May 14, 2021
By Steve Blumenthal
“You have to go back 40 years – to Q3 1981 – to find a higher quarterly
year-over-year wage growth number (+8.5%). This is not an anomaly.
This is not a single quarter aberration. This is not transitory.
This is four straight quarters of the highest wage growth numbers in 40 years.”
– Ben Hunt,
Co-Founder and CIO, Epsilon Theory
Are we in a transitory period? If so, define it! Three months, one year, three years? It matters.
Inflation matters. Rising inflation means rising interest rates. Inflation is the kryptonite to bonds. Inflation is the kryptonite to Fed policy. Getting the call right means everything to your wealth.
The SIC2021 virtual conference is really fun for me. If you are signed up, I bet you’re enjoying it as well. I have so much to share with you and I’ll do so over the coming weeks. Today, I want to give you a sense for several of my early takeaways. The biggest is my core message this week: Deflation or inflation? We sit at a tipping point.
Why is this so important? To clarify its significance, Stan Druckenmiller and Christian Broda wrote an op-ed piece published in the Wall Street Journal titled, “The Fed is Playing with Fire,” and appeared on CNBC. Druckenmiller essentially laid out the biggest mean-reversion trade in 50 years. Speaking about the massive size of government debt he said, “The Fed will have to monetize it. I believe it will have horrible implications for the dollar…. it’s more likely than not within 15 years that we lose reserve currency status.”
A declining dollar is inflationary for the US, and if this is the regime we are moving into, you need to totally rethink your portfolio allocations. In a picture the playbook looks like this, courtesy of Louis-Vincent Gave:
Higher interest rates are problematic. From Druckenmiller:
So my issue here is, in the future, as we go forward, if we look at Federal spending as a % of GDP, the CBO is saying if the 10-year Treasury goes to 4.9%, which is their normalized projection, the interest expense alone will be close to 30% of GDP every year, that’s basically what we just spent on the COVID emergency in the last year. There is no way we can afford to have 30% of all government outlays be toward interest expense, so what will happen is that the Fed will have to monetize that. When they monetize it, I believe it will have horrible implications for the US dollar.
There are only two ways out of this for the US–to let the US Dollar weaken meaningfully, or to put the US economy into a recession to re-attract global capital flows into the UST market.
The problem is that with US debt/GDP at 130%, the US cannot put its economy into a recession to re-attract capital flows into the US Treasury market without crashing the US Treasury market.
In the SIC2021 deflation corner sit current mental heavyweight champions of the world with IQs north of 140, Dr. Lacy Hunt, David Rosenberg, and famed disruptive technology investor Cathie Wood.
In the inflation corner sit the challengers, Louis-Vincent Gave, Ben Hunt, Jim Bianco, and Peter Boockvar.
The referee called them to the center of the ring, “I want a clean fight. No hitting below the belt, an eight count and you’re out–TKO.”
Dr. Lacy Hunt landed the first blow. Presenting alongside Jim Bianco, Lacy bellowed, “Jim, you’re wrong!” You could tell it stung. A few more hard hits followed. Holding great respect for the champ, Bianco responded with a few polite jabs, but stood firm to his inflation position.
No one has been more right over the last 30 years than Lacy–and no one has a greater grasp on the Federal Reserve Act. As economist and money manager, Lacy’s done it with both pen and money. His mutual fund does one of two things: it invests in long-duration Treasury bonds or it invests in short-duration Treasury bills. He has remained fully invested in 30-year Treasury bonds and continues to believe the 30-year yield will drop to 1% before the deflation cycle ends. But nothing guarantees he’s right this time.
Bianco, Gave, Hunt, and Boockvar argue inflation will win the fight. The deflationary forces of debt and demographics are facing an MMT (Modern Monetary Theory) experiment, one we haven’t seen for more than 100 years. Gave said, “We are now all MMT’ers. The theory is that if you are a government that issues money in your own currency, there is no end to what you can print.” He added,
- MMT has been tried many times in the past. What always kills MMT booms is inflation.
