A brighter market horizon, with one economic cloud?

Looking into the data surrounding COVID-19 and its market volatility effects, I believe the numbers are beginning to tell an important story. It involves three main points:

1. The growth rate of global cases of COVID-19 continues to slow to levels not seen since the crisis began, and the U.S. rate is similar (although a bit less slowly).
2. The U.S. consumer is on a buying spree and, perhaps surprisingly, is back near the level of consumption seen prior to the pandemic.
3. Inflation (that amorphous sleeping giant) perhaps has turned over in his bed and is, at a minimum, something to keep an eye on.

With that, let us explore each of these further.

Section 1: COVID-19

Charts 1 and 2 are my favorite representations of what is happening in the world with respect to COVID-19 because they:

• Ignore the headlines.
• Zoom out far enough to discern the relevant trends.
• Show both the levels and the growth rates (as discussed last week, the markets are mostly focused on growth rates).

To orient, the blue lines demonstrate the total number of cases around the world and correspond with the left axis. The grey line demonstrates how the number of cases is growing and corresponds with the right axis.

This is incredibly important and not currently recognized. On March 22, growth rates were roughly 20 percent per day.⁸ Start with 1,000 cases, and tomorrow we have 1,200. Over the past two weeks, the global growth rate has stayed less than 1 percent, and is averaging less than one-half of 1 percent over the past five days.² Using the same example, if I start with 1,000 cases today, then tomorrow we would have 1,005. That is a remarkable difference and helps explain why U.S. equity markets are now up for the year.

Perhaps more intuitively, we can use those growth rates to calculate how long it takes for global case numbers to double. In the middle of March, for example, global cases were doubling every four days. At that growth rate, if you start with 100,000 cases today, in four days, we would have 200,000 cases. Today, given the low growth rate, we are now doubling the global number of cases every 144 days!

Within the United States, the picture continues to show improvement and a similar pattern.

Chart 2 demonstrates this further by zooming in on the growth rate since the beginning of April.

The blue line (U.S. only) in this chart corresponds with the grey line (global) in Chart 1. The growth rate was very high in early April, then fell very quickly, then rebounded a bit toward the beginning of July (as growth in the South exploded) and is now at all-time lows (roughly 0.89 percent on a five-day smoothed basis). To be clear, this is higher than the global growth rate, but improvement nonetheless.

Chart 3 takes the very same data and converts it to the number of days to double the cases in the United States. This is often a more intuitive and relatable way to understand how growth rates are changing.

The chart largely follows the story of the United States. In late March, the U.S. was in complete lockdown as case growth was largely out of control. At that point, the U.S. was doubling cases every three to five days. We learned, we evolved (and no, not quickly enough), but we nonetheless improved to late May and early June where we were now doubling cases every 64 days.

The South then began to re-open, and many states pushed back entirely on some of the government guidelines. Growth rates increased again, and the days to double fell to 37 days on July 13.

Fortunately, that has now reversed.

The U.S. is now doubling cases every 80 days, which is an all-time high (meaning growth is at an all-time low) since the beginning of this pandemic in March. This is tremendous news. This then brings us to my second point, where we explore how spending habits have changed.

Section 2: Consumer spending

As growth rates have slowed, the consumer has shopped. Several months ago, we discussed how quickly the U.S. consumer had stopped spending. The speed of the contraction was unprecedented and was largely a reflection of:

• How many consumers had lost their jobs.
• More broadly, how fearful the U.S. populace was at the time.

That has now reversed itself in a similarly unprecedented fashion.

As a reminder, the U.S. consumer accounts for roughly 70 percent of the U.S. economy.⁵ As the consumer goes, so does the economy…so from an economic perspective, this clearly matters. Chart 4 demonstrates what has occurred by showing the total dollars spent on retail and food service (a good proxy for U.S. consumer spending).

What is remarkable to me about this contraction is:

• Its large size, compared to the Global Financial Crisis of 2007/2008.
• It has nearly recovered.

Like the slowing of global COVID-19 case growth rates, this is a great turn of events. Having said that, as any good two-handed economist knows, there are always other items to consider. This now brings us to the risk of inflation.

