November 2021 Economic Report

Recent polls indicate that most Americans believe the economy is doing poorly on account of persistent inflation. Some pundits have even begun to raise concerns over stagflation.While there are elements of truth in their fears, I do not believe the sky is falling, nor do I believe that this is the last time we’ll be hearing inflation concerns over the next decade.A lot is going on in the world right now, and there are many things to cover in this economic report, so hold on to your seats.In this report, I feel it necessary to review some of our country’s history to show how past decisions have contributed to the current economic environment and how they may affect our future economy.Bretton WoodsTo start this report, I will take you back to the end of World War II, where apart from the United States of America, the economies and militaries of the world were in shambles. All governments faced the staggering challenge of resurrecting their economies while also rebuilding their armies—two very costly activities.Before World War II, most nations adhered to the gold standard where people could exchange their paper currency for gold. In 1944, worldwide gold reserves were exhausted due to the cost of the war, leaving countries with very little to rebuild and no backing for their paper currencies.Without some type of intervention, countries worldwide would be open to a real threat of mass hyperinflation resulting in worldwide civil unrest and countries fighting each other for resources—the possibility of World War III was very high.To address these issues, the United States came up with a proposal and presented it to the Allied nations of the world—this proposal became known as the Bretton Woods Agreement.While the agreement contained many terms and conditions, several new concepts were introduced that forever changed the world economy and its government.U.S. NavyIn the 1940s, most international trade was conducted through the oceans and was a significant economic booster. Historically, countries used their navies to protect their trade routes. However, following World War II, the United States was the only country in the world with a sizeable, functioning navy.This left countries with a difficult decision—use precious resources to re-establish a navy to protect their maritime commerce or leave their trade open to piracy.To solve this issue, the United States proposed using its navy to police the world’s waters at its own expense to ensure safe passage for all maritime commerce and ships.U.S. Dollar StandardAnother problem faced by the Allies was the lack of gold to support their currency. After the war, the United States held 75% of all gold reserves globally, which allowed its economy to remain pretty stable while others faced ruin.Without gold to support the value of their paper money, people would not have confidence in its value, and countries would face an uphill battle of rebuilding their countries without resources.To address these issues, the United States proposed that Allied countries back their currencies on the U.S. Dollar instead of gold and establish fixed exchange rates between the Dollar and Allied currencies.This made a lot of sense since the U.S. had significant gold reserves and people had confidence in the U.S. Dollar more than any other currency at the time.The IMF and World BankThe final part that I will touch on here today was the creation of two agencies to monitor and regulate this new system—the International Monetary Fund (IMF) and the World Bank.The function of the International Monetary Fund (IMF) was to monitor exchange rates, and the role of the World Bank was to facilitate inter-country lending.Collpase of Bretton WoodsFast forward to the 1970s, the United States was in an economic slump, causing stagflation—a time of high unemployment, high inflation, and low economic growth.In response to the stagflation, President Nixon unhooked the U.S. Dollar from the price of gold—this move allowed the United States more flexibility over its currency, but it also closed the chapter on the Bretton Woods fixed international exchange rates.Once the U.S. Dollar was no longer tied to gold, it allowed our government to print money without anything to back it—this resulted in high inflation during the 1970s (nearly triple our current rate) and the price of gold skyrocketing from $250/oz. to over $2,300/oz.. A Government’s RoleWhen it comes to the government’s role in an economy, there are two primary schools of thought—the Keynesian and Austrian economic theories.The Keynesian economic theory believes that markets aren’t always efficient and that if spending stops (or slows), the government has to fill the gap with spending and stimulus.Austrian economists believe that the economy goes through natural processes, including financial crises, and that government action ultimately does more harm than good.After Bretton Woods, the United States government officially adopted and integrated the principles of Keynesian economics into its policies and has created various tools to influence and manipulate the direction of the economy.These tools include (i) raising and lowering interest rates to affect borrowing/debt, (ii) issuing cash payments to citizens during economic downturns, and (iii) funding government infrastructure projects. 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: 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.