Published to the Deep Knowledge Investing blog on November 3rd, 2024.
I have been writing less about the macro-economic environment lately. That’s been for two reasons. The primary one is in 2022 and through much of 2023, it was macro considerations that were driving the market. Understanding what was happening with inflation and the Federal Reserve was more important than individual stock fundamentals. It also helped that I had a differentiated view from the mainstream financial press and most market strategists. While I do value providing financial education, DKI’s primary goal is to help our subscribers make money and right now, focusing on individual stock picking is a better way to fulfill that goal than writing another detailed analysis of the PCE (personal consumption expenditures index).
The second reason is my views on these matters are well-known and expressed in hundreds of posts on this blog and in hours of podcast interviews. I’ve tried to ensure that DKI has a high signal to noise ratio, and I’m not sure that more articles explaining why I think the CPI is understated, what the root cause of inflation is, and the unreliability of the employment data is going to be useful to you.
I still think it’s time for a comprehensive overview of the macro situation. So, as we say every week: Let’s dive in.
The Cause of Inflation:
Over the past few years, people have blamed everyone and everything for inflation including Covid, supply chains, Vladimir Putin, the Federal Reserve, “greedy” corporations, and the boogeyman. If the cause of inflation had been Covid and supply chains, then as those problems receded, we should have had a return to “normal” prices meaning inflation would have been followed by deflation. That didn’t happen and prices have continued to rise. Corporations did not suddenly become greedy in 2021. They’ve always been greedy and it’s their purpose to be that way. The beauty of capitalism is that corporations succeed by offering customers an attractive value proposition. The “greedy” ones that raise prices too much get put out of business by more efficient and customer-friendly competitors.
The original (and correct) definition of inflation is an increase in the money supply. That’s what we’ve been experiencing since President Nixon took the US off the gold standard in 1971. Each successive Presidential administration spent more than the preceding one. This unsustainable practice got put on steroids during the 2008 financial crisis as massive spending to “fix” the financial system became part of baseline spending.
The problem really started in 1971.
It got a lot worse in recent years.
The whole situation got much worse in 2020 as the government shut down the country and sent about $6 trillion of stimulus into the economy. We had more money chasing fewer goods leading to higher prices. Whether you want to consider inflation an increase in the money supply or higher prices, that’s what we had. The institution at fault here is Congress and this is a bipartisan problem. Congress was aided in its excessive spending by a compliant Treasury Department led by Janet Yellen who has openly said she regretted not creating more inflation when she was Chair of the Federal Reserve. Our inflation problem was intentional.
No one running for office is going to fix this and no one is even thinking about cutting spending. (I’ll get to the Trump/Musk plan to cut trillions of spending later in this piece.) Congress thinks they’ve discovered a new way to pay for everything without consequences. No one likes seeing their benefit program cut, and no one likes a higher tax bill. By putting everything on the national credit card and getting the Treasury to issue debt to provide the monthly cash fix, Congress gets to vote for unlimited spending and low taxes. They’re pretending there’s no cost to their choices. However, there is a cost. It’s inflation; the hidden tax.
Does this resemble the actions of an organization about to cut spending?
DKI Takeaway: Congress is to blame for our current inflation. Whether you’re team red or team blue, we’ve all voted for people who are overspending.
The Federal Reserve:
While I do place most of the blame for high inflation on Congress, the Fed did contribute. They kept the fed funds rate at or around zero for far too long and then increased the size of the balance sheet to over $9 trillion. These are the kinds of things that cause inflation under normal circumstances. That, combined with trillions of dollars of stimulus spending, and we got the inflation Yellen requested. Somehow, I’m surprised that people were surprised we have an inflation problem.
$9 Trillion is insane. I’m betting we get more QE before that balance sheet hits $4T.
Fed Chairman, Jerome Powell, frequently has said that the current fed funds rate is “restrictive”. I don’t agree. We went from a negative real rate of interest (fed funds rate less the CPI) to around 2%. That doesn’t strike me as restrictive either on a relative or an absolute basis.
A 2% real rate isn’t restrictive. An accurate CPI would make this even lower.
So, if the Fed contributed to this problem, why am I not placing more blame on them? It’s because they no longer have control of the situation. Congress is overspending which causes inflation and they’re counting on the Fed to bail them out by getting unpopular inflation under control. Certain members of Congress have also been crying for the Fed to reduce rates in order to stimulate the economy ahead of the November elections.
