of old age, they're smothered by the Fed through interest rate increases. So, if the Fed feels compelled, that inflation is so strong and persistent that they need to raise rates to deal with it, that's going to have a negative impact on the economy and if that happens before we're fully recovered from the pandemic hit, that's going to mean you know, it's going to be an even longer recovery period as we deal with this inflation. You know, additionally, we're in a situation now going back to our previous question, look at all the money the federal government has borrowed in the last couple of decades. I just looked earlier today, and the federal debt is up. I don't know six, seven times the level it was in the year 2000 and unfortunately, because interest rates have been so low over this period, our debt service level, the amount it cost to carry that debt has not risen nearly as much but if the Fed raises rates that deal with inflation, that's going to send the federal government's inflation Bill higher, which means they're not going to be able to be as expansive with fiscal policy in you know, pumping money into the economy as the economy slows down due to the higher interest rates. So it's a very difficult corner that it has painted itself into and it's going to be interesting to see over the next year or two, how they're able to figure these things out, to keep the economy growing without letting inflation just run away and become a persistent problem.

19:59

Yeah, you know, that I think a lot of us, you know, we hear the word inflation or the term inflation or talks of inflation and immediately, you know, obviously, we know things are more expensive, but then you kind of mentioned a minute ago, higher interest rates, you know, in higher interest rates not only have an impact on fixed income investors, it's good for some people that are on fixed income that want to just buy bonds and higher interest rates help them do that. But higher interest rates, obviously, you know, affect borrowing. They have a pretty big effect on a lot of things. And I guess my question would be is, as it relates to interest rates and portfolios, since a lot of people moved into the stock market, because let's face it, there haven't been very many attractive places to invest in the bond market, right. So, you know, if interest rates start going up, do people start flooding or leaving, fleeing, you know, the stock market go to the bond market, so I guess my question with all that is, should investors consider changing their portfolios or asset allocation, if we do see some kind of permanent tick or a continued increase, you know, in all this inflation talk?

21:17

Well, David, here at First American, we focus particularly on investing in high quality companies, whether that's through our equity investments in the stock market or through our fixed income investments in bonds. So, we look for companies that are big, have stable financial pictures, strong balance sheets that are growing, and that we believe have strong enough businesses that if inflation stays persistently high, we'll be able to pass on the bulk of those costs increase to their customers, and therefore keep their earnings and their cash flows growing. So that's the equity side. So, I think we perpetually try to make sure our equity portfolios are prepared for whatever scenario we faced by buying high quality companies that can grow the cash flows. On the bond side, we have tended, over the last couple of years, to buy shorter maturity bonds. So instead of buying a bond that matures in five or seven or 15 years, we've been buying bonds that mature in two or three. What does that do for us? Well, number one, the shorter the duration of the bond, the shorter the maturity of the bond, the less the price of that bond will react to an increase in interest rates. So, we don't have to worry about a bond that we bought for 100 cents on the dollar, going down to 70 cents on the dollar because interest rates have risen dramatically since we bought it. That maturity keeps that from happening typically with bonds. Plus, we're going to be able to have those bonds mature and roll over and then we can redeploy those funds into bonds that have been issued, that have reflected the higher rate of interest that's in the economy at that point in time. So, our high-quality portfolios look like they're pretty well positioned to deal with inflation if it comes. If investors have very long-term bonds, or if they're invested in equities that maybe are more speculative in nature than we typically recommend here at First American bank, that certainly could be an issue. If inflation is high and persistent, those types of investments would tend to react negatively to that type of situation. Certainly, more negatively, than the quality types of investments we tend to favor here at First American. 

23:39

So it sounds like you know quality, quality, quality. And, you know, don't reach for yield at this point. There's no reason to, you know, stay short on the on the bond side so that you can take advantage of interest rates right as they do and listen, interest rates have been falling for how many years now? I want to say decades. I mean, we haven't seen a real interest rate increase in a long, long time and we know what's going to happen eventually. But it sounds to me like what you're saying is if you're positioned in quality stocks, companies that can survive anything, and then also on the fixed income side stick with quality and stick with shorter bonds right now so you can take advantage of it. That sounds like the place to be.

24:23

Absolutely, completely agree.

24:27

Thank you so much, man. I appreciate you being here today. It's been very, very helpful. Appreciate it.

24:30

Thank you, David. Appreciate you having me on.

24:35

And that wraps up today's episode of First Forward Podcasts by First American Bank. Tune into our other episodes and stay up to date with us on social media @firstambank.

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