December 5, 2020

You Are What You Watch

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Bottom Line:


In a world awash with data, market fortune tellers must determine which data matters the most. For 2020, the most important economic indicator proved to be…personal incomes. Thanks to stimulus, personal incomes across the economy rose substantially throughout the pandemic. This resulted in record household net worth, record spending activity, and all-time highs for asset markets…despite the worst pandemic in 100 years! As we enter 2021 and the pandemic recedes, investors must align with a new North Star to help with navigation. If I could have only one indicator, dynamically updated, to assess the health of the economy and the opportunities for investors, I would choose…


The Full Story:


Market prognosticators have endless data points to track, measure, and interpret. For instance, on Friday we received a disappointing jobs growth number for November. The recent resurgence in COVID cases and hospitalizations along with reimposed safety measures have led to a deceleration in hiring activity. In response, Congress has intensified its thumb twiddling. The market response? All-time highs. While the daily data releases add spices to the stew, the underlying base determines the flavor. The trick to improving accuracy over time (there are no perfect scores in fortunetelling) is knowing which variable will dominate and when. Therefore, I challenge myself all the time to choose a “desert island” indicator. In other words, if I am trapped on a desert island with only one chart, updating in real time, to properly position our investors’ hard-earned capital, which would I choose?


The three primary actors in the global economy are central banks, governments, and businesses.  Governments influence the economy, primarily through fiscal policy. Cutting taxes, reducing regulation, and increasing spending = stimulus. On the other hand, increasing taxes, increasing regulation, and reducing spending = restraint. Central banks influence the economy through monetary policy. Cutting interest rates, printing more money, and purchasing assets = stimulus. Conversely, raising rates, printing less money, and selling assets = restraint. Businesses make decisions based upon confidence. More confidence leads to capital expenditures and hiring, which = stimulus. Less confidence = restraint. In the current environment, fiscal and monetary policies carry extra weight as uncertainty and marketplace disruption due to COVID continue to discombobulate business leaders.  As such, we need an indicator that measures the will of central banks and governments to continue their sizable support efforts to stimulate this economy.


The Federal Reserve’s testimony in Jackson Hole at the end of August contained real insight into their thinking. The Fed believes that declining demographic trends (i.e., too few babies and too few new immigrants) in the U.S. impose a serious deflationary force upon the economy. For years, they have used their 2% inflation target as a limiter. Any upward trend toward 2% was met with more restrictive monetary policy. In hindsight, they recognize that their preemptive strikes against inflation overestimated the real inflationary threat. In response, they have inverted their inflation framework to consider 2% a suitable floor rather than a suitable ceiling. Therefore, the Federal Reserve will continue their stimulative support for the economy until expected and/or real inflation climb far higher than the tolerance levels of the past.


Congress and the White House have always sparred over suitable levels of public debt. Many believe that ballooning deficits saddle our grandchildren with unpayable bills. Others espouse that the Government can always pay its bills because it prints its own money. Over the past year, the federal debt level has ballooned from 105% of GDP as of September 30, 2019 to 127% as of September 30, 2020. Concurrently, inflation and interest rate levels have fallen. That is NOT how the textbooks read. Theoretically, more government debt should stimulate higher inflation and higher interest rates. But what if it doesn’t? If not, then the Modern Monetary Theorists are right. Without inflation as a limiter, the Government can spend whatever it wants, and deficits don’t matter. This view, justifiable or not, seems to hold the upper hand in Washington. Therefore, the Government will continue their stimulative support for the economy until expected and/or real inflation climb far higher than the tolerance levels of the past.


The two inflation expectations gauges that the Fed and the Congressional Budget Office monitor are the 10-year breakeven inflation rate and the 5-year, 5-year forward inflation rate. Without going into detail, these are market-based indicators relying on the hive mind of investors. Both indicators express where traders believe inflation will be 10 years from now. Let’s take a look at both:




As you can see, fixed income traders currently forecast an inflation rate of 1.86% 10 years from now.  Note the steady decline in the slope of the line since 2004. This is the trend that unnerves the Fed. Also note the rapid decrease in inflation expectations that happened in 2019. Overtightening by the Fed in anticipation of inflation backfired, reinforcing their “loose for longer” strategy shift.


