One of Two Bitter Pills to Swallow

At risk of sounding like a broken record, the monthly CPI report came out this week and showed another four-decade high inflation reading. As much as the President would like to lay the blame at the feet of Russia’s invasion into the Ukraine for our current inflation crisis, the dye was cast long before military action began. To be fair, in my opinion the dye was cast even before the 2020 election. Inflation is, and has always been, a monetary problem. The Federal Reserve is the governor of monetary policy and as a result they are responsible.

We may also want to blame supply chain problems for our current dilemma, but at its core economics is simply the study of scarcity. Inflation is caused by the scarcity of goods given the plethora of money. Whatever the cause may be for inflation there seems to be only one solution, rein in the money supply or face higher and higher inflation. Inflation has not been a problem in our country for so long that we seem to have forgotten the real dangers it presents. It may seem ideal to create a monetary policy that allows our economy to grow unimpeded by recession, but it is a fairytale we need to dispel.

Recessions may be inconvenient for politicians looking to get re-elected, but recessions are vital to the overall function of an economy. Recessions offer a reset—an opportunity for investors and healthy businesses to resupply at more attractive valuations. Think of the benefits of controlled burns in forests, they clear out the overcrowding and allow healthy trees to grow while reducing the risk of destructive, out of control fires. While the economy went into a deep recession in the wake of the Covid outbreak at the beginning of 2020, it was too short to allow a reset. We also crowded out private investment opportunity with massive government spending. In a capitalist society, governments are a competitor of private enterprise, and an unfair one at that. The federal government’s ability to print money creates an unlevel playing field.

Therefore, the recession we did experience in Q2 of 2020 was ineffective at creating that vital reset. This can be witnessed by the swift rebound in US stock indices. The S&P 500 spent all of five months below its pre-Covid high-water mark. For context, the S&P 500 spent 12 months below its prior high-water mark between May of 2015 and May 2016, and we weren’t even in a recession. Depending upon your viewpoint, you can either praise or blame the Federal Reserve for this market response, either way, our inflationary environment is now the result.

Next week we will get a glimpse of how the Fed will begin to respond. All expectations are for a quarter point rise in interest rates. While this seems to be a foregone conclusion, I will be listening to what the Chair Powell says in his post-announcement remarks. My concern is that they will provide cautionary guidance due to geo-political events in Europe. Given that the events in Europe can only add to inflationary pressure I worry that any attempt to slow or delay rate hikes will only exacerbate the problems. Being too myopic at this juncture may delay the economic and market consequences but may deepen the problems and cause greater longer-term pain.

From an investment perspective, should the Fed fail to forcefully contain inflation, I would look for growth to dramatically underperform value in the future. Material producers and energy would continue to be safe havens, while consumer discretionary stocks will suffer. In other words, a complete reversal of the last ten years. Much of this has already begun to take place, but the sustainability of this recent trend will depend on how the Fed responds to the economic challenges. Oil at $100/barrel and gas above $4/gallon saps demand from other areas of the economy, in addition to raising the cost of all goods requiring shipment (which is essentially all goods). Conversely, should the Fed take dramatic steps to curtail inflation expect a recession to follow. This recession would be painful but beneficial to keep our economy from the horrors of hyperinflation.

Thanks for reading,

Zach and Dave

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