Inflation—What's Next?
Inflation! Now there is a word that faded from economic memory for the past few decades. Most of us have little to no experience with how to operate in an inflationary environment. Although inflation has happened many times in the past, you can see from the chart below that the US has mostly experienced very low inflation since the 1970's. But, as the saying goes, the trend is your friend until it bends at the end, and one look at the right side of the chart shows a serious change of direction.
The inflation that we are currently experiencing came as a surprise to many. When it first began to rear its underbelly, Fed Chairman Powell assured us that there was nothing to see here, and any inflation we were experiencing was likely to be temporary and due to supply-side issues related to Covid. If life was only that simple. Instead, flooding the economy with debt-backed currency caused inflation to accelerate to the point where it could no longer be ignored, which is where we are now.
Although the Fed portrays itself as an independent board that emotionlessly analyzes data and makes educated decisions based on the best evidence on hand, the reality can be quite different. The Fed is made of flesh and blood just like you and I, and they are not immune to outside pressures, whether they be political or popular opinion. We can see examples of this when the Fed cut rates in response to President Trump's public cry for them to do so. At first, the Fed publicly stuck with the economic data and held rates steady, but finally they succumbed to the relentless pressure to stimulate, which brought us to where we are today.
After lowering rates to zero and stimulating the economy through quantitative easing to the tune of $95 billion per month, the Fed managed to stimulate, but along with that came an unwanted visitor—high and rising inflation. Since inflation has been absent for the past 50 years, we show a zoomed in chart of the 70's to see how inflation unfolded the last time it paid the US a visit. Notice the waves? Each wave of inflation was higher than the previous until Fed Chairman Voelker was finally able to slay the inflation dragon with near 20% interest rates.
As you can see on the chart below, after a serious bout of inflation during the 1970's, the US has enjoyed an extended period of low inflation. So much so, that people tend to forget what inflation can look like—for most of us, our entire adult lives have been in this low inflation period—so we are here to show you few charts.
When Covid hit, it left an economic mark that is with us to this day. As a quick recap, let's review what happened from an economic standpoint. When Covid first reached the shores of the US, the government panicked and basically shut the entire economy down. This resulted in a cessation of supply of both goods and services. At the same time, the government borrowed money from the Fed and sent it to voters in the form of stimulus checks. This resulted in a unique set of circumstances where we had a public flush with cash and ready to spend, but with nowhere to spend because everything was closed. When stores did re-open, they found they were unable to restock their shelves as they normally would, because much of the world's manufacturing capacity was also shut down.
While the economy was being put on ice, the Fed began to stimulate to the tune of $95 billion every month. It's important to let that sink in... It took $95 billion worth of new money injected into the economy EVERY month just to get us to where we are today. But now the stimulus has largely run its course, and Americans are no longer flush and looking to spend with the same enthusiasm as they did when they were finally released from lockdown and set free.
That means the economy is bound to slow down, even if the Fed does nothing at all. But the Fed isn't going to do nothing.
Now that we can see on the chart above that inflation is re-emerging as a force to be reckoned with, we ask ourselves what is next? Do we continue to get high and rising inflation? If so, will it be in waves like it was in the 70's? Or, is this a one and done type of event? The answer of course is that it depends on what the Fed does. While some inflation is baked into the cake because of the Fed's previous actions, there are some powerful DEFLATIONARY forces that are pulling prices lower as well.
When an economy slows, people reduce spending, which reduces demand. Since price is a function of supply and demand, any drop off in demand will cause a decline in price unless supply also declines by the same amount. The stimulus checks have largely been spent, so we know that demand is declining, but what about supply? If supply isn't also adjusted downward to reflect reduced demand, then there will be too much supply relative to demand. In this case, the law of supply and demand dictates that the price must fall.
We are seeing this play out with big names like Walmart and Target. Both have warned that their warehouses and shelves are full.... TOO full. Sales have slowed dramatically. Faced with excess inventory, stores are finding themselves in a situation they haven't experienced in a while, they need to put things on sale in order to sell it. As merchandise gets discounted, the "general price level" that is estimated through the official inflation numbers should show a reduction.
The problem with an inflation chart such as the one shown above is that it only shows what already happened as opposed to what is going to happen next. Still, a chart of inflation helps us to compare to previous periods and guesstimate what to expect next.
Three years ago, we were pointing to the forces that were causing inflation and warned that it was coming. Now, we are in the midst of inflation, and everyone is expecting more. Our guess? Get ready for a deflationary scare. Although this isn't a popular opinion at the present time (everyone is expecting more inflation), people rarely get what they expect in the markets. This time will likely NOT be an exception, and once again, investors will be caught on the wrong side of history as prices implode for many/most assets. We are already seeing this take place. Trillions of dollars have evaporated this year due to declining asset prices.
The deflation to date has cast a wide net. Cryptocurrencies, commodities, stocks, and bonds have all declined significantly so far this year. As investors see their wealth evaporate, previous spending plans get changed and investors pull back, causing an even bigger decline.
Currently, everyone expects the market to raise rates aggressively to combat inflation, but in our view, a deflationary scare is just around the corner and the Fed may end up cutting rates, which is the exact opposite of what they currently expect/forecast.
Take a good look at the chart of the Dow above. Notice it rolled over earlier in the year. That coincides with when the Fed began to actively reduce the size of its balance sheet. The chart of the Dow isn't alone. One by one, every major asset class is rolling over and trending lower. We don't know when it will stop, but there is nothing on the charts to suggest the bottom is in yet. Our guess is the current decline in almost every asset won't end until there is a visible deflationary scare that causes the Fed to do an about face and begin to cut rates rather than raise them.
To conclude, it's always a good idea to understand what kind of financial environment you are operating in. Right now, everybody sees inflation as the biggest threat. But we think it won't be long before the fear begins to swing in the opposite direction and central banks around the world go back to fighting the battle they had before Covid hit—deflation.
Deflation will change the monetary backdrop, and also the investment climate. In a deflationary environment, there is often excess supply and declining profit. It can be a tough market to make money in, but if it causes the Fed to become dovish again, it could provide the stimulus necessary to start the next rally in the stock market. Ideally, the time to enter the stock market for market timers is after a large decline, when everything looks dire, but the Fed begins to change direction from tightening to neutral to loosening. Right now, we are in the peak of tightening, but already investors are backing off on their predictions of future rate cuts. Once the Fed jumps on board, we could see a nice rally, even as profits decline.
The old saying of don't fight the Fed still rings true to this day, and the Fed might now know it yet, but we think they are about to lose their appetite for repeated rapid rate hikes.