Zero and near-zero rates from 2008 onward contributed to inflation.
If the Fed cuts, then they stimulate the economy, leading to more inflation. If the Fed were to raise the fed funds rate, the government would have higher interest expense. Given our constant deficits, the only way to pay for that higher interest expense would be to print more dollars. That path also creates more inflation. In other words, it’s Congress in control right now, not the Fed. For those of you who want to better understand this topic, DKI wrote a guide last year titled “Counter-Intuitive Inflation” which you are welcome to download and share.
DKI Takeaway: The Fed has made a lot of inflation-causing mistakes, but they’re not in the driver’s seat right now and are still heading in the wrong direction.
Tracking Inflation – the CPLie:
It’s impossible to produce one number that encapsulates the change in prices for an economy as large and complicated as the United States. We all buy different things at different times. People who bought homes and locked in mortgages in 2020 have lower expenses than people who bought similar homes a few years later. People who bought cars pre-Covid didn’t have to face the huge run-up in prices that came immediately afterwards. We’re all paying more for food and services.
Your inflation rate largely depends on whether you locked in housing & auto costs pre-Covid.
The issue with the CPI isn’t so much that it’s trying to track something that varies by person; but rather, that it has been changed in ways that make it intentionally inaccurate. The most obvious one is OER (owners’ equivalent rent) which substitutes actual housing cost for owners’ estimates of how much rent they might receive if they were to rent out their residence. It understates housing cost by a huge margin.
Actual housing cost (blue line) is well-above OER (red line). CPI understating shelter inflation.
Another example is food prices. The Bureau of Labor Statistics (BLS) keeps telling us that food inflation is only 1% – 2%. I keep telling them that anyone who believes that hasn’t been in a supermarket for years. I also can’t find a single person who thinks their grocery bill is up only 2% from a year ago.
There are also hedonic adjustments. Even though the price of some items has gone up, the BLS adjusts them down due to higher quality and new features. I admit that computers are more powerful than they were years ago and that cars have all kinds of entertainment options not available when I got my license at the age of 16, but that doesn’t mean you could buy those items at yesterday’s lower prices. The BLS might change its valuation of a new car, but you’re still going to be out of pocket tens of thousands of dollars more than you would have been a decade ago.
We could go on at length, but during the high inflation of 2022, I regularly calculated that the CPI was understating true inflation by as much as 100%. While I think the current discrepancy could be lower than that right now, I don’t think the current 2.4% figure reflects reality for most household budgets.
DKI Takeaway: The CPI is intentionally understated. People are upset about the higher cost of living for a reason.
The Fed Cut Too Early:
This is an unpopular opinion right now, but I think the Federal Reserve cut the fed funds rate too quickly. Asset gatherers, who get paid based on assets under management, have been begging the Fed to cut since the spring of 2022. DKI said that was both unwise and not going to happen. I thought Jerome Powell was concerned about making the “Arthur Burns” mistake.
Arthur Burns was the Fed Chairman decades ago who cut the fed funds rate when inflation was on the way down, but not fully under control. That mistake contributed to the roaring inflation of the late 1970 which subsequent Fed Chair, Paul Volker, brought down by raising the fed funds rate to an economy-crushing level; almost 20%. Given the size of our national debt, that’s not even close to possible today. That risk is one reason I believe Powell pulled the trigger on rate cuts prematurely.
This is the Arthur Burns mistake being repeated.
The result was a higher-than-expected September CPI and a continued sticky and high core personal consumptions expenditures index. Prices don’t react that quickly to Fed moves so I’m not suggesting that the hot inflation prints were an immediate result of recent Fed policy. My point is that the Fed is reducing rates and doesn’t have inflation under control.
Many of you will disagree with me on this point, but the bond market is seeing this the same way I am.
DKI Takeaway: The Fed cut too early. (Sometimes, the title is enough.)
The Bond Market is Telling You the Fed Cut too Early:
The day before the Fed cut the fed funds rate by 50 basis points (0.5%), the 10-year Treasury was trading at a 3.65% yield. As of this writing, the 10-year yield has risen to 4.36%. That’s a huge increase. The Fed’s intention was to lower borrowing rates. So, how did we end up with much higher rates?
