By Chris Temple – Editor/Publisher
The National Investor
“When I use a word,” Humpty Dumpty said in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”
“The question is,” said Alice, “whether you can make words mean so many different things.”
“The question is,” said Humpty Dumpty, “which is to be master — that’s all.”
― Lewis Carroll, from Through the Looking Glass
At the midway point of 2021, the applicability of the famous egg’s comments to the central bank of the United States of America today has never been more apparent. The Federal Reserve truly has set itself up as ultimate master: of America’s banking system, economy and markets. And—as Carroll’s Humpty Dumpty mused—the Fed has become master, in part, by bamboozling us all with word games of all sorts; the current favorite word, of course, being “transitory” to get investors convinced that the highest producer and consumer price increases in MANY years are nothing to worry about.
To be sure—right or wrong—the Fed pretty much has markets eating out of its hand as we make the turn to the back half of the year. Incredibly, market interest rates have trended downward over the last few months even as the year-over-year C.P.I. Readings have surged rather dramatically, as you see in the chart below.
Consumer price inflation; 12 months through May’s published results
This “Wonderland” creation of the Fed—of falling interest rates even as inflation surges notably higher—has led to the most extreme levels of negative real interest rates in some 40 years. Yet of the several major differences between that era and today, perhaps the most notable is that of the markets’ attitudes and perception of things. Back then, markets were almost universally disdainful of the rising inflation and cheapened U.S. dollar of that time and were clamoring for then-Fed Chairman Paul Volcker to do something about it. Today, of course, it is quite the opposite: Markets will be happiest if the Fed does pretty much nothing to even slow down—let alone end—the craziness.
After its most recent F.O.M.C. meeting, the Fed saw necessary to at least throw somewhat of a bone to those who actually do think it needs to be somewhat cognizant of the recent inflationary pressures. In once again ameliorating markets which weren't sure whether all the fun was over or not, Jerome Powell and Company again bought themselves time via word games and such. Following that meeting, I weighed in on things with my friend and colleague Trevor Hall of Mining Stock Daily; you can listen to that discussion at https://www.podbean.com/media/share/dir-yq95e-ee84ddf?utm_campaign=w_share_ep&utm_medium=dlink&utm_source=w_share.
In one sense, market behavior since that last F.O.M.C. confab has us all even farther through the Looking Glass. That yields would continue to soften even as inflation gets hotter was not on many people’s lists of possible developments for the back half of June especially. But it’s what we got.
So even more as we get into July, investors are going to be animated by this “Flation Debate.” As Michael Mackenzie wrote in a column in the June 11 Financial Times, “No topic dominates investor concerns and conversations more than that of inflation at the moment. It frames both the near term view over the second half of the year and beyond and for good reason. By any measure, prices of both bonds and equities are sitting at rich levels and their high valuations have created a financial system that would not enjoy even a modest inflation shock sustained beyond this year.” (Emphasis added.)
As I have done in the recent past (via the discussions linked above and below and otherwise) and as I will do in The National Investor as we kick off the second half, I will continue to address all this, as will as give you my best guidance on how to manage your portfolio. For present purposes, I want to encapsulate a few themes:
* IT'S STILL CHIEFLY ABOUT ASSET PRICES
I spoke to this debate in some detail fairly recently, in my April-ending issue of The National Investor (which I afterward reproduced for wider, public consumption; you can read it linked at https://www.nationalinvestor.com/2905/the-growing-flation-debate-has-the-fed-finally-managed-to-sow-the-seeds-of-hyperinflation-or-did-everyone-miss-something/.) Also unlike the case in the 1970’s, “inflation” starts with monetary policy BUT then is first manifested in rising asset prices.
The trouble with all that—as Fed Chairman Powell once admitted himself, in properly blaming the Fed for the deflation/asset price busts following the tech bubbles (2000 peak) and mortgage/housing ones (2008)—is that at some point credit/asset price inflation run out of gas. And as we may learn ahead, the present far larger—and more desperate—bubbles being blown by the Fed may lead to even greater busts than the previous ones.
