May 2021 Economic Report

By Scott GardnerIn my last economic report, I contrasted the differences between the 2008 and 2020 recessions. As the current economy recovers from last year’s shutdowns, this difference is becoming more pronounced.The immediate threat to us now isn’t unemployment or a recession—it is unchecked inflation and the hyper-charging of the economy.The Economic MachineThe economy works like a simple machine, but many people don’t understand it or agree on how it works because it consists of many moving parts.The primary catalyst of the economic machine is transactions—people, businesses, banks, and governments with cash and credit buy goods, services, or financial assets. The important thing to remember is that one person’s spending another person’s income.A market consists of all the buyers and sellers making transactions for the same thing—there is a stock market, real estate market, wheat market, car market, etc. The economy consists of all of the transactions in all of its markets.Credit is one of the most essential parts of the economy because it allows people to increase their spending, resulting in more transactions that drive the economy.Credit and borrowing have short-term and long-term effects that create economic cycles.In the short term, credit allows us to consume more than we can produce, which causes the economy to expand. When spending increases faster than the production of goods, prices rise—this is called inflation. When inflation goes unchecked, it creates market bubbles where assets become overvalued.Under normal circumstances, the Fed doesn’t want inflation to get out of control, so they increase interest rates to increase the costs of borrowing and slow spending. The target inflation rate set by the Fed is 2% per year.When the costs of borrowing increase, people spend less, which results in a reduction of transactions and eventually causes a recession. If the recession becomes too severe, the Fed lowers interest rates to increase the demand for borrowing.Short-term economic cycles caused by credit recur every 5-8 years—these are typically mild recessions. Long-term economic cycles occur every 75 years or so—these are significant debt deleveraging events (such as what happened in 2008).IndicatorsEconomists use leading and lagging economic indicators to see which economic cycle we are in—expansion, contraction, or recovery.A leading indicator is an economic measurement that indicates where the economy might be heading. The Consumer Confidence Index (CCI), Durable Goods Report (DGR), the Purchasing Managers Index (PMI), Jobless Claims Report, the Yield Curve, and the Cass Freight Shipments Index are the primary leading indicators.A lagging indicator is an economic measurement that confirms where the economy has been—these indicators include Gross Domestic Product (GDP), the Unemployment Rate, the Consumer Price Index (CPI), total debt expansion, the Quarterly Financial Report (QFR), Interest Rates, and the Balance of Trade (BOT).While indicators are helpful, their downside is that they can only tell you where you might be heading and where you have been, but they cannot tell you exactly where you are. For this reason, economic predictions are regularly incorrect, and you should only use indicators as general signs of economic direction and not as economic gospel.Choppy Waters AheadBefore the pandemic shutdowns, orders on durable goods (things like automobiles, semiconductor equipment, and turbines) were increasing by an average of 0.2% quarter-over-quarter since 2017.When the economy was shut down, there was a huge drop-off of durable goods orders. However, including the significant drop, durable goods have been up 0.7% each quarter on average.This shows that manufacturers have been locking up inventory in anticipation of reduced manufacturing capacities and that they are also preparing for an economic expansion.This is good news for the manufacturers that have prepared themselves with inventory, but it will likely result in the sporadic outages of goods around the country through the remainder of 2021.When the economy was shut down, there was a huge drop-off of durable goods orders. However, including the significant drop, durable goods have been up 0.7% each quarter on average.This shows that manufacturers have been locking up inventory in anticipation of reduced manufacturing capacities and that they are also preparing for an economic expansion.This is good news for the manufacturers that have prepared themselves with inventory, but it will likely result in the sporadic outages of goods around the country through the remainder of 2021.A Rising MenaceIn recent weeks, there has been a lot of news coverage on inflation. I usually think financial news coverage is overly-hyped with implausible scenarios, but in this instance, I think some concern is merited for two reasons.First, with many COVID-related restrictions still in place, manufacturers cannot produce goods as quickly or as efficiently as they did pre-COVID—this means that manufacturers cannot supply sufficient goods to the market.Second, even though manufacturers have been preparing for an increase in demand, the demand for manufactured goods has increased more than anticipated because credit is cheap, some goods are scarce, and the government stimulus programs are taking effect.As previously stated, inflation happens when spending increases faster than the production of goods. The lack of supply and the increase in demand creates a classic supply-and-demand scenario where market prices will be forced upward