The Fed has Printed Itself into a Corner

By David Schassler
Portfolio Manager and Head of Quantitative Investment Solutions
Van Eck Associates Corporation

Welcome and thank you for reading our first ever VanEck Quantitative Investment Solutions (“QIS”) monthly commentary specifically focused on what’s driving the markets. Each month, we will cover key market developments and provide you with insights from the quantitatively-driven research we use to guide our suite of “Guided Allocation Funds”.

So, raging inflation, a U.S. Federal Reserve (“Fed”) that has finally conceded that we have an inflation problem and a new, rapidly-spreading COVID variant. What could possibly go wrong?

We were told to expect mild, narrow and temporary inflation. Instead, we got harsh, broad and persistent inflation. On Monday, November 30, Jerome Powell, Chairman of the Fed and founder of the “transitory” movement, said: “It’s probably a good time to retire that word” (transitory) when talking about inflation. Good idea. That narrative is now indefensible. The Consumer Price Index “CPI” measure of inflation is up 6.8% on a year-over-year basis, which is the highest reading since the runaway inflation experienced in the 1970s and early 1980s.

COVID-19 is a nasty virus: it seems always to be one-step ahead of us. Now we have to contend with the Omicron variant. While information is still limited, it is expected that this variant may spread more easily, but have milder symptoms. If that turns out to be correct, one positive potential outcome is that it helps the world reach “herd immunity” faster and puts us one step closer to normalcy. (One can but hope!)

The U.S. government is turning to its COVID playbook: restrict and pump. This translates to inflate—restrict movement to slow the spread and pump liquidity to support the economy. The global restrictions already started. The pump? Well, that never stopped! Here in the U.S., interest rates are near zero, the Fed just began to reduce its $120 billion in monthly Treasury and mortgage-backed securities (“MBS”) purchases and President Joe Biden is pushing forward with trillions of dollars in infrastructure and social spending initiatives. The good news is that each new COVID strain appears to have a smaller impact on the economy, and subsequently the markets, because we are learning to manage the virus effectively.

The largest issue facing the economy right now is inflation. Yet, the government continues to feed inflation through aggressive fiscal and monetary policies. Mr. Powell just signaled that the Fed will likely speed up the taper to provide it with the flexibility to increase rates faster next year if high inflation persists.

The Fed really has printed itself into a corner: given the massive and unprecedented debt levels, materially increasing interest rates to fight inflation would have a catastrophic impact on the economy. To drive this point home, you just have to look at the last attempt to “normalize” interest rates. The chart below shows that, from 2008 to 2016, the Fed kept short-term rates near zero to stimulate the economy following the global financial crisis. Then, gradually, it increased rates to 2.5%. The market rejected the move with a 20% decline in the S&P 500® Index and the Fed retreated by lower rates.

Short-Term Interest Rates: 2005 – 2021

Short-Term Interest Rates: 2005 - 2021

Source: Bloomberg. Data as of December 9, 2021. Past performance is no guarantee of future performance.

In 2018, the U.S. debt-to-GDP ratio was 105. Today it is 140. Therefore, the capacity of the economy to withstand materially higher rates is significantly diminished from even a few years ago. The last time that the Fed went to battle with inflation was with the Paul Volker regime in the 1970s. He increased short-term rates to 20%, forced a recession and stomped out inflation. However, the political will in 2021 is unlikely to be supportive of the “tough love” economic policies needed to fight inflation directly and the associated human hardships. Therefore, any earnest attempt to hike rates meaningfully will likely not be accepted.

A more likely scenario is a passive approach to combating inflation. The inflation “relief valve” will likely be time, which allows the economy to adjust to pricing pressures, and fiscal belt-tightening—both of which provide slow relief. Fiscal belt-tightening can be viewed in real time. Mr. Biden was forced to cut the infrastructure bill from $2 trillion to $1 trillion and the $1.75 trillion “Build Back Better” plan is expected to struggle in the Senate.

We should expect the inflation of the next decade to be higher than the inflation of the last decade. Therefore, a different investment playbook will be required. It would favor investments that can quickly adapt to, and even benefit from, higher inflation. Those that cannot will suffer. Broad stock market indices are up significantly over the past year, despite high inflation, due to massive liquidity infusions. Give it some more time. Companies are only just starting to deal with high inflation. The CPI breached 4% in April for the first time in 13 years. The inflationary pressures on most companies should become more apparent the longer this continues as they struggle to absorb and pass along inflation.

Investors should seek out inflation beneficiaries. The VanEck Inflation Allocation ETF (“RAAX”) combines key inflation-fighting assets together, using a dynamic and risk managed process, to create a core inflation hedge. Below is the asset allocation mix of RAAX:

RAAX Asset Allocation Across Financial, Income and Resource Assets

RAAX Asset Allocation Across Financial, Income and Resource Assets

Source: VanEck. Data as of December 10, 2021.

RAAX has demonstrated its ability to hedge inflation as the CPI has risen:

RAAX vs. CPI YoY % Change

RAAX vs. CPI YoY % Change

Source: Bloomberg. Data as of December 9, 2021. Past performance is no guarantee of future performance.

The latest market turbulence re-priced real assets and created an attractive entry point. The price of oil fell from a local high of $85 to under $70 per barrel, gold equities are down significantly yet gold prices remain relatively flat and the price of bitcoin fell from $67k to $50k.

Consider RAAX. If high inflation continues, as we expect, then this fund is well positioned to continue to provide strong inflation protection.

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Originally published by VanEck on December 15, 2021.

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CPI – US CPI Urban Consumers YoY NSA Index measures US consumer prices (CPI) as a measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate.

The S&P U.S. Treasury Bill 0-3 Month Index (USGG3M) is designed to measure the performance of U.S. Treasury bills maturing in 0 to 3 months.

The S&P 500 Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Van Eck Associates Corporation. Copyright© 2021 S&P Dow Jones Indices LLC, a division of S&P Global, Inc., and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit S&P® is a registered trademark of S&P Global and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

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