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THE COMBINATION OF INFLATION AND HIGH DEBT LEVELS COULD BE A PROBLEM FOR STOCKS


On July 12, TPA’s World Snapshot report entitled Debt – Its Not A Matter Of If, But When, explained, “So far, these incredible levels of debt have not bothered the stock market at all, but at some point it will.” TPA , pointed out that consumers have returned to building up debt after a hiatus during Covid-19. We showed that the FED’s balance sheet is now at $8.5 trillion, which is up from under $1 trillion before the Financial Crisis. Finally, the U.S. debt is now $28 trillion, which is now much more than the U.S. GDP. This situation is only under control because of the extremely low level of interest rates, which allows the U.S. government to keep its interest payments under control.


If rates were to rise, the cost of servicing this debt would also rise, making it increasingly more difficult to make payments without additional revenue = higher taxes.


Inflation, as measured by CPI, has spiked as Covid restrictions end and stimulus and other economic measures like eviction, foreclosure, and halted school loan payment moratoriums remain. Year over Year CPI’s last reading was 5.4%. The only other time CPI reached this level of 5% or more in the past 30 years was 1990 and 2008 (chart 3). Employment is not great but is bouncing back quickly. (charts 1 and 2 below) Non-farm payroll last month was +850,000. Unemployment is still 5.9%, but that is down quickly from 14.8% in April 2020. (charts 3 and 4).






Interest rates have recently fallen, but Jeffrey Gundlach, who manages Double Line’s $12 billion bonds funds, says that is all due to liquidity (read FED). FED’s mandate is "to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates." Treasury secretary Yellen and FED members have said that recent inflation is temporary, but commodity prices have spiked nationally and globally. Also, although there are still unacceptable levels of unemployment as the economy continues to recover, concurrently, there are anecdotal stories of a widespread shortage of workers and companies raising wages and offering signing bonuses to attract employees.


The preliminary estimate of the index of consumer sentiment released Friday by the University of Michigan came in at 80.8 in July, down from 85.5 in June. The reading missed expectations from economists polled by The Wall Street Journal, who forecast the indicator to increase to 86.3. The reason for less confidence most sited by consumers was inflation. There has been large inflation in every category, but big-ticket items like housing and automobiles loom large for consumers.


TPA sees the underlying reasons for inflation in housing, the largest purchase by most people, as very persistent. TPA has discussed the cause of long-term shortage in housing several times in its World Snapshot reports. It stems in part from large investors and institutional buying in homes from 2010 to 2015, but mostly from the lack of home building following the financial crisis. The table below, from the 4/28/21 World Snapshot, shows the huge deficit in home building from 2007 to 2020. Using the annual housing starts from 2007 to 2020 and the 35-year average, the cumulative deficit was over 7.5 million homes. To compensate for this deficit, housing starts would have to average 3.1 million per year for the next 5 years. The highest annual housing starts, since 1970, was in 1972: 2,357,000. So, the odds of housing starts in any 1 year, let alone 5 years in a row, being over 3 million are very, very low. Using 2.357 million as the annual housing starts going forward, it would take until 2030 or 10 years to erase the deficit.



The housing situation is actually at crisis levels for certain of the population. A study by the National Low Income Housing Coalition https://nlihc.org/sites/default/files/oor/2021/Out-of-Reach_2021.pdf creates a Housing Wage, an estimate of the hourly wage full-time workers must earn to afford a rental home at HUD’s fair market rent without spending more than 30% of their incomes. Fair market rents are estimates of what a person moving today can expect to pay for a modestly priced rental home in a given area. Using that wage, a person would have to make $24.90 an hour to afford a 2-bedroom house or $20.40 to afford a 1-bedroom house or work 97 or 79 hours per week at the current minimum wage to afford housing, respectively.


The map below shows the hourly wage needed to afford two-bedroom housing by state.


Making housing affordable for the large swath of the U.S. population will demand a lot more home building, which will underpin prices for materials and housing for years. In addition, wages will probably have to rise so that workers can pay for housing.


CONCLUSION:

Higher inflation should eventually force the FEDs hand to allow rates to rise. Given the level of debt in the system, the FED knows that rising interest rates will become painfully expensive quickly. They are probably biased toward lower rates (interest costs), but eventually if inflation stays high and employment continues to improve, they will be forced to allow higher rates. Rising rates with high historical stocks valuations could be a huge problem for stock prices.


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