Centre Street Cambridge Corporation - July 2021 - cscc95 meta name="keywords" content="Commentary July 2021

nflation is back in a big way, or the fear of it at least. After nearly forty years of declining inflation rates and relative price stability, the financial press and commentariat have been warning that this benign period of moderate price change may be coming to an end. Ultimately these concerns boil down to the belief that the highly expansionary fiscal and monetary policies undertaken in response to the pandemic will inevitably bring soaring inflation, a view underpinned by late economist Milton Friedman’s edict, “Inflation is always and everywhere a monetary phenomenon.”

Such fears are not without a reasonable basis. Money supply growth across the developed economies has been dramatically above average since the pandemic began (approaching 20% year over year), and recent government statistics do indeed indicate the emergence of pricing pressures in the U.S. economy. The June consumer price index came in at 5%, the highest increase since 2008, and May’s “core personal consumption expenditures price index,” a measure favored by Federal Reserve policymakers in their deliberations, rose 3.4% over the corresponding 2020 period, the biggest jump since 1992. The producer price index, measuring changes in the prices of raw materials for industrial processes, grew 6.6%, a rate not seen since prior to the Financial Crisis. Unofficial anecdotal data from across the business world also indicate widespread price increases for inputs, as well as efforts to maintain profitability by raising prices.

Nevertheless, it is difficult to tell in real time whether such figures augur a fundamental change in the inflation environment, and it is worth pointing out that the prior periods alluded to above did not break the forty-year trendline. Inflation is defined as a “general rise in the price level of an economy over a period of time.” Time will tell whether the recent blips in inflation indicators are temporary statistical aberrations caused by pandemic disruptions, or the sign of something more serious. Predictions of an inflationary spiral have come and gone in the past (in the aftermath of the Financial Crisis, for example), so skepticism is a reasonable stance to take with respect to the short-term data. However, the very thought of inflation causes great consternation on Wall Street (although curiously, inflated prices of financial assets don’t cause much bother), as they bring to mind memories of high interest rates and depressed market activity.

Before we all fall prey to fears of a return to a 1970s-style “stagflation,” it may be useful to gain some perspective on the U.S. experience with inflation. General price increases have been with us since the creation of the Federal Reserve System in 1914, averaging about 3% per annum. (Only in the 1930s was there a notable price decline: about 2% over the course of the decade.) This background inflation is usually viewed as benign, and much more palatable than the economic depressions that convulsed the country every decade or two previously, and which the reserve banking system was designed to resist. It is also important to note that inflation is not uniform across the economy. Technology products, for example, are generally characterized by declining prices. In addition, price jumps here and there caused by isolated supply/demand imbalances in specific industries are not necessarily inflationary, as long as they do not lead to generalized price increases that endure over future periods.

The inflation experience which caused the most trauma for Americans — and that still resonates among policymakers, politicians, and the public — occurred in the 1970s. Towards the end of that decade inflation rates briefly exceeded 15% per annum. In context, the inflation of that period was minor compared to hyperinflationary debacles suffered by the Germans in the 1920s and by Venezuela today (recently about 3000% annualized, down from one million percent a couple of years ago). Still, it was enough to inflict significant pain on consumers and businesses, and it was only brought under control by Paul Volcker’s Federal Reserve imposing a deep economic recession on the country in the early 1980s.

While the 1970s experience informs the anxiety brought on by the recent price pressures, today’s elevated figures result, to some extent, from comparing data from the current, healthier economy with depressed conditions a year ago, as well as peculiar conditions in specific industries. For example, when the pandemic led to an economic shut-down, lumber producers halted production due to great uncertainty about the future of the housing market. But the housing sector rebounded far more quickly than anyone expected, leading to shortages of lumber and record prices for the building material (lumber prices have fallen considerably in recent weeks — Economics 101 at work). That quickly led to higher costs for homes and home repairs. Similar patterns have also occurred in certain metals, agricultural, petroleum, and even labor markets.The Fed and many economists maintain that the price increases we see now are isolated, and, not reflecting generalized inflation, will eventually subside; hence, although inflation indexes should be monitored, as yet they are not cause for alarm. Others, citing the 1970s experience, beg to differ. In the 1970s, Fed officials also claimed that pricing pressures were isolated, caused by one-time events including sudden oil price increases. This belief delayed taking measures to counter growing generalized inflation until Volcker’s elevation to Federal Reserve Chair, by which time inflation, and “inflation expectations,” had become embedded in the economy. This fate, as critics have said, also awaits us now as the Fed is “getting behind the eight ball.”