- Few are talking about the entitlements that are coming our way. There is no we can finance them.
- There is no way the government can get out of this without inflation. At some point, the inflationary boom will become a bust.
Gave asked, “Where will deflation come from?” He then shared this slide, giving us all something to ponder:
Peter Boockvar said inflation is not going to be transitory. He said, “The problem is the world’s bond markets are not set up for higher inflation for a period of time. The bond markets are not prepared for a bout of higher inflation. If the 10-year was at 3%, it would be better prepared. It’s not. That’s why getting this question right is so crucial.” He’s right!
Ben Hunt said that wage and price inflation aren’t coming. They’re already here. Over the past four quarters, the United States has generated more wage inflation than any other point over the past 40 years.
- You have to go back 40 years–to Q3 of 1981–to find a higher quarterly year-over-year wage growth number (+8.5%).
- This is not an anomaly. This is not a single quarter aberration. This is not transitory.
- This is four straight quarters of the highest wage growth numbers in 40 years.
The right question to ask today is, How bad will this wage and price inflation cycle be?
- Ben thinks it’s going to be pretty bad, in large part because it’s not yet common knowledge.
- It’s not yet what everyone knows that everyone knows.
- It’s not yet contemplated as a potential outcome by our omnipotent market missionary, the Federal Reserve, who remains trapped–not by policy but by narrative–in its insistence that this cannot possibly be the start of a wage-price inflation cycle.
As Ben explained, “‘Inflation is transitory’” is the new ‘subprime is contained.’”
- “Do I think we will continue to see wage inflation running at 7% year over year? Not really. I dunno. I really don’t. I’m not here to predict. I mean, these things are always overdetermined, and if you want to tell me that last spring’s wage increases were a constructed illusion based on lots of low-wage workers getting booted and higher-wage workers staying on the job, I can’t say that you’re wrong. But I can tell you that month-over-month wage increases THIS spring are running at more than 10% annualized.”
- “I see a new ballgame when it comes to wages and prices. A new ballgame that we haven’t played in forty years. A new ballgame where we are only in the first inning.”
Hunt concluded, “I’m not predicting; I’m observing.”
Deflation? Inflation? Transitory? Define It.
For me, this is the most important question for us to get right. If inflation is transitory largely due to debt, excess capacity, and demographics, then interest rates are headed lower. And with monetary and fiscal spending at our backs, the bull market in bonds and equities continues. If, however, inflation is the outcome–as Druckenmiller, Gave, Bianco, Hunt, and Boockvar argue–inflation is not transitory. The challengers say inflation is coming, if it hasn’t already arrived.
Over the next few weeks, I’ll take a deeper dive into their conversations, sharing with you what I learned–along with my two cents in terms of what to do about it.
Day five of the SIC2021 virtual conference is today, and it’s setting up to be a big one. William White, former head of the Bank for International Settlements, presents at noon; Mauldin interviews distressed debt investor Howard Marks at 1:35 pm; former Dallas Fed president Richard Fisher presents at 2:40 pm; and the day concludes with a panel discussion comprising insights from Richard Fisher, William White, John Mauldin, and Felix Zulauf. An ex-Fed official, two economists, and one of the greatest investors of our time. I feel like a macroeconomics-investor-geek kid in a candy store.
Next Tuesday morning, May 18, Mauldin Economics’ Ed D’Agostino is going to interview me. Our goal is to help individual investors pull together the information shared during the five days of presentations and put them to work in a portfolio. We’ll talk game plan and process.
Passive was the right strategy over the last 10 years; it won’t be for the next 10. As Felix Zulauf said, investors will need to be more active over the next decade. If you are attending the conference, I hope you’ll join me at 10:45 am on Tuesday. We’ll talk solutions.