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).In 2008, the Federal Government found that it was on the precipice of a systematic financial collapse—the house of cards was caving in. At the time, interest rates were already near zero, and cash payments were already being sent to people, but the economy was still declining.At that time, the government found that its existing tool chest was insufficient to stimulate the economy further, so it developed a fourth tool—quantitative easing.I have spoken about quantitative easing before, but it is essential to understand how it works if you are going to understand the current economy.In a nutshell, when there is an economic gridlock or a decline in a major market (such as mortgage-backed securities in 2008), the government will print money to purchase the gridlocked/declining assets from the private market.Conceptually, QE allows the government to print money without triggering an inflationary effect because it only swapped one asset for another—in other words, they discovered a new accounting trick to stimulate the economy.The problem with the unchecked use of QE is that it must be unwound eventually—this means that the Fed will sell back private assets to the markets, which will result in market swings and unpredictable inflation/deflation rates. What’s Going on NowThere are several issues happening right now—inflation above the Fed’s target 2% annual rate, persistent unemployment with employers unable to find workers, increasing asset prices, wage inflation, and a slowing economy. So how did we get here? And what is happening next?InflationAs previously stated, inflation is when spending increases faster than the production of goods, causing prices to rise.Our current inflation issues are being caused by—(i) manufacturers who are unable to obtain the labor needed to produce more goods, (ii) the supply chain is being choked, (iii) government interest rates policies are incentivizing borrowing resulting in higher demand for goods, and (iv) the government is paying out unprecedented volumes of cash to the American people.As stated in my previous report, the primary tool that the Fed can employ to slow the rate of inflation is to increase interest rates.Despite the economy burning hot and inflation being strong, the Fed’s current policy is to keep the pedal to the metal until the end of next year—this means that borrowing will continue to increase, demand will remain high, manufacturers will continue to lag behind demand, and inflation will continue.So long as inflation remains strong, I believe consumer sentiment will continue to decline because people’s purchasing power will erode their savings faster than wage inflation can fill the gap.StagflationI keep hearing pundits talk about stagflation, but they don’t explain it very well, causing confusion. Stagflation happens when there is high inflation, high unemployment, and slow economic growth.As I see it, stagflation is a slight possibility, but nothing to be concerned about (yet). Here’s why:For there to be stagflation, there need to be three things—(1) high inflation, (2) high unemployment, and (3) slow economic growth.We all agree that there is high inflation right now, so we know it has the first of the three components.According to the latest economic reports, unemployment continues to decline and is nearing historic lows at a 4.6% unemployment rate.Apart from the slight decline in the Durable Goods report reading, all leading indicators show that the economy is growing at a good clip.For me, I won’t be concerned about stagflation until I see that the Fed’s interest rate policy continues unchanged, leading economic indicators are beginning to sour, and there is a significant drop-off in consumer demand.As I see it, stagflation is a remote scenario that isn’t worth debating (for now).Lack of EmployeesAs of August 2021, there are 10.4 million open job positions in the United States and 8.4 million workers who don’t have a job. On its surface, it seems like we could attain 0% unemployment and solve 80% of our labor shortage with just the workers we have now. Unfortunately, the problem goes a little deeper than that.Between the beginning of the COVID shutdowns and now, roughly 3 million baby boomers have taken early retirement. Many of these workers were at the pinnacle of their careers, leaving a significant skill gap between them and the currently unemployed.A recent poll of unemployed workers cited various reasons for not returning to work.As you can see, there are numerous reasons why the current workforce is sitting on the sidelines.While I don’t know for sure, I believe that this issue will persist for the next 6-9 months, at which time I think that most COVID-19 concerns will be resolved, and workers that currently have plenty in savings will begin to run out of money.Until these workers return or the government opens our borders to skilled labor from other countries, wage inflation will persist, pushing prices (and inflation) upwards.There is another employment-related issue that I haven’t heard many people talk about that I believe will cause future hiccups as workers return to work—their atrophied skills.Over the past twenty months, millions of workers have taken themselves out of the game while technology, processes, and skill requirements have changed. This means that I don’t believe there is an immediate solution to our employment woes even if all unemployed people were to return to work suddenly.As these workers return to the workforce, I believe that many will find that their skills are no longer viable, and they will have to re-tool before they can become productive again.I think skill atrophy will add another 3-6 months to the healing of our workforce, meaning that these employment issues will probably not be resolved for a total of 9-12 months.Slowing EconomyAs of the latest economic readings, the economy is still recovering from the COVID-19 shutdowns but is still running strong.As stated in my May 2021 economic report and reiterated in my August 2021 report, I believe this year will probably be one of the best economic years in our country’s history.Over the next 12 months, I believe that the supply chain and employment issues will keep the economy from reaching its full potential, but I see signs that the economy will still be strong next year than it is currently.If Biden’s tax proposals get signed into law effective in 2021, we may see the economy slow down a little more next summer, but otherwise, I think we’ll remain strong. Areas of ConcernU.S. Debt. I previously analyzed the amount of public and private debt expansion that occurs in between recessions. I found that debt expanded an average of 34.6% between recessions (ranging between 11.5% and 87.7%). I also found that the more debt grew between recessions, the deeper the next downturn would likely be. As