Charting the Course
Great Unconformities in Geology, Economics and Investing
By Mitch Siegler, Senior Managing Director
The Great Unconformity, which John Wesley Powell observed when he explored the Grand Canyon in 1869, is one of geology’s deepest mysteries. Powell saw a gap of up to 1.6 billion years – where one sedimentary rock formation was uplifted in the form of great mountains, then subsequently eroded away, eventually to be buried under younger sediments. Like sand in an hourglass, the oldest layers deposited earliest should be at the bottom, the youngest at the top, but that is not the case here with missing pages in the geologic record.
Listen to Fed Chair Jerome Powell and you might conclude that there is no inflation today and little prospects for any in the future. Powell and other Fed leaders describe price pressures as “transitory” and say they plan to keep interest rates near zero until nearly everyone who wants a job has one, even after inflation has crept above their 2.0% annual target. Look elsewhere, though, and inflation pressures appear structural. Consider this:
- Equity values are exploding, with the S&P 500 up 40% in the past year.
- Single-family home prices rose in March at the quickest pace in seven years. The S&P CoreLogic Case-Shiller 20-city home price index in March rose 13.3% year-over-year. In many of our markets in the western U.S., the increases are considerably higher. As home prices rise and homes become less affordable, more people must rent, fueling demand for rental homes and apartments, driving rents higher.
- Rents, until recently have fallen, helping to hold down the Consumer Price Index (CPI) despite large increases in home prices. This is due, in part, to the eviction moratorium, with a small number of renters gaming the system and paying nothing, which lowers average rents. The eviction moratorium is slated to end in September, which could unleash rent growth, contributing to inflation in the housing sector. Homeowner’s equivalent rent, a Bureau of Labor Statistics metric, accounts for one-third of CPI – which conveniently excludes food and energy prices.
- Care to guess what is happening with food, restaurant and gasoline prices? Grocery prices rose 3.5% in 2020, the most in a decade. We expect surging restaurant demand this summer and more customers seeking seats in fewer restaurants (95,000 closed during the past year) means much higher prices at your favorite trattoria. And this recent headline from a local news source: “Average San Diego County gas price rises for 18th time in 19 days”. We’re betting it’s a similar tale where you live. Lumber price futures rose 410% from January 2020 to May 2021 (perhaps the worst is over on this front as futures prices are down 25% from peak levels at press-time).
All this aside, the annual U.S. inflation rate was 4.2% for the 12 months ended April 2021 after rising 2.6% in the prior year, according to U.S. Labor Department data published in mid-May. Higher than the Fed’s 2.0% target, right? An inflation unconformity, perhaps?
We have addressed this subject for years and are no closer to understanding interest rates today than we were a decade ago. For years, a basic principle of finance has been turned on its head. Interest rates, which generally reward savers and ding borrowers, have been set below zero by central banks in many major European nations and in Japan. So, savings lose value and borrowers are paid to take out loans. Dubbed one of the most novel 21st century monetary experiments, negative interest rates became popular after Treasury officials realized they needed new tools because their economies continued to struggle years after the 2008 Great Financial Crisis. When the pandemic slammed the brakes on economies in 2020, central bankers looked for ways to cushion the blow and many cut rates to near zero and even below. With unemployment rates high and growth tepid elsewhere in the developed world, many central bankers will be slow to raise rates. If inflation takes hold, many could be caught flat-footed. Another possible unconformity?
The restaurant business has really had it rough during the past year. Shutdown/stay-at-home orders, followed by scads of operational rules and requirements, re-openings allowed only subject to capacity constraints, more shutdowns and now – or soon (depending on the locale) – the possibility of a complete reopening. Along the way, restaurants laid off their staffs, brought some team members back and now must rehire. But time waits for no man and many employees, buffeted by the winds of change, moved on to other restaurants or entirely new industries. In some cases, it has been a hard sell to recruit a minimum wage (or $15 per hour) former employee who might fare better collecting enhanced unemployment benefits. Of course, it is complicated.
Many restaurant operators and other businesses relying on minimum wage workers have responded by boosting wages. In high income neighborhoods, patrons at fine dining establishments are ready, willing and able to pay a few bucks more for a cocktail, appetizer and entrée, enabling the restaurant to pass on the higher wages. By no means does that work everywhere. As Amazon disintermediates brick-and-mortar retail, robots replace workers and work-from-home trends reverse, the implications for labor – and wages – are vast. Unconformities for labor abounds.
The national unemployment rate, 8.3%, remains elevated and millions of Americans need government assistance. But this assistance may be becoming a permanent fixture. A third round of government stimulus checks are still being issued. While a fourth round is less certain, it is not inconceivable. A multi-trillion-dollar infrastructure bill is being bandied about so, one way or another, trillions more will likely find their way into the economy, sloshing around and adding to inflation pressures.
The U.S. national debt, $28 trillion at the end of 2020, is up 42% from 2016 and rose $5 trillion during the pandemic. Our nation’s debt level has doubled since 2010. If those stats don’t scare you, this may keep you up at night: the U.S. national debt is likely to reach $89 trillion by 2029, according to USDebtClock.org. This would put the country’s debt-to-GDP ratio at 277%, surpassing Japan’s current 272% debt-to-GDP ratio. Gulp. Yet another unconformity?
So, what is a savvy investor to do?
- Beware the bond market. When (not if) interest rates rise, bond prices will likely fall.
- While you’re at it, beware the stock market following a year when values rose 40%. Tech stocks, the market leaders during the past year have been looking a bit wobbly. There are still great opportunities for individual companies but across-the-board buying of broad indices seems increasingly risky at today’s prices.
- It’s a good time to be a borrower. Fixed rate loans in particular look enticing.
- With apologies to all of you with savings and money market accounts, it’s a tough time to be a saver.
- Stock up on assets that hedge inflation and shelter income with depreciation. We like real estate, especially apartments, on both counts.
We always like to end on a happy note, and we do see lots of light at the end of the tunnel. The nationwide vaccination rate is now over 50%, nearly two-thirds for American adults. More teens are getting vaccinated, and school-age kids aren’t far behind.
Every seat on every airline we have flown on during the past few months has been full. Cruise ships are gearing back up. Entertainment venues are opening back up and ticket sales are brisk. Hotel rooms are booking up fast at higher nightly room rates. Restaurants are getting busier and we expect they’ll be chock-full this summer. Hiring is brisk. There are shortages of just about everything and waitlists, backorders and prices continue to rise. The economy is coiled tight like a spring, and we are increasingly bullish about the economy for the balance of the year.
It’s a good time for investors to be vigilant, not complacent. There’s risk for investors lurking behind every corner so proceed carefully and keep an eye out for unconformities.
Mitch Siegler is Senior Managing Director of Pathfinder Partners. Prior to co-founding Pathfinder in 2006, Mitch founded and served as CEO of several companies and was a partner with an investment banking and venture capital firm. He can be reached at email@example.com.
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