Markets are a data driven industry and with data whizzing around the world at light speed, it gets also gets incorporated into securities prices almost at that same speed. Speed however, does not account for quality. What if they quality of the data we are looking at to price stocks, bonds, options, swaps and any other securities are just plain wrong? How would that affect prices we assume reflect the best and most accurate information?
Funny enough, bad data is what many of us are consuming and basing decisions on right now. The mainstream financial press and securities markets seem to be ignoring the growing voices from many economists that the data we are looking at is much more low quality and inaccurate compared to what we looked at before. The figures are being reported as if they are just as accurate as in years or even months before the pandemic and this logic is faulty.
Unemployment
Take unemployment for example. On a very high level, the unemployment data between much of Europe, the U.K. and the US is just not comparable. The US is letting furloughed workers claim unemployment while many European countries have used government intervention to keep workers officially “employed” but in reality they are sitting home collecting government backed checks the same as many in the US are. Even the attempts by some organizations such as the OECD to “harmonize” unemployment figures still looks dubious.
Source: OECD and the UN
Italy and France suffered severe lockdowns which were as strict or more strict than those in even New York City, which was the initial epicenter for the US and they would like us to believe that Italian unemployment actually went down at this time while US unemployment increased dramatically by 11%? This just doesn’t make intuitive sense, especially considering the fact that the US depends a bit more on the tech and finance, both which are heavily working from home now and hence staying employed, compared to Italy.
Add to the fact that the US and Canada calculate much of their national unemployment rates in the same way and it seems that the above chart is not comparing apples to apples even after attempts to “scrub” the data and trying to make it comparable.
GDP
GDP is another example of where figures are not following the old paradigm and may not reflect reality. A few days ago, the media picked up on the official release of quarterly GDP of the UK from the Office of National Statistics. GDP was reported to have fallen by 20.4% in the quarter, a massive drop reflecting the loss in output due to lockdowns. Headlines blared about the largest quarterly GDP drop ever recorded for Britain. A week earlier, France also saw one of its biggest ever drops in quarterly GDP at 13.8% in data released by its own national statistics office but as one UBS Economist points out, the calculations for GDP in each country are unique and tabulated in different ways.
The reality is that there were actually more people employed in Britain than France in Q2 of this year. France and Britain have similar sized economies at around $2.7 trillion and $2.8 trillion respectively with populations at around 66 and 64 million respectively. Yet, to take one example of how the national figures are calculated, in France educational GDP is measured by teachers wages and British educational GDP is measured by number of pupils. If everyone is on lockdown and there is no school, but teachers are still being paid due to government programs, then the British figure will show a massive drop while the French one would likely stay buoyant. This could be just one example of how despite the similarities in size and taking lockdown measures, the U.K. saw a GDP drop that was 6.6% greater than France.
As statisticians adjust to the new reality in the coming months and years, these figures will likely be revised. In the example above we may likely see the French GDP drop revised down further while the U.K. GDP drop may prove to be better than initially reported.
CPI
So what? You may say, this doesn’t have much to do with markets. They have decoupled. Stonks always go up. Just get a Robinhood account and blow your stimulus check on Hertz and Kodak stock.
Markets do seem to have given the GDP and unemployment information short shrift, but those are also lagging indicators. What markets and economists are looking for are trends that point to the future. The market already wrote off Q2 GDP and unemployment so almost any number could have popped up and the market would have shrugged. The real elephant in the room though, may be the Consumer Price Index or CPI, which could have a big effect on bond pricing and inflation expectations. These expectations filter through to all securities.
A recent paper by a Harvard economist, the author, Alberto Cavallo, makes an attempt to revise the official CPI figures for the US as well as other countries to show that actual inflation has been significantly higher than what has been reported. It takes an understanding of how CPI is calculated to see why it needs to be adjusted for COVID.
The CPI monitors prices of a basket of goods and services to calculate the official inflation rate. It also weights the impact of price raises based on an assumed percentage of how they make up a typical consumers consumption. This means that housing takes up a big part of the inflation calculation while food and transportation, make up lesser but also significant parts.
The argument for adjusting the CPI in recent months and from the author of the study is that lockdowns and the impact of COVID has changed consumption habits. He notes that the latest consumption weights are based on 2017-2018 data which doesn’t reflect the current situation. In order to account for this, Cavallo adjusted the consumption weights to arrive at a COVID adjusted CPI, the output of which can be seen below.
Housing and food at home make up more significant portions of consumption and hence inflation while transportation has dropped in importance as more people stay at home and avoid driving and public transport. Education and communication also grows in importance as those of us working as well as going to school rely more on the internet for our daily lives.
Cavallo shows that even core inflation, which excludes food and energy, also has changed significantly. Core CPI is used by many economists to cancel the “noise” of volatile food and energy prices.
The results of the all items CPI by month shows that the COVID adjusted CPI tracked the standard CPI in the first few months of the year but the figures decoupled as the lockdowns and pandemic hit. The latest monthly data as of May shows a significant difference of 0.95% inflation annualized versus the official figure of 0.13%.
So again, why does this matter? Well rates have dropped significantly since the start of the pandemic, investors have become accustomed to low inflation and low inflation expectations. So much so that they have brought real treasury rates down to negative real levels. The current 10 year treasury note yields 0.713%, this denotes a real yield of .513% if May CPI were to hold for the year. But if inflation is 0.95% then real yield is -0.237%.
With literally trillions of dollars sitting in treasuries, not to mention benefits in the US calculated off of CPI, this makes a difference. If real inflation is actually higher than reported, then it means that social security purchasing power is being eroded and liquid retirement savings are at risk and pricing may need to adjust to reality. This would essentially raise rates if yields jump due to this information at a time when we don’t need it. It would also put government stimulus and spending plans at risk if the cost to service the national debt suddenly became much more expensive.
The equity premium would also need to adjust to reflect this new reality, meaning that not just bond prices could be affected if the COVID adjusted inflation is to be believed. Equity prices would be discounted by a higher rate meaning they would have to fall to adjust, all other things equal.
So getting the inflation figures right is a big deal that filters through to all asset prices in the economy. The question is, will the pandemic permanently shift consumption habits or is this a short lived inflationary phenomenon?
As stated in my last post, I personally believe inflation will stay low in the medium term as long as people don’t change their inflation expectations. If this difference in rates is further studied, gains more attention and starts to affect the inflation expectations of investors and the general public then all bets are off. This is why the continued adjustments to inflation deserve a close look in the coming months. What officials in the government do and how they plan to take this into account will matter a great deal since, as I mentioned so many official figures and benefits are based off of the CPI.
As a side note, Cavallo also found that different income levels also saw different inflation rates. This is a known phenomenon. The poor are actually seeing higher inflation than the rich, which in essence fuels inequality even further. This gives more fuel to an argument for any incoming Democratic government to raise taxes on the wealthy as well as raise taxes on capital gains for the rich.
If you are willing to bet that inflation figures are wrong and inflation is much higher than officially recorded, and you think there has been a permanent shift in consumption habits then it would behoove you to move out of bonds in the near term and towards hard commodities as a hedge towards higher inflation. Extrapolate from that investing in equities of commodity producers, which have been hammered in the past 10 years, and we could well be on our way towards that renewed rally in cyclical and emerging market stocks that I have been anticipating for so long. Keep an eye on inflation going forward and be skeptical of the figures the mainstream financial press is feeding you.
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