Inflation Head Fake?
Investors’ sentiment today is even more negative than during COVID.* The fear is that Fed Chairman Powell will transform into Paul Volcker and raise interest rates dramatically to crush inflation. No wonder stock markets are down significantly (the NASDAQ is down over 30% from its highs). In the following video, we share our variant thinking on how investors might be mistakenly interpreting the inflation threat.
A Differentiated View
This is not That 70’s Show. Investors are mistaken in using the playbook of that period to solve today’s challenges. The 2022 mess is very different from the 1970s mess. We observe indications that inflation is in the process of rolling over, which should give the Fed cover to resume its easy-money policy later this year. Just in time for elections.
Washington is aggressively trying to slow the economy. It is working. There are now multiple observations that the economy is slowing.** The money supply (M2) is even shrinking. If the money supply and consumer spending shrink relative to output, that implies disinflation, if not deflation.***
If by the late summer or early fall, we begin to see price inflation slow, we believe the Fed will signal a return to its earlier easy-money policies. At the first whiff of that, market prices would likely rise quickly. This would position Biden to declare victory over “Putin’s inflation”, just in time for the November elections.
Illusion of a Fix
The scenario above would create the illusion that the problem is fixed. Near term, that may appear the case. But it won’t be. Washington’s dirty secret is that it wants – and needs – inflation. The reason is that it’s in a debt trap. That means it cannot allow interest rates to go much higher. That would raise the interest cost of servicing the government’s growing debt. That would crowd out spending on critical things in the federal budget.
Ultimately this would return Washington to its earlier policy playbook:
1) Monetizing its debt (the Fed buying US government bonds to fund our deficit)
2) Keeping nominal interest rates low (so Washington can keep its interest payments at a manageable percent of its budget)
3) Tacitly allow higher inflation target (high single digits, perhaps higher?)
Is This sustainable?
Of course not, at least not over the very long term. Ultimately, years into the future, there must be a reset. That’s a big topic for another day, but for now, suffice to say that we want to own assets going into a reset. That gives far better odds of preserving our real wealth than holding I.O.U.’s (cash and bonds) denominated in the currency of a failed government.
Of course, everything above could ultimately prove incorrect. There are wild cards such as Ukraine's impact on energy prices. We should not try to predict the future. We should instead observe, and based on what we see, position in way that we believe stacks the odds in our favor. Today we observe Washington actively crushing consumer demand and shrinking the money supply. Its playbook is to crush inflation before the fall elections. So far it appears to be working.
Our earlier advice thus remains: own a diversified mix of quality assets, and hold on. The ride will be bumpy. Ultimately, we believe this gives us the highest odds of preserving our wealth through the coming inflation.
For more color, be sure to watch/listen to our discussion HERE.
Yours in the Field,
Frank Byrd, CFA Steve Korn, CFA
*AAII Sentiment Survey, Bull-Bear Market Spread. June 17, 2022 (Factset)
**For a good summary, see Multiple Indicators Signal Slowing Economy” ,Josh Mitchell and Bryan Mena, Wall Street Journal, 6/17/22.
*** In other words, if money supply (M) and velocity (V) fall relative to output (Y), this implies lower price inflation (P).
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