The beginning is the most important part of the work – Plato

I often make the claim that the government is solely responsible for today’s consumer inflation and not the Federal Reserve but I fear I haven’t explained it well enough in past missives.  I’ll try to explain my point in this piece.

First of all, the most critical point of every cash flow analysis is determining where the cash flow starts.  If we’re purchasing government bonds, cash flow is determined by the authority to tax or from usage fees in the case of revenue bonds.  For equity analysis, cash flow starts with revenue, typically from the sale of a product or service.

The second step is to understand the stability of the above cash flow.  Has the government overtaxed its constituents in previous years such that the lemon has been emptied of juice?  Are the company’s products still needed?  Do they have pricing power in their industry?  Are there better options?

This form of analysis is elementary but I seldom see analysts or economists practice this critical step.  It’s why I believe we have an extraordinary opportunity in long duration US government bonds and why I believe the current inflation will prove transitory.

Transfer Payments

People in their handling of affairs often fail when they are about to succeed.  If one remains as careful at the end as he was at the beginning, there will be no failure – Lao Tzu

In general, a US government transfer payment is a cash flow for which no current or future goods or services are required in return.  Social Security, Medicaid, unemployment insurance, and disability benefits are all examples of transfer payments but there are many others.  They are supposed to represent redistribution of societal income but in recent years, they have become more closely aligned with uses of government debt.

Recent announcements from audits of Treasury and Social Security payment data show that the tide of illegal immigration has been managed by a combination of transfer payments including Social Security and Medicaid.  This helps to explain the change on the margin of the chart below that reflects US government transfer payments as a percentage of US gross domestic product.

Transfer payments are not a healthy driver of an economy.  The chart below reflects just how damaged the US economy has been since the 2008 financial crash.  Notice how these payments ticked up from the 11% to 12% range to the 14% to 15% range as people permanently went on the dole following the economic chaos of that time.

Today, we’re sitting above the 15% line following two jumps above 25% that coincided with Covid relief.  We’re in extremely unhealthy territory as a nation and it’s the reason why voters chose a different path for the future.

Timing is Everything

All things entail rising and falling timing.  You must be able to discern this – Miyamoto Musashi

It’s easy to be a Monday Morning Quarterback and suggest that policy makers made this mistake or that mistake.  Let’s put aside the nonsense and objectively look at identifying the reasons for inflation’s return. 

I’ve read analyses of economists, especially at the Fed, and I’ve concluded that they’ve taken an easy analysis and junked it up with the unnecessary.  It’s what they do to hide their mistakes – which are many.  I don’t say this to be demeaning, only to shatter their carefully crafted reputation for omniscience.  My observation is that their dependence on data makes them a backward-looking organization.  Money is made looking forward.

The simple answer to what happened is that the adherents of MMT, or Modern Monetary Theory, overstimulated the consumer economy amidst a supply shock brought on by Covid.  The global supply chain was reeling from China being locked down at the same time the US Treasury was mailing checks.  Furthermore, this was made worse by an immigration policy that admitted millions to the US in a short time – millions who needed to buy the necessities to set up households.

You could credibly say that it was a perfect storm and thanks to our over-reliance on data systems that over-prioritize near-term trends, producers misjudged demand and pricing trends.  Voila!  Automakers assumed everyone was suddenly price insensitive and investors bet inflation is permanent.

But the trends were never sustainable because they were a function of a few unprecedented cash giveaways.  This highlights the problems of modern forecasting.  The reliance on data means losing common sense perspective.  As you’ll see below, betting on inflation means betting on the increase in the rate of change of new debt.  Instead, debt growth is set to slow.

The combination of excessively high interest rates, reversal of immigration trends, downsizing of the federal government, tariff uncertainty, and a global economic contagion will combine to create a sharp decline in the economy and the markets later this year.  The good news is that consumer prices will fall along with economic activity, clearing the Fed to cut aggressively.  

Tariffs and Inflation

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design – Friedrich August von Hayek

The economic policies of both political parties have been ridiculously bad for the past 30 years.  The desire to maintain the dollar as global reserve currency led our economic leaders to export industries where we enjoyed competitive advantages in the hope of generating global economic growth.