* DEFLATION STILL A GREATER DANGER THAN UNDERSTOOD – The reason why the Fed will continue to occasionally talk about the possibility of tapering its bond buying and/or eventually raising rates—but actually DO nothing for some time still—is that it knows full well that we are in “Inflate or Die” mode. As I have occasionally reminded folks, even before the self-imposed recession and yet more “extraordinary” monetary policy intervention that began late winter, 2020, the Fed was having to deal with stress in the repo markets, among other places. The more it has constructed the present skyscraper of cards, the more it has been challenged to keep all the associated bubbles from imploding.
Liquidity issues that saw the Fed needing to pump hundreds of billions into repo markets back in September, 2019 continue. Among others, Rishahb Bhandari spoke to this dichotomy in the Financial Times in his own comments from the June 22 issue; see https://www.ft.com/content/82845ef0-28a5-4f92-b40a-c4c59e17bc27?segmentId=114a04fe-353d-37db-f705-204c9a0a157b.
Allianz chief economic adviser Mohamed El-Erian is but one of numerous experts who have articulated the Fed’s current plight of arguably being behind inflation already; see https://www.cnbc.com/2021/06/28/el-erian-says-the-fed-is-behind-on-inflation-and-risks-another-recession-if-it-is-forced-to-catch-up.html. Yet even he seems a bit stuck in the 1970’s, thinking that the Fed will act if that thesis is proven out: that inflation does not prove as “transitory” as it continues to insist. That’s debatable. Seemingly stuck in being all-in now in that “Inflate or Die” mode, the central bank may well keep its foot on the accelerator for longer than many think likely; and hope—as I wrote at https://www.nationalinvestor.com/2590/the-feds-calculated-risk-but-just-how-high-will-they-let-rates-go/ --that when the bond vigilantes do start to rebel again, that they will act as a “governor” on inflationary pressures without things getting too out of hand.
* PRICE INCREASES MAY PROVE “TRANSITORY” SOMEWHAT; BUT NOT FOR GOOD REASONS –
Here again, I have discussed this at some considerable length in the above-linked discussions; so will not repeat everything in those for time’s sake here.
But that said, this whole “transitory” theme from the Fed remains a work in progress. If the central bank is vindicated in the end, it will most likely be due to the economy bogging down once more. So generally speaking, I can throw in to a point with the Fed’s gamble: once the sugar high from all the monetary and fiscal stimulus of the last year and a half dissipates, we will be back largely where we started: with an economy plodding along at best…but with, now, gazillions MORE in debt to service.
Where things will be interesting for investors in all of this is in identifying those sectors/themes where price rises will continue even if the overall economy bogs down anew. Those are the areas where a LOT of money will be made.
And likewise—if price pressures persist longer than markets seem to currently expect—what companies/sectors should be avoided? A lot of the price increases in shipping costs, energy and perhaps even labor may well prove to be “sticky.” And you won’t want to be invested in areas where price increases can not be passed on to customers, but end up being “eaten” by companies, with earnings and dividends suffering as a result.
* THE LIKELY OUTCOME – I have believed for a while that we are heading for a kind of “Stagflation Lite” in the end: a pattern similar to the 1970’s, but (most likely) without the extremes of those days. None of us will see double-digit Treasury yields again in our lifetime (at least as long as the U.S. dollar remains the world’s reserve currency; that’s a discussion for another time.) Nor will inflation get persistently as high as it was in the 1970’s; the economy—as I discussed in that conversation above with Trevor Hall recently—is simply, mathematically unable to pay such high prices for an “extended period” (to use another of the Fed’s occasional favorite phrases.)
In short, I throw in wholeheartedly with the below Tweet posted by Sven Henrich as 2021’s second half ended. . .
What if inflation is transitory and stagflation is permanent?
. . .which, if we are correct, means that a LOT of presently-held investment theses will have to be revisited. And that is one of the tasks I’ll be undertaking as we get deeper into Summer.