My hope today is to give you a sense of what the next four weeks or so of OMR letters will look like. For me, putting pen to paper challenges my thinking and helps me gain greater clarity on the present and future. Most individual investors want a simple answer. It’s easy to see that earning 1.65% on a 10-year Treasury does little for us. It’s evident that the stock market is extremely overvalued.
Few understand the markets better than this guy:
Inflation and rising rates are the kryptonite to low-yielding bonds and overpriced equity markets. It will take a 66% market correction just to get back to fair value.
Deflation? Inflation? Transitory? Define it. Getting the deflation/inflation call right, to me, is what matters most today. I believe the dollar will decline and inflation will rise. That’s my view. However, I remember entering 2018, when 25 of 25 economists expected rates to rise by more than ½%. I was in that camp. We were all wrong. Rates declined ½%. Yet, my favorite bond indicator, the Zweig Bond Model (which I share with you each week in Trade Signals) said to stay long bonds–that rates were moving lower. You can have a perspective but use technical trend analysis to make sure price behavior confirms your view. The Zweig Bond Model was right, and I stayed long bonds, despite my perspective.
Grab a coffee, find your favorite chair and read on. You’ll find Christian Broda and Stan Druckenmiller’s WSJ article, “The Fed is Playing with Fire” (worth the read) and the most recent Trade Signals post below. In the Trade Signals section, I’ve included an important valuation chart, as well as one that shows just how far the market is above its long-term growth trend. At our current starting point, expect negative S&P 500 Index returns over the coming 11 years.
This week’s On My Radar:
- The Fed is Playing with Fire, by Stanley Druckenmiller and Christian Broda
- Trade Signals – Market Outlook: Negative S&P 500 Index Returns Over the Coming 11 Years
- Personal Section – Great Weather and Some Golf
The Fed is Playing with Fire
Clinging to an emergency policy after the emergency has passed, Chairman Powell courts asset bubbles.
By Stanley Druckenmiller and Christian Broda
With Covid uncertainty receding fast, and several quarters deep into the strongest recovery from any postwar recession, the Federal Reserve’s guidance continues to be the most accommodative on record, by a mile. Keeping emergency settings after the emergency has passed carries bigger risks for the Fed than missing its inflation target by a few decimal points. It’s time for a change.
The American economy is back to prerecession levels of gross domestic product and the unemployment rate has recovered 70% of the initial pandemic hit in only six months, four times as fast as in a typical recession. Normally at this stage of a recovery, the Fed would be planning its first rate hike. This time the Fed is telling markets that the first hike will happen in 32 months, 2½ years later than normal. In addition, the Fed continues to buy $40 billion a month in mortgages even as housing is clearly running out of supply. And the central bank still isn’t even thinking about ending $120 billion a month of bond purchases.
Not only is the recovery happening at record speed, excesses of fiscal policy are already visible. Consumers are spending like never before, construction is booming, and labor shortages are ubiquitous, thanks to direct government transfers. Two-thirds of all relief checks were sent after the vaccines were proved effective and the recovery was accelerating. Opportunistic politicians didn’t let the pandemic go to waste. Especially after the Trump years, Congress has decided to satisfy its long list of unmet desires.
Isn’t the Fed’s independence supposed to act as a counterbalance to these political whims?
The emergency conditions are behind us. Inflation is already at historical averages. Serious economists soundly rejected price controls 40 years ago. Yet the Fed regularly distorts the most important price of all—long-term interest rates. This behavior is risky, for both the economy at large and the Fed itself.
Future fiscal burdens will put the kind of political pressure on the central bank that hasn’t been seen in decades. The federal government has added 30% of GDP in extra fiscal deficits in only two years, right as the baby-boomer retirement wave is beginning to accelerate. The Congressional Budget Office projects that in 20 years almost 30% of all yearly fiscal revenues will have to be used solely to pay back interests on government debt, up from a current level of 8%. More taxes simply won’t be enough to bridge the gap, so pressures to monetize the deficit will inevitably rise over the years. The Fed should be adapting policy today to minimize these risks.
