The covid-19 crisis hit the United States very hard, with over 30 million people being infected and half a million that have tragically passed away, and while the human cost has been the most devastating, the pandemic has also had an obvious impact on the economy. The nation is still 8.4 million jobs away from pre-pandemic levels and many small, medium, or even large corporations went bankrupt or are still far from recovering, especially in industries like tourism, hospitality, energy, and entertainment. In an attempt to fight the devastating consequences of unemployment and a massive drop in both industrial output and consumption in the country, the Federal Reserve has printed approximately 40% of the active money in circulation today, within the last 12 months. Money printing, combined with an increase in private sector borrowing and a drop in productive capacity are generally circumstances that lead countries to high levels of inflation or even hyperinflation. In a recent article, published on March 22 “Behind the bubble: why we haven’t seen hyperinflation (2/2)” we talked about how the record-high amounts of liquidity injected into the system led to a hyper-inflated stock market, and while we believe that is certainly true, it probably isn’t the only consequence of recent monetary policies.
Worrying signals
According to recent data from the Philadelphia branch of the US Federal Reserve, prices paid by manufacturers have risen to the highest level since March 1980, when inflation went out of control and the Federal Reserve rose interest rates to 15-20%. Also, according to Reuters, goods prices soared 1.7%, accounting for almost 60% of the increase in the PPI (Producer Price Index) last month, which represents the biggest increase since December 2009 and followed a 1.4% increase in February. The PPI for final demand jumped 1% last month (that’s 12% on annual basis), while the CPI (Consumer Price Index) likely rose 0.5%, which is 6% annualized, three times the usual 2% inflation target for Central Banks. Basic materials, essential for most products, have skyrocketed in the last 12 months: Iron Ore’s price has increased 112%, Lumber +256%, Corn +91%, soybeans +74%. The only reason why these price increases aren’t fully reflected in the CPI is probably because of timing since most economies are still partially locked down and people haven’t got back to fully spending their income. M1 money supply, which is basically the amount of cash and cash equivalents actively circulating in the economy, has been increased by 500% in a few months. Meanwhile, M2 money supply (which includes M1 plus savings deposits, money market securities, mutual funds, and other time deposits) has grown approximately 290% since January 2020, while being by its very definition “closely watched as an indicator of money supply and future inflation, and as a target of central bank monetary policy”. In addition to these numbers, there is going to be another US$ 2 trillion infrastructure plan coming from the Biden administration, which will cause more spending, thus fueling inflationary pressures. In a recent interview at CNBC, Jerome Powell, chair of the Federal Reserve, stated that a rise in interest rates would be the only instrument the Central bank has to fight high levels of inflation, which seems already a change of register compared to the statements of the last months, also considering that less cautious words could cause an immediate stock market crash. However, how much would interest rates need to go up to cause a housing and stock market crash?
M1 Money Supply USA (1980-2021)
M2 Money Supply Growth vs Inflation USA (1945-2021)
When it comes to bubble scenarios, all alarm bells are ringing right now: The S&P 500 P/E ratio is at 40x and it hasn’t been so high since 2002 and 2007, while both the housing and the stock market are extremely overleveraged due to low-interest rates and a general sentiment that easy access to credit and cheap money will stay that way indefinitely. But let’s give a practical example of the magnitude of the problem in the housing market right now: For the average person a US$ 500 000 mortgage with a 3% interest rate would be 2108$ per month for 30 years; however, if the Fed raises interest rates by just 2%, it could lead banks to raise their mortgage rates to at least 6%, which represents an increase of almost 50% in monthly payments for the average person, going from 2108$ per month to 3008$. How many middle-class Americans have an additional 1000 dollars in their monthly budget to cover this rise in interest rates? Probably not many, and we are assuming a rise in interest rates of just 2%. Also, data shows that margin debt is at all-time highs, and every time that it peaked through history, a stock market crash followed, like in 1929, 2000, and 2007. What just happened with Credit Suisse facing a US$ 4.7 billion loss after the speculative hedge fund Archegos defaulted, could be just the tip of the iceberg. The Buffett Indicator is also flashing right now, since for a market cap to be significantly overvalued, it should be equal to or above 137% of the nation’s GDP, and currently, the S&P 500 is at 201.4%.
Margin debt in the USA and the S&P 500 (1997-2021)
Our conclusion
Governments around the world probably overreacted to the recession, central banks simply printed too much money, giving too much stimulus to the economy, and we are just starting to see the consequences of inflation in current data. At this point, we can say with almost certainty that the Fed has two choices: Letting inflation run and potentially see hyperinflation or starting to lift interest rates to get inflation under control, causing the housing and stock market to crash and to potentially lose 30/40% of its value. Meanwhile, China has started to pull the alarm of high inflation concerning raw materials, and things might get worse once economies completely reopen. Stay tuned and SUBSCRIBE to become a MarketsTalk member and get free access to discussions!