The InterPrime Newsletter - Issue #15 - Inflation & Markets

In this edition of the newsletter, in addition to our market update we talk about the hot topic of Inflation. It’s the word on everyone’s mind these days. We aim to provide some insight how to watch for it and how to combat it.

The Oxford dictionary defines inflation as “a general increase in prices and fall in the purchasing value of money.”

Yes, you read that right, it says that the money you hold is becoming WORTH-less due to inflation. Inflation is the invisible evil that leads to prices of things “rising” and the value being provided staying the same. Remember when in 1990, the price of a gallon of gas was less than $1 (nearing $5 in CA now), and a loaf of bread cost $0.75 (over $3 now!). 

In case you were wondering what has led to the prices of these products rising, and making your dollars WORTH-less over time - it’s INFLATION.

Economists generally agree that inflation is caused by two primary factors

Supply Side effects - This happens when 

In this scenario, demand for goods and services stays constant but the supply side constraints lead to higher prices which are then passed onto the consumer.

Demand side effects - This happens when

In this scenario, prices rise because consumers are willing and able to pay more. This historically has occurred in times of economic expansions and growth. 

However, in the recent past in the USA, we have seen inflation solely due to the monetary policy actions of the U.S. Federal Reserve. They have flooded the system with “cash” there by making the existing cash be WORTH-less than it was before, leading to an increase in prices.

Inflation will make the price of most things rise, especially things that are essential and non-substitutable. Think gas for your car, or for heating your home in the winter.

Inflation also leads to an increase in housing costs, whether it’s rent or the purchase of a home. This happens because of the raw costs associated with housing (commodities & labor), and the fact that we all need to live somewhere!

Basically, inflation makes things more expensive!

The last major period of inflation in the US was the 70s and early 80s, with Fed Funds interest rates rising to 20%! Yes, you read that right 20%!

For context, inflation in 1964 and the preceding 6 years was at ~1%.

History tells us that there were a variety of reasons for this:

Those years were difficult and with a lot of economic slowdowns and recessions, until inflation was brought under control in the late 80s. It took over 10 years to tame the beast! For those of you interested in more details on this, check out this essay by Michael Bryan from the Federal Reserve of Atlanta.

Inflation is a tough nut to crack. It’s really quite hard to beat it without taking “risk”. This would mean investing money in stocks, real estate, gold, oil or “high yield” bonds. 

For those of you that are more safety minded, the options would be limited to US Government Bonds & Investment Grade Corporate Bonds. These will help you reduce the drag on your capital caused by inflation. We go into the details of leveraging this option in our blog post here.

For those of you interested in the more sophisticated strategies that hedge fund managers use to manage inflation we recommend reading “The Great Monetary Inflation” by legendary trader Paul Tudor Jones.

We want to start this market update by looking at how certain business sectors, commodities and assets are reacting to / driving the 2021 inflation story.

The price of crude oil has risen ~ 80% through 2021! 

Unfortunately, the price chart tells us it might not be done. The rising 200 day moving average keeps the bullish price trend intact.

Be prepared to continue to pay more at the pump.

We apologize to our readers who live in cold weather locations. You are already paying a massive price increase from 2020. And you should expect an increase as demand grows during the coming deep winter months.

At one point in 2021, natural gas was up ~ 165%!

Currently, it is hovering at a mere ~ 100% increase. Yuck.

Real estate investment trusts are an investor favorite when inflation fears come around. The thinking is that real estate prices tend to outpace inflation making them a wonderful hedge.

The REIT ETF ( VNQ ) has risen ~ 34% through 2021. Thus giving REIT investors a net real return after inflation.

Beef prices have risen during 2021. And with supply issues and holiday season approaching that should continue. Cattle prices are currently up ~ 17% this year.

Again, supply chain issues and reviving economies are pushing prices higher. Fingers crossed you are not in the market for a used vehicle.