People often talk about the Federal Reserve like they control all interest rates. In reality, the Fed controls the overnight rate. The bond market sets the price for everything else from one week to 30 years. (YCC, or yield curve control, is the exception where the Fed buys bonds in the open market to try to change the yield on longer-duration Treasuries.) I believe that what happened is the Fed cut the fed funds rate, and the bond market correctly anticipated higher future inflation. That lowers the present value of future bond payments and leads to lower bond prices. Lower bond prices mean higher yields and higher borrowing costs for the rest of us.
Rates up for everything > than 1 year after the Fed cut. Graph from US Treasury Yield Curve.
Some prospective home buyers held off on making a purchase because they were waiting for the Fed “pivot” to lower interest rates. Yet, when the Fed cut, mortgage rates actually rose. When I tell you that the Fed isn’t in the driver’s seat, this would be exhibit A.
DKI Takeaway: The bond market appears to agree with me that the Fed cut too early. That doesn’t mean I’m right; only that I have some smart company right now.
The Employment “Data”:
I have been writing about our misleading employment “data” for years. The pattern has been that we get a positive employment number on the announcement day. Then, in subsequent months, when there’s relatively little attention being paid, those figures get adjusted down. Frequently, the amount of the downward adjustments is a multiple of the initial “beat” over expectations.
Confirming my point, this year alone, we’ve had two massive revisions approximating 800k jobs each. Anyone want to guess the direction of those adjustments? Down – it’s always down. The market is trading off of inaccurate data. The pattern is so obvious that I’ve stopped writing about it. Why analyze “data” that’s both fake and going to be revised. The beats become misses. Basically, the government tells us whatever they want us to believe, then revises the information months later when few are watching.
The big revisions are almost always down.
I’m writing this section on Friday, November 1st. This morning, we saw a terrible employment number indicating there were 12k new jobs, far short of the 100k expected. Some smart people on Twitter/X were saying they credit the BLS for finally giving us an honest number just before the election. My response is, how can we know? Maybe the actual number was lower. Maybe the unemployment rate was higher. We’ll find out months from now. That’s the problem with being consistently inaccurate. Even when the BLS gives us a believable number, we have no idea if it’s correct or hiding a bigger disaster.
Earlier in this piece, I wrote that the Fed cut the fed funds rate too early and dismissed many who disagree as asset gatherers who needed the Fed to create profits for them. However, there’s another group of dissenters who have an excellent argument. They claim that the US economy is already in recession and the Fed was too late to cut. For them, the employment numbers are exhibit A, demonstrating the poor state of the economy.
This is a valid argument, and one I will amplify. Not only is the employment situation worse than the government tells us, the kind and quality of jobs are also declining. There has been no growth in employment of native-born Americans in years. Full-time employment is down, meaning all of the reported job growth is people taking on additional part-time jobs. More people aren’t working. The same people are working more to make ends meet. Finally, all job growth has been in government jobs or fields heavily funded by government.
Massive overspending out of Washington DC has crowded out the productive private economy, and we’re all paying for those additional government jobs through more inflation. When I say we have a Potemkin economy, this is what I mean. I’ve also been saying we have a bifurcated economy. A small number of wealthy people do very well with high inflation. The ability to buy hard assets and finance them with debt that will be repaid with debased dollars is limited to people with high credit scores and available cash. Much of the country isn’t doing so great right now.
When people disagree with me on these grounds, I think they have an excellent point. Like them, I don’t think the economy is in great shape. I just don’t think Fed rate cuts are going to fix the problem and may exacerbate it.
DKI Takeaway: The employment data is so fake that any use of it for analysis or market forecasting is pointless.
The Election and Policy:
In this piece, I’ve laid out some serious problems we’re facing. The 2024 election takes place the day after we’re posting this to the DKI blog. It’s a contentious election, and many people on both sides believe the country and democracy will end if their side doesn’t win. I have strong political preferences as do almost everyone associated with the firm. Despite differing opinions, we all collaborate and question each other respectfully. Contentious ideas are met with “that’s interesting, can you explain further” and not “you’re a terrible person”. As always, we’ll address policy and leave politics to others.
