What Investors Need to Know About the Taper, Inflation, and Real Assets
Summary: Last week, Chairman Powell announced the Fed will begin to “taper” its bond purchases by $15 billion each month. The latest reports show big numbers for both producer prices (8.6%) and consumer prices (6.2%) over the past year, a very tight labor market, weakening credit standards, and rising inflation expectations. To top it off, Fed Governor Quarles–an inflation hawk–submitted his resignation, giving President Biden five vacancies to fill with inflation doves next year, supporting the case for an accommodative Fed and continued inflation. Investors should take steps now to protect capital from inflation by reducing their exposure to high-multiple equities and increasing allocations to income-producing real assets.
Transitory Inflation? Busted!
Busted! After months of claiming that inflation was transitory, caused by a growing list of special temporary factors, a barrage of data forced the Fed to admit that inflation is a growing problem, and they need to do something about it. As you can see from the front-page stories in The New York Times and The Financial Times, the news is getting around. Turns out the only thing that was transitory was the term “transitory” itself.
The PCE deflator—the Fed’s favorite inflation index—was up +4.5% and the Employment Cost Index up +3.7%. The JOLTS report showed 10.4 million job openings and 4.4 million quits. October Producer Prices jumped +8.6% and Consumer Prices +6.2% from a year earlier. The Senior Loan Officer Survey showed banks shoveling out credit on borrower-friendly terms. The Michigan survey revealed heightened 1-year (4.9%) and 5-year (2.9%) inflation expectations. October retail sales were up 1.7% for the month but more than half of it was from higher prices.
The Fed’s had plenty of reasons to announce it will begin to “taper” its bond purchases by $5 billion each month. So how does the taper work?
The Tiny Taper
The Fed has been buying $120 billion of bonds and mortgages every month in the name of Quantitative Easing (QE). They now plan to reduce, or “taper”, these purchases by $15 billion every month, to $105 billion next month, $90 billion the following month, and so on, until they reach the point where they stop buying bonds altogether late next year—unless, of course, they see ‘developments’ that change their mind along the way.
Purchases of $120 billion per month is huge—roughly $6 billion every trading day. These massive purchases have pushed bond and mortgage prices higher and bond yields and mortgage rates lower than they would have been without the purchases. (I know, duh.) To make it simple, when the elephant gets into the bathtub, the water level rises, and we all get wet.
It shouldn’t come as a surprise that the $23 trillion of assets the Fed and other major central banks have purchased since 2008 have pushed asset prices pushed asset prices sharply higher in all major markets, as you can see in the charts above. In the US, the S&P and NASDAQ have jumped by more than 40%, and home prices are up 13% in the past year.
The reason the Fed has decided to taper now is that asset price inflation, which many people cheer, has spilled over into consumer and producer price inflation, which they don’t.
In fairness, it is not clear how much of the increase in the CPI and PPI over the past 12 months has been caused by the Fed bond buying firehose, how much by COVID-triggered helicopter money that has left household bank accounts $3 trillion richer than they were before the pandemic, and how much by supply-line turbulence that has clogged the ports, slowed delivery times, emptied warehouses, and shut down auto plants. It is clear, though, that the inflation genie has been let out of the bottle and that the Federal Reserve Board Governors know they need to find a way to put it back in.
By comparison, the $5 billion reduction announced by Powell is tiny—less than one day’s average purchases–and should have about the same effect on prices as the Federal Reserve Bank of New York’s bond trader taking a personal day off. But it is a (tiny) step in the right direction.
What has investors worried is what will happen to interest rates and asset prices next year when the Fed gradually turns off the firehose. It’s obvious that Treasury yields and mortgage rates will have to be higher—and multiples lower—than they are today, because the mother of all buyers will have left the party. But the story can’t end here. Next year, after the taper is over and the Fed has stopped buying bonds, they will still own the $7 trillion of bonds and mortgages they have already purchased. To reverse inflation pressures, the Fed is going to have to sell the trillions of dollars of bonds and mortgages they vacuumed up during the QE period. That is going to be a problem for asset prices.
Transient or New Normal?
This is where the resignation of Fed Governor Quarles comes in. Quarles is one of the more reliable inflation hawks on the Federal Reserve Board and it’s almost certain that the person Biden (or perhaps Yellen?) chooses to replace him will think it’s worth living with a little higher inflation to get a little more growth, even if it’s temporary. Remember that President Biden has five Fed vacancies to fill next year and that a Federal Reserve Board appointment has a term of 14 years. His advisors have a taste for so-called Modern Monetary Theory, the idea that you can print your brains out with little consequence. There won’t be an inflation hawk in the bunch.
The answer to the question everyone has been asking—whether inflation is transient or the new normal—won’t be found by combing through the line items in the CPI report or by counting the ships waiting to unload their containers in Long Beach. (Disclosure: I can see more than 30 of them from my office window in Newport Beach.) Those factors are relevant for inflation over the next year or two but not beyond that. In order to know whether a car driving west on 42nd Street is going to end up in a driveway in Jersey City or in Los Angeles you have to know two things: who is driving the car, and where he or she wants to go. In the same way, long term inflation will depend, more than any other single factor, on the mental models in the heads of those next five appointments.