We are rounding the final corner to the end of 2021. With 2 months left in the year, we do not expect major surprises in the markets. Most investors are now on autopilot into 2022.

Our September market update touched on the potential for yields to rise, with stocks and Bitcoin testing all time highs. All three views came to fruition, so let’s take a peek at what could be coming for the remainder of 2021.

The easy money / low rate policy of the Federal Reserve continues to drive the bond and rates markets. But there are changes on the horizon.

The FOMC meeting concluded on Nov 3 with the Fed announcing the start of bond purchase tapering (link). This is the first step to removing government support of the markets due to COVID-19. We discuss what bond tapering actually means to individual investors in this post.

Chairman Powell was again clear that the end of bond purchases does not mean a rate hike is imminent. However, the markets are now expecting the first rate hike sometime in 2022. This is welcomed news for investors looking for higher interest rates.

Let’s take a look at current yield charts to see where yields might go through the end of 2021.

We expected the yield on 2 year notes to rise to 0.38% and they overshot to 0.53%! Our inclination is now to say that 2 year notes likely do not rise much past 0.53% until 2022.

The speed of the yield rise can be linked to the expectation of bond tapering announcement and potential rate hike in 2022. Now that those expectations seem to be realized. There is little to drive yields higher into year end.

The zone to watch into 2022 is now 0.38% - 0.53%.

Our view was that 10 year yields would reach 1.74% - 1.95%. They abruptly reversed in front of 1.74% and are now hovering near ~ 1.50%.

This leads us to believe that in the final 2 months of 2021, 10 year yields will be capped at 1.75%. If they drop below 1.30% - a sprint to sub 1% may take hold. Such a dramatic move would likely be connected to deteriorating economic conditions or another spike in COVID-19 infection rates.

The 30 year yield fell short of our expected 2.40% - 2.47% zone noted in the September market update. It topped out at 2.17% and has now fallen to 1.80%.

We view 1.80% as a line in the sand for what 30 year yields will do through the end of year. A break below 1.80% could set off a move to 1.50% or lower.

Take away: bond tapering starts in Nov 2021. The yield rise coming into the announcement possibly created the near term high yield watermark for the remainder of 2021. Borrowers are still getting most of the benefits thanks to low yields.

We expected an October rally due to historic patterns. That came to fruition with the indices moving into new all time high territory. Expectation is for the remainder of 2021 to see equities hold onto the bulk of those gains with further upside possible.

The 200 day moving average is still rising indicating the long term bull trend is intact. No reason to assume stocks will sell off until under the 200 day moving average. We view 4200 on the S&P 500 as the trigger to medium term stock weakness.

Take away: historic October strength played out with indices going to new all time highs. Bulls remain in control and should have the upper hand through the end of 2021. Stay strong and be long!

Our view that Bitcoin could retest all time high by year end was confirmed in October. Buyers remain in control but a pullback can happen near current psychological price levels. Price dips should find buyers with $50k being the first price support level to watch.

The adoption of Bitcoin for speculators and investors continues to grow. The thesis that Bitcoin can be a hedge against inflation and store of value builds as well.

For example, CPI inflation reading for October 2021 came in at 6.2%. This was the highest reading in the last 30 years. All while Bitcoin price rose ~ 45% during the month of October!

Take away: psychological price levels like new all time highs can bring price trend pauses. Look for dips to be bought as the investors base grows. Price volatility continues to make Bitcoin not appropriate for corporate cash management.

The Federal Reserve low interest rate environment continues to drive the financial markets. All things should remain the same until they finally start to adjust rates higher.

Equity and Bitcoin price charts look firmly pointed up and to the right. Recent short term bond rates rose but are now likely capped. And long term rates still favor the borrower.

Rising prices across commodities, sectors and businesses are still ramping. If the December 2021 & January 2022 inflation reports come with the current path. The reality of a Fed rate hike increases.

Reach out to us if you want to talk about markets. Be sure to check out our blog, youtube & twitter.