The Mystery of Low Inflation: Blame Investors
Over the past seven years, the Federal Reserve has used everything in its arsenal to get consumer spending moving, pumping $4 trillion into the US economy and initiating three rounds of quantitative easing. Yet, inflation stubbornly hovers around 1.7%, well below the Fed’s target rate of 2%.
This lack of upward price pressure has perplexed the Board of Governors and the FOMC. Economic indicators across the board imply that consumers should be driving up the price of goods. Unemployment is below pre-crisis 2007 levels, borrowing money has never been easier or cheaper, and we just witnessed record holiday spending. But inflation remains low. Janet Yellen recently remarked on this confusing disconnect, “My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation.”
Yet, perhaps the answer to why this low level of inflation has persisted since the crisis lies somewhere else entirely, and not with consumer demand, disposable income, or the expanded monetary base. Instead, the answer may be hiding in the changing preferences of investors toward disruptive technologies, which has allowed certain firms to keep their prices artificially low, thus suppressing inflation below its desired 2% level.
Take the darlings of the US stock market over the past three years: the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google). Investors have been scrambling to own any piece of these five companies, driving the average price up 50% this year alone. This demand on the part of investors seems to show little concern for underlying net income of the firms. Amazon is widely predicted to be the first trillion-dollar company, yet it only has $2.3 billion in net income per year. This yields a staggering price-over-earnings ratio of 300, which is ten times the rest of the market. Similarly, Netflix only has net income of $187M per annum, yet is valued with a 200 price-over-earnings multiple.
This increased investor appetite for “disruptive” companies effectively subsidizes firms’ front-end prices (e.g. the price of goods on Amazon, rentals on Netflix, or the price of Lyft/Uber rides). The price subsidies help companies widely attract consumers onto their platforms and begin gathering information on their behavior. In other words, investor demand, in the form of inflows into these companies’ equity (reducing their cost of capital), feeds directly into the business model of many of these companies: build up the value of an asset (usually customer information) that can be sold or used years down the line by subsidizing prices in the near term.
This investor-subsidized pricing is reflected directly in cost of various goods over the past seven years. Since 2011, the CPI has gone up 12% overall (non-seasonal adjustment), while the cost of computers, software, and wireless communication have all dropped an average of 27%. Digging further into the data shows that consumer durables and non-durable items (think anything that is sold on Amazon or sites such as Houzz) are also bucking the upward trend, remaining essentially flat (up only 1%) over the 7-year period, and spending on motor vehicles, also remaining completely stagnant.
These flat prices are a testament to the spillover effects that disruptive technologies are having on the economy. Even though many of these companies aren’t directly automobile or retail related, their operations affect the prices in these arenas. For instance, because Uber and Lyft now offer cheap transportation, many in urban areas have little incentive to purchase new cars or even own a car at all. This has forced down prices and expenditures on cars. Or consider the drastic shift in how we purchase standard household goods. The online presence of companies like Amazon, Wayfair, or even Walmart has forced all other traditional consumer durable and non-durable operators to compete and drop their prices as well.
The overall price growth has mainly been driven by industries that have seen the least amount of disruption — and the least amount of investor attention — over the past seven years, namely health care, education, textbooks, and housing (to highlight a few). Without new entrants disrupting the status quo and forcing prices down (with the help of investor capital), these industries have maintained price growth well above the average level of inflation.
Broad Evidence for Investor Demand for Disruption
Investors’ desire for growth and disruption “at any expense” shows up not just in demand for the FAANG stocks but more broadly across the market, which can be seen by following the movement of capital in mutual funds and ETFs. While S&P 500 index mutual funds have seen inflows of $58B over the past 7 years, $110B has flowed out of Value mutual funds (15% down from 2011 AUM). More drastically, $32B has flowed out of Dividend mutual funds (-39% of its AUM at the start of 2011). The vast majority of these mutual fund outflows have actually been from Dividend funds that concentrate in growth stocks, which have diminished by $25 billion between 2011 and Q3 2017. Basically, investors are saying loud and clear: “We don’t want value companies, we don’t care about dividends, and if you are a growth company you better be investing every single dollar of earnings back into expanding your company’s line of business, or subsidizing your prices”.
The story is the same in ETFs. Between 2011 and Q3 2017, investors poured 40% more into Information Tech and Internet ETFs as compared to S&P500 ETFs.[1] Technology was the single industry that saw inflows on a percentage basis (% of ETF assets in 2011) that exceeded inflows into S&P 500 index ETFs over this time period. Counter to this, housing and homebuilders saw the greatest outflows, topping 100% of ETF 2011 AUM as compared to S&P 500 ETF inflows.
Investors have spoken resoundingly over the past 7 years: They are willing to sacrifice near-term profitability and dividends as long as companies deliver disruptive technologies that will (hopefully) pay out long into the future. And companies have responded in kind to satisfy investor demand, dropping prices across the board for consumer durables/non-durables, software, and even automobiles, in the hopes of delivering valuable assets (sometimes ambiguously defined) years down the line.
With the Fed meeting again in one month to consider a rate hike, the question of when we will see inflation pick back up to a 2% level still remains. The answer may be not until investors shift back to seeking dividends and value firms, and stop subsidizing the discounted prices that disruptive companies are offering.
[1] Between 2011 and 2017, investors poured over 200B into S&P 500 Index ETFs (over 100% of the total AUM in these funds in 2011). The above graph adjusts for this by subtracting the percentage change in inflows into the S&P500 ETF on a yearly basis — this gives us an abnormal measure of flows.