Based on everything I know about the current and prospective Fed Governors, I believe the Fed is going to cave the first time they see a significant drop in stock prices or home values or a disappointing jobs report. They will say they are data-driven and that the data is telling them to suspend the taper operation until we get past the “rough patch.” At bottom, I don’t believe the Federal Reserve Board members will have the stomach to see the taper through to conclusion, which means some elevated level of inflation is going to be around for a long time. This is extremely important for investors.
Real Asset Inflation is What to Watch
The inflation rate investors need to pay attention to is real asset inflation, not consumer price inflation. That’s because real assets like houses and land are owned by the same investors who own financial assets like stocks and bonds and investors allocate capital between real and financial assets based on their returns and risks, just like professional money managers. From that perspective, real asset inflation is simply the capital gains component of the total return on our $100 trillion stock of real assets.
When real asset inflation goes up, it increases the total yield on real assets relative to the yield on financial assets like bonds and stocks. This makes people sell a portion of their bonds and invest the proceeds in more real estate. This inflation-driven shift in desired asset mix drives real asset prices up and bond and stock prices down. That’s why people buy real estate, commodities, artwork, gold coins, classic cars, and baseball cards as inflation hedges, and that’s why inflation and interest rates move together over long periods of time.
When orchestrated shifts in portfolio preferences of this sort happen, they are truly massive in scale relative to the usual savings, investment, deficit and GDP numbers everyone pays attention to. That’s because our economy’s balance sheet—our assets, liabilities and net worth–is many times larger than its profit and loss statement—the national income accounts–just as it is for most businesses.
How big? People in the US today own roughly $400 trillion of total assets, roughly twenty years’ times as big as our $21 trillion annual GDP. If you think of our collective balance sheet as a $400 trillion pie, people today hold roughly one-quarter of the pie ($100 trillion) in real assets like houses, land, factories and machines and the other three-quarters ($300 trillion) in stocks, bonds, bank accounts, and other financial assets as shown in the graphic above.
Because the pie is so big, what seems like a modest change in how people choose to hold their assets amounts to a lot of dollars trying to find a new home. For example, if real asset inflation were to increase by 5 percentage points, say from 5% to 10% per year, investors would enjoy a 500-basis point increase in the total return on their stock of real assets relative to the total return on their financial assets.
Based upon our research over more than forty years, that 5% increase in real asset inflation would lead investors to attempt to shift about 5% of their total assets from financial to real assets. That’s 5% of $400 trillion, or $20 trillion, roughly the size of the national debt and equal to a full year’s GDP. When something like that is going on, it swamps the effects of savings, deficits, and other factors like corporate profits on interest rates and stock prices.
I say “attempt to shift” because the fact that investors have changed their collective minds about what they want to hold does not mean there are any more houses or any fewer treasury bills than there were before the shift and because, after all, investors can only sell their existing asset holdings to each other. The only thing that changes are the prices, real asset prices up, financial asset prices down. But that’s exactly what investors care about, isn’t it?
What Investors Should Do
You don’t have to be Warren Buffett to figure out the right investment strategy for this situation. I would suggest shifting a good-sized chunk of your portfolio (10-25% depending on the individual) away from long-dated financial streams towards income-producing real assets, or companies that produce real assets, before other investors get the memo, and let the tidal wave of repricing caused by other investors’ actions wash over your portfolio and increase your net worth. There are finer points to consider too, of course, about bond duration (shorter), leverage (less), sector mix (more cash flow, dividends, stock buybacks and less projected but unproven future growth), and contractual terms (index future rent increases if you are the landlord, fix them at 2% per year if you are the tenant), and so on. I will write more on this in a later post.
It should be clear that you can use this same analytical framework to think about other policy issues as well. Any policy that increases the return on real assets relative to financial assets will have the same effect on asset prices as an increase in inflation. For example, an increase in tax rates on dividend and capital gains income will significantly reduce the total after-tax return on financial assets but will have a much smaller impact on the total after-tax return on real assets because much of real asset income, like the imputed income on owner-occupied properties, is not reported or taxed at all and because there are more generous tax benefits for real property than there are for income from securities.
This framework is also the key to understanding why it is so difficult to see the impact of government deficits—even big ones–on interest rates, especially relevant given today’s spending, deficit, and debt projections. I will make that the topic of my next post later this week.
Dr. John
The views and opinions expressed in this article are those of Dr. John Rutledge. Assumptions made in the analysis are not reflective of the position of any entity other than Dr. Rutledge’s. The information contained in this document does not constitute a solicitation, offer or recommendation to purchase or sell any particular security or investment product, or to engage in any particular strategy or in any transaction. You should not rely on any information contained herein in making a decision with respect to an investment. You should not construe the contents of this document as legal, business or tax advice and should consult with your own attorney, business advisor and tax advisor as to the legal, business, tax and related matters related hereto.