Inflation Isn’t Everything, It’s The Only Thing
By Thomas A. Martin, CFA, Portfolio Manager
It’s been quite an adjustment. Inflation had been averaging 2% or less from 2007 to 2020. You could say that the experience of low inflation had become “entrenched.” Some said inflation was dead. The worry was that we couldn’t get enough of it. When people become used to something for a long period of time, it can be difficult to process and accept that a change is actually happening. You know: shock, denial, anger, bargaining, depression, etc. Consumers and capital markets are showing signs of all of these things.
The causes are multiple. We know, we know. COVID, China, supply chain, consumer preferences, employment preferences. Russia’s war against Ukraine. Concentrated dependencies for energy, food, raw materials. Energy transitions and regulations. Overdone monetary and fiscal stimulus. Understanding the cause(es) is the start of the path to the cure. The trouble is that many, if not most, of the causes are not particularly controllable by any one action, person, party, or institution. Some are intertwined, some are independent, and potential solutions are subject to vast differences of opinion.
The response is unanimous. Except for one, it seems. Everyone, (and by this we mean every central bank), with just a couple of notable exceptions, says the answer is to raise interest rates. Raise, raise, raise. Now, faster, keep on going. Destroy demand until it comes into line with supply. Our interpretation is that the central banks are signaling that the proper way to fight inflation, clearly, is with a heavy, blunt club, and just indiscriminately bash everything over the head. And so, we are in the midst of one of the fastest and biggest rate rises in a long time and yet financial conditions are not terribly restrictive, and the beast continues to roar.
Out of this, one thing is becoming increasingly clear: The central bankers believe deep down in their fully converted souls that if we (they) don’t get inflation right, nothing will be right. The bedrock of civilization will be torn asunder. First and foremost, inflation is the only thing that matters. The markets are slowly working towards the acceptance stage that maybe the Fed and its compatriots really will raise rates higher for longer and really will tolerate economic contraction. Maybe the only other thing they will protect against is prolonged dysfunction and collapse of the system.
The effects will take a while to work out. All the effects on everything. The laser focus for now though is on one thing. The effect of central bank tightening on inflation. So far, the effects seem to be not all that appreciably different from zero. Yes, there have been data points hinting at the easing of some prices, but they haven’t been able to muster sustainable momentum. Inflation has remained stubbornly high and widespread. Even housing prices are not really budging. In the meantime, consumers seem to be willing to pay up, but unit volumes are weakening. Supply chains are improving, but there are still many problems. Corporate earnings growth is slowing but is not falling off a cliff. Employment remains strong.
The range of potential outcomes from here is very wide. Relatively benign is still a possibility but its odds have been decreasing. The odds of a rough patch in 2023 and potentially beyond are significant, in our view. Potential stock and bond market price actions in response also vary widely.
Investment positioning requires patience. When uncertainty is high and lopsided positioning can have unwanted consequences, it does not pay to guess. We believe the current environment is best addressed with cautious and conservative positioning and trading informed by meaningful weight of the evidence.
Sources: FactSet, Piper Sandler, RENMAC
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