The risks are no longer hypothetical. For decades Treasurys have been the preferred asset for foreigners looking to hedge global portfolios. It was therefore shocking and unprecedented that in the midst of last year’s stock-market meltdown and while the Cares Act was being debated, foreigners aggressively sold Treasurys. This was dismissed by the Fed as a problem in the plumbing of financial markets. Even after trillions spent to prop up the bond market, foreigners have continued to be net sellers. The Fed chooses to interpret this troubling sign as the result of technicalities rather than doubts about the soundness of current and past policies.
America’s deep divisions also make the central bank’s independence crucial. Fighting inequality and climate change are very far from the Fed’s central mission. There’s a reason central bankers are supposed to be unpopular. Inflation is often the result of a fragmented society that feels unrepresented by weak political leadership. Eventually, the choice between fiscal discipline—lower taxes or higher spending—and forcing the central bank’s hand becomes an easy one for politicians to make.
With these risks in mind, and with unambiguous evidence of a strong recovery, the Fed should be doing more than just reanchoring inflation expectations to a slightly higher level. Fed policy has enabled financial-market excesses. Today’s high stock-market valuations, the crypto craze, and the frenzy over special-purpose acquisition companies, or SPACs, are just a few examples of the response to the Fed’s aggressive policies. The central bank should balance rather than fuel asset prices. The pernicious deflationary episodes of the past century started not because inflation was too close to zero but because of the popping of asset bubbles.
With its narrow focus on inflation expectations, the Fed seems to be fighting the last battle. Just because the Fed hasn’t faced big trade-offs in recent decades doesn’t mean trade-offs aren’t coming or that they no longer exist. Chairman Jerome Powell needs to recognize the likelihood of future political pressures on the Fed and stop enabling fiscal and market excesses. The long-term risks from asset bubbles and fiscal dominance dwarf the short-term risk of putting the brakes on a booming economy in 2022.
Mr. Broda is a partner at Duquesne Family Office LLC, where Mr. Druckenmiller is chairman and CEO.
Trade Signals – Market Outlook: Negative S&P 500 Index Returns Over the Coming 11 Years
May 12, 2021
Notable this week:
“Three of the 4 major valuation measures of the SPY (Crestmont PE, Tobins Q and Buffett indicator)
are higher than at any time in history along with margin debt, euphoric or complacent
sentiment and most indices trading at 3 standard deviations above the main trend line.”
– Steve Forbes
One of my favorite valuations metrics is the value of the stock market in comparison to the U.S. gross domestic income. The red arrows in the following chart indicate level (orange line – middle section of chart) and the percent over the trend line growth (light blue – lower section of chart). The data goes back to 1925. The upper left arrow points to the actual equity market performance 1, 3, 5, 7, 9, and 11 years later (highlighted in yellow).
The next chart looks at the long-term deviation from trend (lower section, light blue line). Notice where we sit today vs. the monthly tracking going back to 1928. Ned Davis Research (NDR) sorts the data into quintiles. Performance 5 and 10 years later is best when your starting point is below trend (Bottom Quintile) and least when your starting point is above trend (Top Quintile). The red arrow pointing left shows us we are in the Top Quintile today. The Average % Change in the S&P 500 Index was 9.81% 5 years later and 39.89% 10 years later. That translates into very low single-digit annualized returns.
I just finished listening to Grant Williams interview Felix Zulauf at the Mauldin SIC 2021. Felix too sees the overvalued level of the market, believes the next six months in the stock markets will be down perhaps 10% and said the next decade will require investors to be traders and not buy-and-hold index investors. Trading can be about buying and selling based on short-term, intermediate-term, or long-term trend following and momentum indicators or it can be about using risk hedging to accomplish the same. In any event, given the extremely overvalued nature of the market it is important to be aware of the risk you are taking – especially if you are near or in retirement. Risk management is what Trade Signals is all about.
