When I was a teenager my parents taught me, repeatedly I might add, that if I intended on changing the results of my actions, I should consider changing my actions. Invariably, only through the experience of occasional failure would I learn this important lesson. In my 1980s youth I was a bit of a hothead on the tennis court, often throwing my rackets in disgust at shots I felt I should have made. This behavior did not lend itself to more winning tennis, rather in a game that was usually decided by just several points out of more than 150 points in a match, the value of keeping cool headed and focused when facing adversity was essential to winning matches. The difference between success and failure required introspective analysis and an immensely short memory regarding the previous lost point. The most important point of the match, one coach told me, was the next point – attack your opponent’s weaknesses and avoid relying on your own weaknesses. Further, I was taught, that when attempting to change the path of a losing match one should try a different tactic than the one that got you to the precipice of a loss.
When relating this wisdom to government policies it is apparent that US politicians have avoided following this much heeded advice. Congress seems entrenched in its belief that more spending is the path to lowering inflation. The great Albert Einstein defined insanity as “doing the same thing over and over and expecting different results.” Using Einstein’s definition there appears to be an enormous supply of US government insanity with very little demand for sound fiscal policies. Somehow, in a world where there is clear evidence of excess consumer demand and limited productive capacity, the US government just passed yet another enormous spending package insanely called the “Inflation Reduction Act.” Congress is under the belief that taxing large corporations and greatly increasing the size of the Internal Revenue Service to spend money on various climate and healthcare initiatives will lower prices for goods and services. I tend to believe that by enforcing a 15% corporate minimum tax on “large” companies, the boards of directors of such companies will be highly incentivized to find ways to recapture those lost dollars, and invariably will work tirelessly to find a path for passing on the tax increase to customers via price increases for their products. Only time will tell if this new legislation winds up lowering inflation – but I wouldn’t hold my breath.
Given all this fiscal recklessness, it appears that the only sane government department is once again the Federal Reserve Bank (“Fed”). In my opinion the last thing the Fed wanted to see is yet another government spending program to constrain the supply of goods and services. As usual, the central bank will consider the new spending and adjust the policy stance accordingly to offset the potential effect on prices. Under Chairman Jerome Powell’s leadership, the Fed has embarked on its most aggressive tightening campaign since the days of Paul Volker. The Federal Open Markets Committee (“FOMC”) has communicated that its most important initiative is to lower the pace of inflation towards its two percent target regardless of the effect on the pace of GDP. Recent economic data point to a pace of PCE inflation that is near seven percent. With inflation running at nearly triple its target, the only choice for the Fed was to reduce monetary accommodation aggressively in the hopes of aligning aggregate demand with potential supply, thus effectively lowering the pace of price increases. The bet they are making is if they can slow down the economy perhaps prices would begin to slow down as well.
Powell and company have raised rates by 2.25% in just four meetings and are promising another large increase on September 21, 2022. I would not be overly surprised by another increase of 0.75% at this meeting with potential for year-end rates approaching 3.75%. Furthermore, should inflation remain uncomfortably high I would expect the Fed to consider a more rapid reduction in its balance sheet, thus contracting the supply of money in the banking system. As of this writing the Fed has been permitting the balance sheet to roll off at a pace of $30 billion per month. Furthermore, the Fed has announced that starting in September they are planning to increase the pace of balance sheet reduction to $95 billion per month. There has never been such a rapid pace of quantitative tightening attempted before. The perception that investors have garnered is that the Federal Reserve will be too aggressive this year only to be forced to cut rates early next year. It is my opinion that the more likely path for rate policy is that the Fed will raise rates to roughly 3.75% and then leave it in that mildly restrictive range for the balance of 2023. In addition, the Fed may be able to inflict additional tightening by increasing the pace of balance sheet runoff to further contract the supply of money in the economy. This stealth tightening could very well be the tough medicine that might lower the pace of inflation.
The question we must ask ourselves as investors is how all this exciting interest rate action will play out on our portfolios? The first order of business is to understand how the current macro backdrop will play out for the overall economy. My sense is that the Fed’s actions will translate to lower consumer demand, and thereby begin to negatively impact the pace of job growth. This is what we in the trade call “recession.” As real wages (which is wages adjusted for inflation) have contracted by approximately 4%, consumers have begun to shop more judiciously; consumer spending has downshifted in the first six months of 2022. The manufacturing sector appears to have entered a contraction recently as new orders are faltering while inventory levels are bloated. Housing has slowed down markedly as increased mortgage rates have had a considerable negative impact on loan demand. Price cuts for home sellers are becoming more prevalent as buyers are demanding concessions. Recently even the price of oil has come down as investors are pontificating upon the potential for lower energy demand with a reduction in GDP. The energy story is a much larger discussion that is beyond the scope of this article. But given the potential for continued Russian aggression in Eastern Europe I would suspect that energy prices will be challenged to meaningfully fall sans a resolution to the Russia-Ukraine conflict. Russia has proven its ability to display resolve in the face of long periods of instability, and unless Vladimir Putin can be convinced that the conflict is somewhat detrimental to Russia one could envision the war lasting well into 2023. My long-term prognosis for oil is somewhat lower as it seems the globe has awakened to the importance of energy security and the need for finding alternative energy solutions. Yet the immediate environment does not lend itself to seeing a material drop in fossil fuel prices.
The most likely path for growth for the balance of 2022 is somewhat disappointing. The consumer is constrained by high inflation and negative real wages. Demand has materially dropped in Europe as the Russia-Ukraine War has caused humanitarian and economic displacement. In addition, the war has begun to shape a less globalized economic order in favor of regionalization. China’s Zero Covid Policy continues to disrupt supply chains. Furthermore, China is experiencing a material slowdown in economic activity. The real estate market is being negatively impacted by higher mortgage rates. Taxes are rising for corporations as new government policies are being adopted. And in the official fight to lower inflation, global central banking authorities are rapidly removing accommodative policies. This rather sanguine macro backdrop could very well flatten or even reduce corporate profits, which could cause continued consolidation away from more speculative equities. Continued portfolio vigilance and defensive strategies may be preferred until there is some confirmation that either inflation is well on the path to normalization and that the Fed signals that the end to restrictive stance of monetary policy is within visibility. Given that we have yet to approach even a slightly restrictive policy, we may have to wait until early 2023 to embrace a more growth-oriented approach to risk management. For now, we will remain predominantly allocated in a balanced portfolio while nibbling on some solid yielding short term bonds. And as my tennis coach used to say, “now is not the time to go for the winners … play out the points and try to outlast your opponent.” In the world of investing, I would prefer to have some dry powder in the event market volatility increases as we approach the next Fed meeting.