as a result. In recent weeks, there has been a lot of news coverage on inflation. I usually think financial news coverage is overly-hyped with implausible scenarios, but in this instance, I think some concern is merited for two reasons.First, with many COVID-related restrictions still in place, manufacturers cannot produce goods as quickly or as efficiently as they did pre-COVID—this means that manufacturers cannot supply sufficient goods to the market.Second, even though manufacturers have been preparing for an increase in demand, the demand for manufactured goods has increased more than anticipated because credit is cheap, some goods are scarce, and the government stimulus programs are taking effect.As previously stated, inflation happens when spending increases faster than the production of goods. The lack of supply and the increase in demand creates a classic supply-and-demand scenario where market prices will be forced upward as a result. Inflation has already started manifesting itself in the Consumer Price Index (CPI). Based on the Fed’s 2% annual inflation mandate, the CPI should ideally not exceed 0.17% in any given month.After the dip in CPI last year, the index has been averaging 0.34% for the past ten measurable months—that is double the ideal rate. In recent months, the CPI has ticked up to 0.60%, which is over triple the ideal rate! While it is possible that the Fed can increase interest rates to slow the economy and mute the effects of inflation, they have indicated that they will not touch interest rates for the foreseeable future, which means that 2021 will likely be a year of higher-than-usual inflation.While I believe that inflation is a legitimate short-term concern, I believe it will simmer down as soon as the government’s COVID restrictions on businesses have ended and when the Fed begins to increase the interest rate. Until that day, inflation will continue to affect the cost of goods.The Inflated UpsideWhile inflation should be a real concern for savers in the near term, I believe that there will be many tempting investment opportunities opening up for savvy investors.Real EstateI believe that most real estate markets will continue their runup in value by double digits throughout this year. I see indications of some bubbles forming in certain markets throughout the US, but I do not yet believe it is widespread enough to be a national real estate bubble as it was in 2008. Before investing in housing, you should pay close attention to the affordability index of the given city/region, the net population growth/decline, and barriers that force the housing markets to remain tight—think Manhattan island. Lastly, be very cautious when your hairdresser is flipping houses.StocksGenerally speaking, stocks tend to be great investments during inflationary periods because well-managed companies can pivot their operations to take advantage of different economic environments. Note that I said well-managed companies would benefit—that means that poorly managed companies are likely going to suffer from inflationary pressures. Before investing in stocks, you should pay close attention to valuation multiples compared to their historical averages, consumer sentiment, and the prevalence of speculative/meme stocks.Private LendingDuring times of economic prosperity, banks cannot keep up with borrower demand, so they tend to increase their lending requirements to curb the demand. Coupled with increases in asset values, it creates a lucrative environment for private lending. Before investing in private money lending, be aware of, and prepared for, potential lending pitfalls—foreclosures, delinquencies, re-negotiation of loan terms, etc. Due to these pitfalls, I strongly discourage lending to friends, family members, and acquaintances.Alternative InvestmentsThere tend to be many novice investment managers and con men who come out of the woodwork during economic booms with hypothetically lucrative investment ideas. Before investing in alternative investments, pay close attention to the manager’s performance history, be sure that they are legitimate, and be thorough with your due diligence.Despite its potentially positive effects on most investments, investors should be cautious during this time because the Fed and Administration are planning to overheat the economy by design—this means that bubbles will be forming over the next couple of years, and they will also be popping.ConclusionOver time, no two economic cycles are identical—they may have similarities, but they will not always function in the same manner.I believe the reason for this is three-fold:Technology exponentially increases in capacity, which exponentially changes how transactions take place.Productivity is constantly rising as people discover new and better ways of doing things. This constant ingenuity affects the way we consume and the effects of economic movements.Consumer sentiment and values are changing more rapidly a time moves on. Rapid changes in consumer sentiment can turn any market on a dime.While the lessons of the past can help guide us, they cannot address every future scenario. That is why savvy investors should learn to look for signs of market inefficiencies caused by greed, euphoria, and mass speculation.So, in this economic environment, I recommend that you (1) identify your financial goals and ideal investment strategy, (2) invest optimistically and cautiously, (3) be aware of forming bubbles, and (4) above all, don’t let fear and anxiety of an unknown future ruin your fun or derail your investment plan.Read the Full Report