of right now, public and private debt have expanded by 35.87% since the 2008 recession. While I don’t believe this reading indicates an impending recession, I think it is a cautionary reading—don’t overleverage yourself, be prudent with your money, and save for a rainy day.Quantitative Easing (QE). The government discovered how to implement QE in the 2008 recession. For it to work correctly without causing future issues, the QE must be reversed in between recessions—this means that all the private assets owned by the Fed need to be sold back so that the markets can re-regulate themselves. Unfortunately, the Fed has continued to add to its stockpile of private assets purchased in 2008 and only recently decided to ‘taper’ the asset purchases. If the Fed continues to use QE without unwinding it, I fear we will continue to kick the can down the road until it is an insurmountable problem. Also, I believe the Fed’s support of the stock and bond markets is one of the primary reasons for the current price increases—withdrawal of the Fed’s support may result in some wild market swings.Inflation. Inflation is always a concern when it is high. I believe that it will slow down as soon as employment/manufacturing picks up, and I don’t see that happening until next year. Since many countries still tie their currencies to the U.S. Dollar, I am a little worried about worldwide inflation—I have already seen it happening through Canada and Europe. My big concern here is that this inflationary period will have lasting impacts on retirees and recent retirees who projected certain returns and purchasing power to sustain them through retirement. For these individuals, I highly recommend sitting down with your financial advisor to make sure you’re still on track or, if you’re not, what you need to do to get back on track.Tax Attacks. I have seen politicians step up their attacks on Billionaires not “paying their fair share.” I believe that the only way for the government to tax Billionaires in the way they are suggesting is to unlock one of three dangerous methods of taxation—taxation on unrealized gains, seizure of property, or killing them. While I think the latter two options are far-fetched, I am alarmed to find that the first option is being considered. The problem with the government finding a way to tax unrealized gains is not that they won’t be able to tax Billionaires successfully, but it will give them a new method of taxation that they can (and will) use on any asset class and anyone. One of the main concerns I have here is that the people they are targeting have the money to move their citizenship elsewhere, which means it will only be a matter of time before they start lowering the unrealized gains threshold. I worry that this will deter business owners from reinvesting in their business and result in a slower future economy.Asset Valuations. Real estate and stock markets have gone up considerably over the past twenty months, and the Fed’s QE program has propped up both of these markets. As previously said in this report, inflation creates market bubbles if left unchecked. While the Quarterly Financial Report (QFR) indicates that corporations are earning money at a record pace, I see that some companies are significantly overvalued due to speculation. Even though the real estate and stock markets are really hot right now, I don’t think that the markets as a whole are necessarily overvalued—I think that overvaluations can be found in specific pockets within those markets. While I’m not very worried about the overall health of the markets, I am concerned that the government’s withdrawal of market support and rampant speculation by novice investors will result in market swings. I believe that swings in the market will hit speculative assets the hardest, but most other asset classes will probably feel something as well. ConclusionOur economy is working through some crazy things right now, and it is unlikely they will be resolved any time in the next few months.Things to WatchHere are some things to watch for:Pay attention to the Fed minutes (where they talk about the interest rates) and the unemployment rate. Once the Fed signals that it will begin raising interest rates, you can expect inflation to slow.Watch the unemployment rate. Once it gets in the low 3% range, or when another 3+ million workers have returned to work, I believe that manufacturing will jump, which will cause inflation to slow.Pay attention to new car tags—so long as you see many newly acquired cars on the roads, it is a general sign that people feel good about the economy.Things to DoHere are some things to do over the next few months:Review your financial plan to ensure that your emergency fund is adequately funded. In this economy, I’d say that 6-12 months of cash is a safe plan.Create an aggressive plan to eliminate your debts. Debt creates financial risk—you should use periods of prosperity to eliminate/reduce financial risk.Don’t let a lot of your money sit idle—look for safe ways to invest the money that is still liquid and earning you more than the 0.01% interest rates you’re getting at some banks. The idea here is to offset some of the purchasing power loss occurring on account of inflation.Review your investments—don’t wait until there is a market swing before you notice that you’re overallocated in risky assets. Clean up your investment portfolios to align with your risk tolerance.Write down your financial goals and make sure that your current investment allocation is the best method of attaining them.If you are in retirement or are about to retire, speak with your financial advisor to reevaluate your retirement plans. It would be best to do this annually but now is especially important due to the erosion of your purchasing power.Review your estate plan to make sure that your estate is in order. I’ve seen people with a lot of money pass away without any planning—don’t do it.No matter what is happening in the economy or politically, I am still majorly bullish on the United States—I think that our best days are still ahead of us (albeit with some bumps along the way).Be wise with your investments and enjoy life!