Section 3: Inflation

First, let’s be clear on what inflation is. Aside from a term we self-aggrandizing finance types throw around freely, inflation matters to us as consumers because it quite literally damages our ability to buy.

Consider an example:

Assume you have $10 and you want to buy a loaf of bread. You walk into the store, and the loaf of bread is $5. Ignoring sales tax, you can buy two loaves of bread. Now assume a year goes by, and you have another $10. You walk into the same store and the loaf of bread is now $7.50. You can buy only one loaf. This is inflation.

Inflation is how prices change in aggregate. Yes, there are different measures and different definitions, and all sorts of precision and complication but, at its core, it is a very simple concept: How much purchasing power does a dollar have?

For years now, inflation hasn’t mattered. It has bounced around immaterially for years and hasn’t been enough for most consumers to notice. Yes, the loaf of bread is a bit more expensive than it was a year or two ago, but the difference was trivial and largely offset by falling prices elsewhere.

Interestingly, however, inflation has jumped the last two months. Chart 5 demonstrates one version of a measure of inflation; the Consumer Price Index (CPI).

Note the 2020 data only reflects July and August CPI measurements, all other data points are 12 months.

Let me explain. The blue bars are the average inflation (annualized) for each year since 2001 in the United States. As mentioned, inflation has been very low for the last several years, and a bit higher before the 2008 crisis. The orange bar, however, measures inflation for June-July this year and shows it on a similar scale (annualized).

Clearly if this were to continue for the rest of the year, this would be massive change in inflation. Now before we think about implications, I want to be clear that:

• The data is incredibly noisy.
• This is very possibly just a reversion from prior declines.
• These two months are, by definition, hand selected because I am surprised by their enormity. Therefore, I am not forming any conclusions, but I am cautious about what I am seeing.

Why do we care, one might ask?

Well, there are a number of insidious elements of inflation. Here are a few examples:

1. Spending — Quite simply, if our wages are the same, but the cost of goods is higher, we have to spend more to get the same. We therefore have less purchasing power.
2. Lending — Our central bank, the Federal Reserve, has a dual mandate to control prices (e.g. temper inflation) and maximize sustainable employment. As such, if inflation rises, the Federal Reserve uses various tools to slow inflation. This generally means the cost of borrowing goes up, and the amount of lending goes down.
3. Bonds — Right now, if an investor purchases a 10-year Treasury bond (a very common fixed income instrument in many portfolios) and holds that bond for 10 years, based on current rates, that investor will receive a yield of around 0.6 percent per year. If I tell you that, for example, inflation will be 5 percent over the next 10 years, that essentially means the investor is agreeing to lose money over the next 10 years (if I earn less than 1 percent per year, but the goods I buy are increasing by 5 percent per year, I am essentially losing 4 percent per year). That transaction doesn’t make sense, so investors would generally sell their bonds or, at a minimum, demand a higher yield on their bonds to compensate for the increased inflation. This means the price of bonds will go down, and those that hold bonds will incur losses on those bonds.

With all of that said, let’s be realistic. Two months of higher inflation measurements do not necessarily mean this will continue, as again, the data is inherently noisy and we have just experienced an unprecedented pandemic that has created many different dislocations.

It is simply to say, I believe this is a risk on the horizon and may be worth paying attention to.

Conclusion

Let me leave you with the idea that economies are incredibly complex and yet simultaneously incredibly simple. Consumers and businesses make decisions based on incentives and constraints, and those decisions have consequences (both intended and unintended). Our job is therefore to understand the large drivers (e.g., capitalism, philosophy, incentives, macroeconomics, and the like) while using recent lessons and observations to expand our fundamental knowledge and, therefore, make better decisions.

In aggregate, the world looks much better than it did just a short period ago. Global case growth is falling, consumers are spending, banks are lending, and markets are stable. Are there risks? Absolutely…but I would contend there has never been a time in human history when there haven’t been risks. Therein lies the proposition for investing: markets have historically been wonderful generators of returns in the long term, and yet are wildly confusing, risky, and volatile in the short term.

In closing, focus on controlling those things that can be controlled, mitigate risk that can be mitigated, save as much as possible, and try not to focus on short-term gyrations and volatility.

Stay safe, stay calm, and please turn off the financial news channels.

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