Fortunes were made while the middle class in the US declined.  Shortsighted analysts cheered the GDP number that grew in a straight line while ignoring the extraordinary build up in both public and private debt to accomplish this low volatility miracle. 

To maintain the growth trajectory of GDP, the US needs to accelerate the growth trajectory of new debt, faster than the red trend line in the chart below.  The reason should be obvious by now; it takes an increasing amount of debt to move the needle for each unit of growth.  Taken to its logical conclusion, maintaining the current trajectory of GDP growth requires debt growth to resemble a parabolic growth curve.  But don’t worry; Keynes tells us that in the long run, we’re all dead!

The ascendancy of the Freedom Caucus in the House of Representatives to the position of spoiler in budget votes puts a governor on the rate of change of new federal debt.  It also brings us closer to deflation because the post-2009 economic and market expansion was built on the growth of federal debt. 

Tariffs will raise the cost of some imported products but they won’t cause inflation because the system lacks a funding mechanism that will allow consumers to pay the higher prices.  Instead, we’ll see substitution and a decline in living standards until domestic sources are available.  The critical point is there is no feedback loop that injects new money into the system to compensate for higher imported prices.  This suggests that higher tariffs can not be inflationary.

Instead, the likely scenario will be a sharp increase in the value of the US dollar in currency markets thanks to fewer dollars received by our trade partners.  A higher dollar will offset some of the impact of tariffs.  In addition, the US has the channel power to force foreign suppliers to eat part of or all the tariffs.  In the end, I expect the impact to be relatively modest on US consumers.

China

Bad company is like a nail driven into a post, which, after the first and second blow, may be drawn out with little difficulty, but being once driven up to the head, the pincers cannot take hold to draw it out, but which can only be done by the destruction of the wood – Saint Augustine

The tariff changes proposed by the Trump Administration are designed to create a level playing field where US producers can compete without obvious disadvantages.  But China is different; the tariffs are designed to destroy China as a global competitor.  I believe they will succeed. 

The Chinese model is built on a growing global economy.  It is predominately debt-funded and its industries are full of operating leverage which is great when turnover is growing but disastrous when revenues drop. 

They no longer have the option of developing a consumer model because their population is rapidly aging, birth rates are plummeting below 1%, and their population is much smaller than official statistics suggest.  Young people in China are highly indebted thanks to Covid lockdowns.

The real estate bubble that sustained China from 2010 through 2020 has popped, effectively destroying the wealth of China’s middle class.  In addition, they no longer have the benefit of home building in driving GDP.

The only avenue of growth left is in exports and the US President has shut that door – as well as China’s closest trade partners including Pakistan!  China lacks channel power with US distributors such that they won’t be able to pass along higher costs to US consumers.  This will effectively reduce their ability to generate US dollars in trade with which to service their international debt.  The result will be a sharp drop in the value of the yuan.

We are at breaking point levels for the yuan.  Once we break through 0.136 dollars per yuan, it’s going to become increasingly difficult for China to import the necessary inputs to maintain the fiction of growth.  When it happens, global deflation will start in earnest and the value of the US dollar will spike.  This is why it’s critical for central banks to intervene in the currency markets today to drive the dollar lower versus the yuan and euro. 

Conclusion

Destruction, hence, like creation, is one of Nature’s mandates – Marquis de Sade

If you don’t make the connection between the level of US debt and inflation, you’re missing the most significant signal in decades.  US consumer inflation starts with government transfer payments, not Federal Reserve interest rate policy. 

I’m not caught up in the tariff news because I assume that tariffs on US produced goods will drop, only to be replaced by a much higher value of the US dollar.  Therefore, re-establishing our industrial businesses won’t be smooth and easy.

That will be an analysis for another day.  For the near-term, deflation and a negative credit cycle are our biggest risks even as the Fed is missing these clear signals.  The Fed is going to take a huge hit politically when this is finished because interest rates are strangling the US economy. 

I continue to like the beneficiaries of lower interest rates even as I dislike companies that depend on the wealth-effect to drive profits.  The breakdown of the basis trade is presently obscuring the underlying trends that favor our thesis even as it signals a decline in asset prices later this year.     

If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley. 

Philip M. Byrne, CFA