Seeking Balance

One year ago people across the globe wished for nothing more than to return to normal. The pandemic had thrown virtually every institution out of equilibrium, and we have been trying to regain the balance we enjoyed in 2019. But that steadiness has been elusive, as we have lurched from one imbalance to another as policymakers try to bring society back to an even keel.

Manufacturing, for instance has gone from a depressionary state to boom times over the last year. Demand for electronics has led to a critical shortage of semiconductors which of course are ubiquitous in many products that we buy. Everything from washing machines and household appliances to laptop computers have been impacted. Automakers have been among the hardest hit, as the electronic content of new vehicles soars due to the demand for sophisticated chips for engine management systems, safety features and navigation. Numerous makers have had to shut down production as they are unable to complete their cars and trucks for sale. This would have been hard to imagine in the early days of the pandemic, but we have gone from glut to shortage in no time at all.

Home sales, too, have gone from bust to boom, as the demand for single family housing has climbed. Driven by the work-from-home trend, a desire to get out of crowded city centers, and supported by rock bottom interest rates, available homes were quickly snapped up. This has led to two phenomenon which underscore the imbalance in the real estate market. First, bidding wars have reached ludicrous new heights, with anecdotal reports of buyers bidding more than $100,000 over asking price in order to secure a new home (and still not getting the property). Some reports from southern California have described bids of one million dollars over asking price for luxury properties. Second, in April, the inventory of available homes was so low that there were actually more realtors than homes for sale in the U.S.

Home demand has caused the cost of lumber to soar beyond all expectations, with the lumber price chart moving almost vertically before its recent retreat. Lumber is adding some $30-$50,000 to the cost of a new house these days, helping to feed the buying frenzy in the world of residential real estate. Soaring demand is pushing home builder sentiment to new heights of optimism, but in a classic case of economics at work, home buyer sentiment is reaching very low levels as high prices crush buyer demand, even for modest homes. This disparity cannot continue in its current state, and is indicative of the imbalances we now see as stimulus efforts of the last twelve months are turbocharging demand.

Nowhere are America’s economic imbalances more glaring than in the labor market. A year ago, households were hit by the most abrupt wave of layoffs since the Great Depression, pushing the unemployment rate briefly above 14%. With vaccinations allowing for widespread reopening and public gatherings, businesses have been trying to make up for lost time (and revenue). Braced for a flood of job applicants, many businesses are finding just the opposite—very few takers. Consequently, employers have had to resort to hiring bonuses and (gasp!) higher wages to entice people to come back to work. It remains to be seen whether these incentives work, but the recent report on job openings from the Bureau of Labor Statistics indicates it will be a while before the supply and demand for labor return to balance.

We don’t have to look far to discover the source of labor’s reluctance to take the jobs on offer. There have been three pandemic relief packages, the key features of each have been a significant boost in federal unemployment benefits, both in amounts and duration. Many workers, finding to their delight that staying home can be more profitable than showing up for work, have opted for the couch. It is estimated that anyone who made $34,000 or less in the pre-pandemic era is better off taking unemployment benefits. Companies, and especially small businesses, that have been scraping by with skeleton crews find they are still having to operate understaffed, and this has prompted 23 states to warn they will soon stop paying the federal benefits in order to ease the labor shortage.

Helped by direct transfer payments, nominal disposable personal income grew 10.6%, or $1.8 trillion, from the 12 months before April 2020 to the 12 months through last month. By comparison, income grew by an average of 5 percent per year over the prior three years — despite those years having much stronger overall economic growth.

Imbalances in input costs are starting to impact businesses, while rising housing and food costs are hitting consumers. Thus, the word “inflation” is appearing in headlines daily. The Federal Reserve continues to judge current inflation worries as “transitory,” but with each passing day their assurances seem to grow less credible. Moreover, they are steadfastly committed to their latest iteration of “quantitative easing” (QE) which started in March 2020, and currently adds $120 billion a month to the banking system. Despite clear signs of inflation, the Fed remains adamant in their desire to keep interest rates pinned to the floor, and to many minds, is squandering their inflation-fighting credentials. The imbalance between inflationary trends and Fed policy has rarely been greater. Indeed, the Fed’s QE efforts, invoked originally to avoid deflation resulting from 2008’s recession, may finally be feeding an inflationary psychology that was the bane of the 1970s.

For Main Street, this is no academic argument. It is well known that inflation indices have been massaged over the years to create a downward bias in the data to reduce the impact on government benefits that are indexed to inflation, notably Social Security beginning in 1975. Looking at data from Shadowstats (www.ShadowStats.com), inflation based on the methodology used in 1990 reveal estimated consumer inflation to be 8%, double the 4% currently reported. The dichotomy between official statistics and actual costs is probably not imaginary.

The Fed’s monetary imbalances have led to perilous imbalances on Wall Street as well. Speculation is still running rampant, fueled by high levels of money creation. Valuation levels are at, or exceeding, highs seen at previous market tops. Central bankers have created so much money that we have had to invent places to invest it all. Crypto-currencies such as Bitcoin, “blind pools” known as Special Purpose Acquisition Companies (SPACs), and “non-fungible tokens” (NFTs) are a few examples of assets that have become valuable largely due to the amount of money available and the public’s willingness to believe they possess some intrinsic value (or maybe it’s just the Greater Fool theory at work-when risks are ignored because the expectation is that one can sell to a “greater fool” down the road).

Margin debt has leaped to an all-time high, creating what we believe is currently a major imbalance on Wall Street. Moreover, the rapid rate of increase in margin over the last year is indicative of investor overconfidence and perhaps a willful blindness toward risk. The Wolf Street blog (www.wolfstreet.com) provides a striking view of the jump in margin debt over the last year. While we’ll only know in retrospect whether today’s level of margin debt is marking a market peak, we do know that such high leverage increases risk, and will create problems for investors when the Fed tries to rebalance monetary policy from its current high growth rate.

It has been an article of faith on Wall Street that the Fed’s QE policy will always be good for stock prices. But can there be too much of a good thing? The “repurchase” (or “repo”) market provides a clue. This market is where banks lend collateral and borrow cash for short periods, overnight or perhaps a week. It is a source of daily liquidity, but can also be a source of emergency funding. In a “reverse repo” a bank buys Treasuries from the Fed and reduces the cash on its balance sheet, and there has been a surge in reverse repos in the last sixty days.

With these reverse repos, the Fed is now massively selling Treasury securities to counterparties and taking their cash, thereby draining liquidity from the market – the opposite effect of QE. By buying Treasuries in the repo market, the banks lower their reserves and increase their Treasury holdings. Surging reverse repos are a sign that the banking system is struggling to deal with the liquidity that the Fed has been injecting. And that is why there are now some rumblings on Wall Street for the Fed to taper QE, because the banking system is now drowning in the liquidity they have as reserves on their balance sheets.

The Fed has created huge amounts of reserves since March 2020, and now banks simply don’t have the balance sheet capacity to warehouse any more reserves at current spread levels. Either the Fed will have to hike the interest they pay banks on the reserves they are still creating, or rates will soon go negative. Put simply, the reverse repo market is signaling stress in the money markets, not because banks need cash, but because they have too much.

The long-awaited pandemic recovery is here but is characterized by imbalances unusual for a post-recession recovery. Investors who have been accustomed to an unending diet of the Fed’s QE should prepare for its eventual “tapering” sooner than forecast, as rising inflation and repo market activity signal that perhaps the Fed is being overly generous in its money printing efforts. Monetary and fiscal policy have been the prime drivers of these imbalances, and they will eventually have to be brought into some sort of equilibrium, lest we lurch from bust to boom and back again.

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