So far, at least, the financial markets have not exhibited any indication of fear among investors in the aggregate, despite the inflation chatter; bond interest rates remain extraordinarily low, equities are at or near record levels and valuations, and mortgage rates are still near their lows. The public has been pumping more cash into stocks than at any time since 2015. One would expect both fixed-income and equity markets to be hurt by genuinely increasing inflation, as price pressures tend to lift interest rates, hurting bonds directly and stocks indirectly. Other indicators, such as the relative valuations of high quality and junk credits, do not seem to indicate much anxiety over credit or economic conditions.

Our view is that no matter what happens — benign price increases or something more pernicious — the economy will adapt. Even the decade from 1973 to 1982 — straddling the “stagflation” period — can be considered one of adjustment, when viewed from a long-term perspective. It was a decade of unusual challenges and changes: two oil crises, the untethering of the dollar from gold, interest rate deregulation. Nonetheless, the adjustments, though sometimes painful, laid the basis for strong economic performance thereafter. As difficult as the challenges of a future high-inflation scenario could be, we have no doubt that businesses would make the necessary adjustments, hopefully aided by careful and thoughtful policies on the part of fiscal and monetary authorities (avoiding a bond market rout that would raise interest rates and do for the economy and inflation what Paul Volcker did in 1980 through central bank action).

As individuals, there is little we can do to forestall the vicissitudes of life, but as investors we can reduce their impact and even lay the foundation for a better economic future in our own spheres. The 1970s proved to be fruitful hunting ground for good investments. Any dislocations caused by future inflation or regulatory missteps could likewise prove advantageous. As always, we do what is in our power.

The Asset Classification of Real Estate

The housing market has been on a tear this year. In a June report, the widely-quoted Case-Shiller home price index showed an annual rise of 14.6% in April, the biggest jump in over 30 years, leaving home prices at record levels. The U.S. is not alone. In Canada, some areas saw house prices rise 40% in the past year; England, too, has seen sharp increases. Non-homeowners are affected as well, as rents have increased along with property values. The price action in housing is fundamentally due to supply/demand imbalances. Pandemic-induced flight to the suburbs, growth in liquid assets when lockdowns curtailed spending, record-low mortgage interest rates, and a dearth of housing inventory for sale, both new and previously-occupied, all contributed to the price surge.

While many observers, including some central bankers, have expressed concern about a rapid rise in home values leading to another bust, our interest lies in the ramifications of another feature of the current boom: financialization. The combination of the prospect of price appreciation, along with relatively steady and increasing income (from rents) has attracted the interest of investment funds. (More obscurely, the relatively low correlation of the fluctuations in property values with those of stocks and bonds is also a draw for these portfolio managers.) As a result, large, institutional investors have become enamored of housing as an investable “asset class.” Instead of people buying a home to live in, we now have PO boxes bidding for properties.

This trend dates at least from the Financial Crisis of 2008-09, when private equity groups swooped in and purchased tens of thousands of abandoned and foreclosed homes, turning them into rental housing. The pandemic period has seen another acceleration in this trend as people fled cities for the suburbs. Reflecting the strong housing market there, investors in parts of Canada now account for 20% of new mortgages. Institutionalization in the U.S. continues as well; in June private equity group Blackstone purchased another institution that specialized in suburban rentals.

While there are perfectly good economic arguments to support this trend — it promotes the availability of housing, etc. — there are downsides, such as higher prices that reduce affordability for would-be homeowners, as well as the fear that in a crisis, investors would bail out of properties, rendering local markets less stable. The introduction of remote and impersonal ownership and control by financial interests also brings with it an issue well-known in corporate governance, the agency problem. In housing this takes the form of ever-rising rents, poor maintenance, and annoying, picayune charges for minor repairs. Housing is a peculiar business because it is literally “close to home.” People get upset when the feeling of security provided by the roof over their heads suddenly seems threatened by forces beyond their control. The problem was summed up by one Canadian observer, who said “The moment we want houses to be good investments is the moment we want prices to grow faster than local economies and local earnings.” As the old saying goes, “there goes the neighborhood.”

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