The questions that are currently dominating the conversation in the financial markets are “Inflation: Has it finally arrived? Will it stay long? What is the cause of it this time? How will the Federal Reserve (Fed) respond? Will they taper or not? Will interest rates rise?” And, then – most importantly – what does one do about portfolios in an era of inflation? The latter is an issue with which almost everyone that entered the financial markets after 1980 has never had to contend.
The posturing, pronouncements, and pontifications of the economic and strategy communities on this issue resemble a mash-up of Sunday morning news shows meeting all-night sports talk radio. The intensity with which positions are held is great, and now that there is legal online betting, in both instances there is money to be made having the right opinion. We do not profess any greater insight than others, but we have had the professional experience of investing in a world dominated by inflation.
What is the cause of it this time?
The “arrival” of a new bout of inflationary pressure has been a long time coming. It has been routinely forecast by many people since the end of The Great Recession (TGR) of 2008/09. At that time the central banks of the world, to prevent the collapse of the global financial system and with it the global economic system, undertook driving interest rates to zero and going to the point of buying bonds outright. The vast quantities of money created in this effort have not produced a wave of higher prices to the surprise of most economists, whose models uniformly suggest that prices “should” have gone up. Between 2009 and 2021 to date, the average annual rate of increase in the CPI-U index (Consumer Price Index for All Urban Consumers), the most commonly quoted measure of inflation, has increased 1.66% per year. The rate of increase for the PCE Index (Personal Consumption Expenditures), which is the Fed’s “preferred measure” has been 1.48% per year.i
What has the Fed been doing?
Will the impact of a global pandemic change things? Recent economic data suggests a new regime may be taking shape. The rate of change in the CPI-U and PCE Indices for 2021 shows a rapid uptick in prices across a wide array of goods and services. Jumps are being seen in every category of goods as a disrupted supply chain has not been fully restored and higher costs of labor ensue as employers struggle to find workers. Jerome Powell, Chair of the Fed, refers to these increases as transitory. By that, he is suggesting that prices, which fell more dramatically last year when demand fell off the table as the country shut down, are merely rebounding as the economy reopens. After all, changes in demand can occur very abruptly; one day you’re flying to another city, and the following you’re staying home and having your meetings on Zoom. Or you don’t go to a restaurant for an evening, but rather hunker down and watch something on Netflix. And so on.
Supply chains, however, are less nimble. They were built over time on the basis of becoming more streamlined and efficient to meet a presumed unending demand. When demand abruptly stopped, some suppliers cut prices sharply in a futile effort to stay operational until they no longer could. When they finally closed, they laid off employees and stopped ordering for raw materials. When the country reopened in the spring, demand picked up quickly as people wanted to get out and resume “normal” life, but the supply chains to meet the demand take longer to rebuild and reorganize. From computer chips to potato chips, we see more demand than supply available, and prices are doing just what they should be doing: signaling the need for more supply. Companies may respond by trying to automate more, but they almost certainly will pay higher wages for the skilled labor that can operate the machines. Low-skill labor will return once the disincentives to work in the form of massive relief packages run out or it is seen that the benefits do not provide enough now that prices for goods and services are higher. Mr. Powell is suggesting that it may take some time before demand and supply equalize, but when they do, prices will resume a degree of stability more similar to the past.
On the other hand, there are many observers who suggest that once the inflation genie is out of the bottle, it is not easily put back. The virtuous cycle has been broken, and higher wages will allow consumers to pay higher prices, and a new feedback loop, this one vicious rather than virtuous, will lead to more inflation, more wage increases and on and on, all fueled by the vast amount of liquidity that the central banks have (imprudently, in our opinion) issued.
To be sure, this is a simplified summary of the debate, but we would like to offer a few observations based on first-hand experience from the last round of inflation and one view on the longer-term outlook. The Great Inflation that started in the late 1960s and ran until the arrival of Paul Volcker as Fed Chair in 1979 had about 15+ years to get its roots established in the psyche of the American public before it started to grow like a weed. Several key factors contributed. First, America was pursuing a “guns and butter model"ii trying to fight a war and trying to build new social safety nets domestically through the War on Poverty program. Second, the Baby Boomers were coming of age, straining an economy running at full capacity. Third, U.S. businesses did not feel the pressure to compete with foreign producers and were pretty much indifferent to the risk of rising prices. Inflation was just part of the way things were.