What do you do? Opportunity remains, but it is not in cap-weighted market indices. We currently favor value (high and growing dividend stocks), risk hedged stratified weighted index funds, gold, real estate, select private equity, and trading strategies. The bond market is broken. We favor fixed income trading strategies, trading strategies in general and cash flowing short-term private credit yielding mid to high single-digits in replace of traditional bonds yielding 2.25% or less.
Posted each Wednesday, Trade Signals looks at several of my favorite equity market, investor sentiment, fixed income, economic, recession, and gold market indicators.
For new readers – Trade Signals is organized into three sections:
- Market Commentary
- Trade Signals — Dashboard of Indicators
- Charts with Explanations
Click here to see the Dashboard and Charts with Explanations from this week’s Trade Signals post.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Personal Note – Great Weather and Some Golf
“Remember, if everything came easy we wouldn’t know what
it felt like to truly succeed. Obstacles are meant to be overcome.
Fear is meant to be conquered. Success is meant to be achieved.
Believe. Take action. Play to win today.”
– Jon Gordon,
Bestselling Author and Keynote Speaker
Son Matthew’s Penn State graduation last week was a win. The university held services for the business school outdoors in Beaver Stadium. Parents and students sat together while the dignitaries spoke. There are nearly 6,000 students enrolled in Penn’s Smeal College of Business. You can imagine how long it might take to issue diplomas to each student. Instead, the students rose collectively when their major was announced. Awkward times but they pulled it off. And fittingly, the sun came out just as the graduates began to stand.
An exciting new adventure begins. Believe, take action, and create great! We need you!
Following are a few photos.
I’m finishing today’s letter early. Mark Yusko kicks off today’s SIC at 11 am, followed by William White, Howard Marks, Richard Fisher, and the White/Fisher/Mauldin/Zulauf panel. More for you next week.
The weather forecast for the weekend is exceptional. Sunny and 72 degrees. Tomorrow is Callaway demo day at my club, and daddy could use some new irons. Three of our six kids are home already, and Matt’s driving in to golf with me tomorrow. Love when we are all together.
A big congratulations to you and your family if you’re celebrating a graduate this season. Forever forward!
Wishing you a great week,
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Consider buying my newly published Forbes Book, described as follows:
With On My Radar, Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth.
If you are interested in the book, you can learn more here.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
IMPORTANT DISCLOSURE INFORMATION
Investing involves risk. Past performance does not guarantee or indicate future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by CMG Capital Management Group, Inc. [“CMG”]), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CMG. Please remember to contact CMG, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. CMG is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice.
No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or provided directly by the referenced funds and/or publishers, have not been independently verified, and do not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods. See in links provided citing limitations of hypothetical back-tested information. Past performance cannot predict or guarantee future performance. Not a recommendation to buy or sell. Please talk to your advisor.
Information herein has been obtained from sources believed to be reliable, but we do not warrant its accuracy. This document is a general communication and is provided for informational and/or educational purposes only. None of the content should be viewed as a suggestion that you take or refrain from taking any action nor as a recommendation for any specific investment product, strategy, or other such purpose.
In a rising interest rate environment, the value of fixed income securities generally declines and conversely, in a falling interest rate environment, the value of fixed income securities generally increases. High-yield securities may be subject to heightened market, interest rate or credit risk and should not be purchased solely because of the stated yield. Ratings are measured on a scale that ranges from AAA or Aaa (highest) to D or C (lowest). Investment-grade investments are those rated from highest down to BBB- or Baa3.
NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE.
Certain information contained herein has been obtained from third-party sources believed to be reliable, but we cannot guarantee its accuracy or completeness.
In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professional.
Written Disclosure Statement. CMG is an SEC-registered investment adviser located in Malvern, Pennsylvania. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy, or exclusively determines any internal strategy employed by CMG. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at www.cmgwealth.com/disclosures. CMG is committed to protecting your personal information. Click here to review CMG’s privacy policies.