Now, let’s look at the 5-year, 5-year forward measure:




The charts reinforce each other. Both suggest a trend of lower expectations. Both also reveal rising inflation expectations from the morose levels earlier in the year. IF the Fed still relied on expectations to craft policy, these charts might suggest tightening conversations within the Fed. Furthermore, the run up in asset prices might cause some Fed members to advocate for a tighter policy stance to deflate rising bubble risks. BUT, because the FED has been burned on using inflation EXPECTATIONS to calibrate policy moves, I believe actual inflation measures will now direct Fed action.


Here is actual inflation as measured by personal consumption expenditures excluding more volatile food and energy prices (Core PCE):




With the Federal Reserve now rooting for inflation of 2%+ and the Federal Government adopting “deficits don’t matter without inflation”, a current inflation rate of 1.5% foretells continued accommodation if not outright stimulus from both the Federal Reserve and the U.S. Government for the foreseeable future. As the vaccine distributes and economic brownouts end, business confidence will rise. The combination of the Fed, the Government, and businesses collaborating on higher inflation and higher economic growth amounts to a holy trinity of support for investors.


With the Federal Reserve and the Federal Government in tacit agreement that they will continue to provide monetary and fiscal support for the economy until ACTUAL inflation exceeds 2%, the Core PCE inflation measure becomes the most important indicator for investors to follow…and the one chart I would take with me to a desert island for 2021.


Have a great weekend!



David S. Waddell 
CEO, Chief Investment Strategist



David Waddell
Author: CEO Chief Investment StrategistAfter graduating from the University of the South with a BA in Economics, David began his career with Charles Schwab & Co., Inc. in Phoenix, AZ. Having been recognized for his outstanding business development record, David was promoted to the San Francisco- based Institutional Strategic Accounts Team, which interfaced with the Big 5 accounting firms and Schwab’s largest customers. David left Schwab to continue his education at the graduate level in Boston. While earning his MBA degree with a concentration in finance and investments at the F.W. Olin School at Babson College, he was appointed by the college Trustees to manage a team of seven portfolio managers overseeing the student-managed portion of Babson’s endowment fund. David also founded the Babson Investment Management Association to assist undergraduate and graduate students with training and career path planning in the investment management field. As the firm’s Chief Investment Officer, David chairs the W&A investment committee and combines macro economic forecasting, macro market analysis and macro risk assessments to design portfolio strategies utilizing public market securities worldwide. A civic leader in Memphis, David currently acts as Chairman of Epicenter Memphis, and Co-Chair of the Memphis Chamber Chairman’s Circle while also serving as a board member for LaunchTN and the New Memphis Institute. David previously served as chairman for The Leadership Academy, the RISE Foundation, and the Economic Club of Memphis. He also chaired the capital campaign to build the “Live” stage at the Memphis Botanic Garden. David was a member of the 2004 Leadership Memphis class and has been recognized as one of Memphis’ “Top 40 under 40” by the Memphis Business Journal, and as a finalist for “Executive of the Year” in 2007. In addition to weekly columns in the Memphis Daily News and the Nashville Ledger, David has appeared in the Wall Street Journal, USA Today, Forbes, Business Week, Investment News, Institutional Investor News, The Tennessean and Memphis Business Journal. He has also made appearances on Fox Business News, Yahoo Finance, Bloomberg TV, CNBC, and CBS News and ABC News Channels. Read some of David's articles on his author page in Inside Memphis Business. David has two wonderful children, Easton and Saylor, an obedient Labradoodle named NASDAQ, and a devoted Goldendoodle named Ripley.


David S. Waddell


Chief Investment Strategist

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