The most important thing that needs to happen from an economic point of view is a huge reduction in spending. That’s not going to happen. Kamala Harris is a big government big-spending liberal in the worst possible way. Donald Trump took the bloated Obama budget as a starting point, and increased spending from there (as has every President in my lifetime). He’s said he wants to reduce the independence of the Federal Reserve. My analysis is that his reason for that is to pressure the Fed to keep rates low and stimulate the economy and the stock market. I disagree with that approach. No matter who wins, be prepared for more spending and higher inflation.
I made this point about both candidates wanting to overspend recently on Twitter/X, and someone correctly pointed out that President Trump has talked about bringing in Elon Musk to cut trillions of dollars of government waste. It’s a great idea and there’s plenty of waste to cut. For several humorous and horrible examples of that, see my Twitter thread noting excessive and wasteful government spending. Somehow, we actually spent millions of dollars training Chinese prostitutes to drink more responsibly on the job and wasted $100MM on unused flight tickets by not requesting refunds when available. There’s room to cut government spending if there’s a will to do so.
I respect Elon Musk and think he’d be great at the job. Even Ron Paul, one of the few former DC politicians who advocated for smaller government, is talking about getting involved. Unfortunately, I remember that President Reagan, who had a deep suspicion regarding government power, increased spending. Vice President, Al Gore, was going to reinvent government and reduce waste, but I can’t recall a single meaningful reform. The Biden years have made it clear that in the absence of a functional President, the unelected bureaucracy really runs the country. The Trump presidency made it clear that the unelected bureaucracy will resist and sabotage anyone who tries to challenge them. I’ve seen no evidence that anyone or anything is capable of bringing our bloated government bureaucracy and wasteful spending under control. (I would love nothing more than to see events prove me wrong and, in that event, I will be happy to publicly admit my error.)
When it comes to the economy, I do see two places where Trump policies will be more advantageous than the Harris ones. First, he’s more friendly to lower-cost energy, and high energy costs are a huge economic drag. Second, I think the greatest achievement of Trump’s presidency was his aggressive reduction in the number of economy-slowing regulations. Governmental overreach has made it so that we need to ask permission and to file forms to get anything done.
When President Obama promised us $1 trillion of “shovel-ready projects”, I knew it wasn’t true. I’m not calling Obama a liar. I just know that $1 trillion of infrastructure projects require years of studies, approvals, and red tape. Eight years later, when Donald Trump ran for the Presidency, he promised he’d build roads, bridges, and airports. I knew that wouldn’t happen either. No one can get permitting and environmental studies done for an airport in just four years. Both men had good intentions and good infrastructure ideas, but it’s just difficult to get anything meaningful done anymore. If President Trump wins a second term and takes an axe to another 20,000 or so regulations, that would be a win for all of us.
In the short-term, I see two patterns worth illuminating. One is that on election night in 2016, once it became clear that Donald Trump had won, the futures markets soared and the stock market rose the next day. We tend not to trade one-day trends, but if you do, then that’s your parallel. There also has been a correlation between the election prediction markets and the price of Bitcoin. Trump is much more friendly to Bitcoin than Harris and a Harris win would likely send the dollar price of Bitcoin down. DKI’s thesis on Bitcoin relates to dollar debasement, and we’ve made the case for that in this report. The dollar will lose purchasing power regardless of who wins tomorrow and I have no intention of selling any of my Bitcoin regardless of election results or short-term price movements.
I’m choosing not to address the tariff issue here. It’s a much bigger and more complicated conversation and beyond the scope of this piece.
DKI Takeaway: No one is going to cut spending. Trump is better on some economic issues. You’re probably going to vote based on other issues anyway. Whether you’re team red or team blue, DKI will be here for you on Wednesday focused on how we’re going to make money over the next four years.
The End Game and Event Horizon – Dollar Debasement:
I’ve laid out a pretty bleak picture. Inflation is both higher than people want and higher than reported. The employment situation is stagnant unless you’re looking for a second part-time job. Even the GDP figures are fake. Government spending is accounting for all of the growth and is crowding out the productive private economy. Even worse, the spending is debt-fueled. Our on-balance sheet debt is $36 trillion and is growing around $3 trillion a year. Our off-balance sheet liabilities are another $200 trillion.
