Inflation is Obstacle for Stocks and Bonds!
By Mitchell Anthony
June 15, 2022
Money managers, market strategists, and economists generally agree that financial markets are driven by three things. 1.) Expectations for inflation, 2.) Expectations for central bank policy, and 3.) Expectations for economic growth. And in that order! When all three of these economic criteria are friendly money tends to flow heavily toward risk assets (stocks, real estate, and bonds). When even one of these economic criteria becomes unfriendly, than money flow will change direction and move away from risk assets. The reason why these criteria drive financial assets is that when inflation is very low interest rates are also very low and investors are forced to embrace investment in risk assets by the simple fact that low-risk investments return nothing. Conversely when inflation is high interest rates are also high and investors are more likely to allocate their capital toward fixed income investments or short-term cash instruments with high return and little risk. Interest rates have always risen and fallen with inflationary expectations. Inflation has been down for the count for over 30 years and many of us have forgotten about how this relationship works. All we have known is that inflation has been anchored at 2% and this combined with very slow economic growth, and very accommodative monetary policy, has worked to keep interest rates near zero. This in turn caused financial assets to rise in value dramatically over the last 30 years as investors piled into risk assets.
Inflation is no longer anchored at 2% and is currently running at 6-9% depending upon the gauge. This high inflation has come from the pandemic induced Government stimulus that caused demand to be pulled forward and production of raw materials and durable goods to be reduced. Producers of raw materials and durable goods have taken advantage of the pandemic induced production cutbacks to raise prices considerably and keep them high by continuing to restrict and hold back production. There has been strong cohesiveness amongst producers and price wars have not developed to bring down prices and increase production as demand has returned to normal after the pandemic.
Risk Assets Untimely Until Inflation Subsides.
The central bank thought the inflation would be transitory and did not act during the early months of steep inflation to keep it anchored at 2%. The central bank was too worried about the recovery from the pandemic and forgot about its primary mission of managing inflation. As a result we have high entrenched inflation today that may not break without significant intervention from the central bank and Washington policymakers. This may occur in months or could take a few years.
Stocks, bonds, real estate are all likely to stay flat or move a bit lower until this inflationary environment becomes more benign. Some investors have already reacted and sold stocks and bonds vigorously to try to get ahead of the higher interest rates that are likely to come. Market indices in stocks are off 20% or more from recent highs. Fixed income markets have suffered similar losses. The outlook for both is poor and as a result a high cash position is warranted. MACM’ dynamic growth portfolios are already in a 25% or more cash position and we expect to increase this cash position further on strength and optimism that will ebb and flow as the outlook for inflation changes. We have taken a significant position in a short-term bond exchange traded fund (JPST) that is yielding around 2% and it has a duration under one year. We will weather the storm there and be prepared to get back into a fully invested position when inflation expectations begin to subside.
Inflation Is High And Entrenched.
CPI is currently being measuring at 8.6 % and PCE is registering about 6% annually. Acceptable Inflation is 2-3%. Markets will return to highs well before inflation returns to 2% but until that trend is in place prices will be flat.
Central Bank Policy has Historically been great but has become Problematic over the last 10 years
The Fed recognizes how damaging inflation is to the economy and markets and clearly wants to control it. However the current Fed is not experienced managing Inflation and has made several errors over last decade.
- Powell has failed to understand the current problem and has acted far too late and also in dramatic error in first labeling inflation as transitory
- Powell misunderstood inflation in 2017 and raised rates over 7 times when there was not any inflation visible yet.
Inflation is both Supply and Demand related and both must be addressed.
- Producers are leveraging the pandemic induced production cuts and have benefited from unusual cohesiveness amongst themselves to keep production at or below demand.
- Demand is strong in durables and services as Consumers have been wealthier than ever and willing to spend despite the high prices.
What Will Cause Inflation To Break?
To get inflation under control both Supply and Demand must be attacked with vigorous steps by authorities at the Fed and in Washington.
To Address Demand:
The Fed has tools to address demand. Higher rates have always been effective at reducing demand and we are already seeing it manifesting itself in softening housing prices and significantly lower consumption of durable goods. Consumers using credit cards to continue to over-consume are finding reasons to rethink that strategy with much higher rates on consumer installment debt today.
To Address Supply:
Washington Lawmakers could act to increase production of key raw materials. There are a few choices that policymakers have. This would include – Tax breaks, and Government subsidies for capital investments to increase production of key raw materials and goods. The government could also invoke the defense production act to stimulate production.
We are optimistic and believe undoubtedly that Equity and Bond Markets will make new highs when inflation has been re-anchored.