What is different today is that inflation is still not part of the given order. Changes finally did occur in the global economy, and technology and globalization have changed the viewpoint of companies such that cutting costs rather than raising prices has been the mantra of management teams for the last 30+ years. This new state of affairs will continue only if something permanent has changed, and it is far too early to know.
What may keep inflation at bay, however, are two factors that don’t get a lot of attention. First, what is the strength of the global economy post-rebound? Population growth (the fertility rate) is declining and shows little signs of changing. Further, the significant technology shift to non-carbon energy may produce growth opportunities but only at the cost of displacing plenty of existing resources, both physical and human. This technological disruption is not going to be the equivalent of the introduction of the car, the electrification of the country, or the development of the microchip in terms of creating a significant number of new jobs.
Second, the wall of debt issued following The Great Recession has not been paid down. We went from one crisis to another, layering in multiples of new debt on top of what was a big burden to begin with. If the global economies are slowing, how is this monstrous debt burden going to be serviced in the future? Debt is thought to be deflationary. It pulls forward tomorrow’s consumption to today, taking a source of demand away from tomorrow. One can kick the can down the road for only so long, particularly, if the borrowing today to be paid back in the future is to pay for today’s consumption rather than paying for a long-lived asset like a school building.
What to do: Keep calm and mind the cash
This leads to the final question of what does one do with an investment portfolio of income-producing assets if inflation turns up when income is already hard to come by? Most people have willingly or unwillingly taken on much more risk to keep up returns. But dialing up risk to achieve a return is not a cause-and-effect phenomenon. One can’t simply say, “If I take more risk, I will earn more return.” If it were the case, the solution would be simple, but in finance, that kind of thinking is known as “the greater fool theory.” The price of a security is by itself the greatest protection against risk that we have. If the price is low enough, the securities of the weakest companies may present an opportunity worth taking. If prices are too high, the securities of the highest quality company may be very risky.
If the notion that inflation is taking hold becomes widely embedded in the economy, interest rates will go higher. To protect against higher interest rates, one might consider reducing duration, which is a technical term describing how sensitive a security is to a change in interest rates. The longer a security has to mature, the higher its duration will be. As rates go up, the longer duration asset will see the price go down further. While the measure is used mostly for fixed income securities, one has to realize that stocks (which, after all, never mature) are long-duration assets and respond accordingly in terms of quality and degree of exposure.
One must understand that we may be entering a period of substandard returns relative to historical experience as valuations are stretched and expensive by any standard except a zero-interest environment. This does not mean “sell everything,” but it does mean that investors may have to be prepared to modify plans. Being forewarned is part of being forearmed.
We see potential regime changes such as this through a “keep calm and mind the cash” lens. What we mean is that for many years, we have held the view that the single most important price in the world was that of the 10-year U.S. Treasury note, the yield of which was the best reference rate for every other financial asset. After so many years of the yield being “administered” by the central banks for policy reasons, it may no longer be useful. Instead, we should “keep calm” (i.e., stick to our discipline) and “mind the cash” by watching the value of the dollar in the foreign exchange markets.iii If the dollar remains strong relative to other currencies in the world, it will be an endorsement of the policies the U.S. government is pursuing. If it starts to fall, it will mean that the rest of the world’s view is that a major policy mistake may be unfolding, and different kinds of portfolio changes could be in order.
i The Consumer Price Index-U (CPI) measures the change in the out-of-pocket expenditures in all urban households, using a fixed basket of goods and services, while the basket the PCE Index uses changes from year to year to reflect what consumers are buying that year, either in response to higher prices or other changes to behavior.
ii This model demonstrates the relationship between a nation's investment in defense and civilian goods.
iii We acknowledge and appreciate the work of Jason Trennert, Chairman, Chief Executive Officer, and Chief Investment Officer of Strategas and its related companies, for laying out this notion recently.