Either we default on our debt or keep printing dollars to pay our debts until those dollars are useless. The only other solution is to cut spending and change the social contract on programs like Social Security, Medicare, and pensions. This isn’t politically viable. Some like to say that if we could only get the rich to pay their “fair share”, we could solve these problems. I’m going to avoid a discussion over the moral implications of an ambiguous non-specific term like “fair share” and cut to the practical point that there is no level of taxation or asset confiscation that will produce a quarter of a quadrillion dollars. The rich don’t have enough money to pay our debts. No one does.
Annual interest expense recently crossed $1 trillion and will be at $1.5 trillion by the end of this calendar year. We have so much debt that the US government is printing dollars to pay the interest on dollars we printed last year. If that sounds like a Ponzi scheme, that’s because that’s exactly what it is. Evey fiat currency in history has gone to zero and Congress and the Treasury and going to ensure the dollar heads that direction as well.
Not sustainable. Congress is pretending this bill will never come due. It’s gone parabolic.
The term “event horizon” comes from @peruvian_bull on Twitter/X. I respect his work and recommend following him. The event horizon is the point near a black hole where nothing can overcome gravity. Once you cross this point, there is no return. Both of us believe the dollar has reached that point. As interest expense heads towards a level where it will consume the full amount of taxes collected (which I refuse to refer to as “revenue”), our only option will be to create more dollars to pay that interest. More dollar creation without more productivity just leads to more inflation. I frequently say you can’t save in dollars because the purchasing power of your money will decline each year.
This was done intentionally. You cannot save in dollars.
Again, this doesn’t prove that I’m right, but gold and Bitcoin agree with me. These two forms of zero-yield wealth storage are some of the best performing assets in recent years. That trend should accelerate as the spending power of the dollar declines and as the BRICS countries, which have more than half the world’s population, buy gold and attempt to reduce their reliance on the dollar.
Most people describe gold and Bitcoin as trading at or near all-time highs. That’s accurate. Another way to think about gold in particular is that it’s holding its purchasing power while that of the dollar is declining.
What do you think–are gold & Bitcoin rising in value, or is the dollar losing purchasing power?
I will emphasize that DKI is never a black pill operation. Even when things are bad, it’s our job to find ways to help our subscribers make money, and we’ve positioned the portfolio to do just that. There are high-quality companies with growth rates well above the inflation rate. We have made huge profits on gold and Bitcoin and continue to hold. We’ve made money in silver. Energy positions benefit from both the worldwide demand for a higher material quality of life and a declining dollar. The dollar may have hit the event horizon, but we can still position ourselves to make money from unappealing policy.
DKI Takeaway: The government is going to ride the dollar down to zero. We can’t stop that. What we can do is own a portfolio that benefits from a bad situation.
Conclusions:
- The Fed can’t get inflation under control.
- Congress could get inflation under control, but won’t.
- Taxing the rich more is politically popular, but economically ineffective. All tax increases are going to fall largely on the middle class regardless of how they’re marketed in the press.
- Debt and interest are piling up at increasing and unsustainable rates. This won’t ever be fixed. Interest expense has gone parabolic.
- The government is providing inaccurate or misleading “data” to convince us things are fine. None of this is fine, and the data loses credibility every month.
- The Fed cut too early and will cut again.
- The people who claim I’m wrong because we’re already in a recession make excellent points. DKI reads the other side of the argument and I respect that point of view.
- More inflation is on the way. We’ll see higher inflation rates in the next few years due to additional debt and money printing. Soon, all tax collections will be used to pay just the interest on the debt.
- A bad economy, bad data, and a weakening dollar doesn’t mean we can’t have a “good” and profitable portfolio. DKI exists to help you get better returns regardless of conditions.
IR@DeepKnowledgeInvesting.com if you have any questions.
Acknowledgements:
Intern, Andrew Brown, from the University of Tennessee worked with me to prepare this report. Even before reading it, he understood what I wanted to convey and began suggesting exhibits that would assist you in understanding the economic backdrop. His command of the material is outstanding and his contribution is material.
Howard Freedland is a member of the DKI Board of Advisors. He’s also the DKI editor and worked with me to get this piece ready on short notice. Howard has tempered my tendency to produce 87-word sentences with 7 different clauses. If you found this report easy to read, that’s because of his contribution.
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