Stagflation Is Here

Stagflation Is Here
People visit one of Stockholm, Sweden's busiest shopping streets during the ongoing COVID-19 pandemic, on Feb. 4, 2022. (Jonathan Nackstrand/AFP via Getty Images)
Gary Brode
In February, we started writing and talking about stagflation.
Stagflation is the rare combination of high inflation and negative economic growth. We’ve previously expressed the point of view that inflation was understated by approximately 100 percent and that it was actually in the mid-teens. Further, we noted that once you adjusted fourth-quarter gross domestic product (GDP) for inventory restocking and the amount that inflation was understated, actual GDP growth was negative. We concluded that instead of stagflation being a future downside possibility, it was something that the United States was actually experiencing and that the truth was being hidden by dishonest or misleading government statistics.
Last week, the first-quarter GDP estimate came out at negative 1.4 percent. We believe that estimate was reduced by about 0.8 percent inventory destocking (fewer goods on store shelves). Because adding or subtracting the change in private inventory stock nets to zero over time, we like to adjust GDP for that. Just as we didn’t think that a nearly 5 percent increase in post-holiday restocking was a real addition to economic growth, we don’t want to penalize first-quarter results because merchants sold more than they bought in the quarter. Adjusting for private inventories takes our adjusted GDP number to negative 0.6 percent. Still not great, but not a disaster.
The real issue comes when we look at the inflation adjustment in the GDP numbers. That category, called Gross Domestic Purchases, was up by 7.8 percent. We’ve pointed out multiple times in this newspaper that the official inflation numbers are understated by at least 8 percent because of an undercounting of the increase in the cost of food and housing. Another opinion on this comes from a blockchain-based pricing tracker called Truflation. This index shows a current inflation rate of 12 percent. From that we can conclude that the inflation adjustment for first-quarter GDP was understated by somewhere between 4 percent (the Truflation index) and 8 percent (the Deep Knowledge Investing estimate).

Based on the above, our estimate of actual first-quarter GDP was somewhere between negative 4.6 percent and negative 8.6 percent. That would be the second quarter in a row of negative economic growth, which is the official definition of a recession. Combine that with a consumer price index (CPI) that’s officially 8.5 percent and unofficially well into the double-digit range, and we have the second straight quarter of stagflation.

People who are more positive on the released statistics are pointing to increases in consumer spending and a robust job market. While this is technically correct, we have a differing interpretation. Much of the increase in consumer spending is coming as a result of higher prices. Spending more to receive less isn’t an indication of a strong economy, even if it means consumer spending rises. Anyone who has been in a supermarket in the past year understands this point viscerally. We’ve advised readers to stock up on food, and also warned about future food price increases as a consequence of both the war in Ukraine and U.S. sanctions on Russia.

The employment situation is also complicated. It’s true that unemployment is low right now and that many U.S. companies are trying to hire qualified people. Job openings have been exceeding the number of unemployed people, and these additional options are giving job seekers pricing power. Lower unemployment and higher wages all sound pretty good from the point of view of evaluating the economy. Again, while we would concede this as an excellent point to those who think the United States has a healthy economic situation right now, we would also counter that, in general, wage growth has been below inflation. Simply stated, even with higher wages, the average U.S. family is able to buy less and has a declining quality of life as measured by material goods.

The above situation is also unevenly distributed. For example, for people who own their homes and have refinanced at favorable interest rates during the past few years, the huge increase in housing prices doesn’t affect their household budget. For anyone who rents or who needs to buy a home now and is facing both high housing prices and increasing mortgage rates, they’re facing huge cost increases in the largest category of a typical household’s expenses. For Americans who have needed to buy a new or used car recently, they’re seeing huge price increases and a lack of choice for a large expense. Finally, for lower-income families, food makes up a larger portion of the household budget, and we’ve previously expressed our doubt regarding the official statistics showing food inflation in the high single digits. For most people, it’s much higher.

Our point is that people spending more while they lose purchasing power isn’t a sign of economic health, even though it appears to increase headline GDP numbers. In the end, we have huge inflation numbers that we believe are understated. We’ve had one quarter of official negative economic growth and two quarters of negative growth if you adjust for inventory stocking and inflation. The stagflation that we said was present back in February should now be apparent to everyone.

Gary Brode has spent three decades in the hedge fund business. Most recently, he was Managing Partner and Senior Portfolio manager for Silver Arrow Investment Management, a concentrated long-only hedge fund with options-based hedging. In 2020, he launched Deep Knowledge Investing, a research firm that works with portfolio managers, RIAs, family offices, and individuals to help them earn higher returns in the equity portion of their portfolios. Mr. Brode’s work has been featured in the Wall Street Journal and Barron’s, and in appearances on CNBC, Bloomberg West, and RealVision.
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