Playing It Down the Middle

Posted on Jan 28, 2021 in Investment Strategy

Playing It Down the Middle

There is an epic debate raging in the investment community, and whichever side prevails will have a massive edge over the losing side. This topic is front and center on all the financial news channels and publications, and the markets gyrate, sometimes daily, based on the fresh evidence supporting either side. There are indeed credible and thoughtful arguments supporting each viewpoint, but in the end only one side can win. The debate I’m referring to, of course, is whether or not the economy is on a path to uncontrollable levels of inflation. The answer to this question will have dramatic implications for investors for many years to come.

Those that believe inflation will inevitably spike higher invariably assign the most blame to the Federal Reserve. The Fed has kept short-term interest rates at very low levels effectively since the Global Financial Crisis, with only a short 2-3 year period (2016-2018) during which the Fed attempted to normalize rates before being forced to reverse course. At the same time, the Fed has gone on a spending binge by buying enough bonds to swell its balance sheet to over $7.4 trillion. The effect of these large-scale bond purchases has been to artificially suppress longer-term interest rates as well. Sustained low interest rates across the yield curve would be expected to cause inflationary pressures under normal conditions. But until recently, most of the inflation associated with the Fed’s wizardry has shown up in asset prices, with stocks, bonds and residential real estate surging in lockstep with the liquidity injections. In time, many economists say, the Fed’s largesse will ultimately cause the more widespread price spikes that forced former Fed Chairman Paul Volcker to dramatically raise interest rates, thereby causing a recession in the early 1980s.

While the Fed would surely receive the most blame if that scenario were to transpire again, there would be plenty of finger-pointing to go around. In its own efforts to fight the effects of COVID, the US Treasury is running up massive budget deficits. The budget deficit for 2020 exceeded $3 trillion, and, depending on the negotiations for additional stimulus, it could reach that level again this year. Six trillion dollars, which represents well over a quarter of current GDP, is one heck of a lot of stimulus. And while much of the money that was sent out to struggling households was spent on daily necessities, a lot of it was socked away out of fear. A survey conducted by the New York Fed last year found that aid recipients spent just 29% of the money they received in the first round of stimulus payments while 36% was saved and 35% was used to pay down debt. This skittishness, which reduced the economic impact of the stimulus package, caused the consumer savings rate to spike as high as 33.7% in April before falling back down to a still-high 12.9% in November. Businesses, for their part, have also been reluctant to open the purse strings. Business fixed investment fell at an annual rate of 6.7% in the first quarter of last year before plummeting 27.2% in the second quarter. While there was a bit of a rebound in the third quarter (and perhaps the fourth quarter), business investment is still well below levels from prior to then pandemic.

Another factor that could exacerbate any increase in inflation might be the continuation, or even intensification, of the trade wars with China. Protectionism and tariffs negatively affect supply chains for companies and raise prices on all kinds of consumer goods. If the Biden administration decides to continue ratcheting up the pressure on Beijing, companies may be forced to source their production inputs else. Consumers will pay more for flat-screen TVs and other electronics.

In sum, those worried about inflation believe that the successful inoculation of most of the population will be the catalyst that unleashes a torrent of pent-up demand made possible by high consumer savings rates, deferred business investment, and ample access to low-cost credit. The pent-up demand for services, like hotels, restaurants and flights, could be particularly acute as the US population because more confident about returning to their normal lives. Ancillary factors like trade pressures could amplify the effects, but the lion’s share of the concern lies with the sheer magnitude of the fiscal and monetary stimulus that many believe must ultimately be removed from the system if we are to avoid a problem with inflation.

The $64 trillion question is whether or not an inevitable (in our view) increase in prices later this year turns out to be or transitory or more lasting. This is a very important question, because if the Fed sees the spike in prices as temporary, it will be much slower to react by raising interest rates to fight the creep in prices. If, on the other hand, the Fed gets nervous and views the price increases as more endemic, it’s response could trigger an economic downturn coupled with a nasty drop in asset prices. All rhetoric to date suggests the Fed will be very slow to the trigger. But will they maintain a steady hand if and when consumers begin to get hit with higher prices for food, shelter, health care, and other non-discretionary goods and services?

There are very good reasons why any spike in inflation later this year could be temporary. The best reason, in my view, is that ultra-low interest rates and lax lending standards have kept the global economy well-supplied with just about everything. In any economic cycle, there is a process of “culling the herd” that forces economically unviable companies to go out of business because they are unable to compete effectively in anything other than a booming economy. It can be argued that ever since the GFC over ten years ago, this process has not been allowed to happen. Companies operating in all kinds of industries have been thrown a life preserver in the form of cheap credit. The classic example of this is the US energy industry. Even as oil prices fell sharply during the GFC, a slew of newly formed companies entered the fray looking to employ new technologies (fracking, horizontal drilling) in energy exploration. Under normal circumstances, many of these companies would have gone belly up as oil prices kept falling lower and lower. But the insatiable desire for yield, caused by the Fed’s interest-rate suppression, enabled many of these companies to access the capital markets and continue funding operations at a very low cost. The continued presence of these suppliers has put a ceiling on the oil price – a major input for just about everything.

Many economists also believe that inflation will be contained because there is excess “slack” in the economy right now. These economists, who include the Fed itself, believe that relatively high unemployment and low capacity utilization will help contain any upward pressure on prices. After all, companies don’t need to pay up for employees if there are several others standing in line for any particular position. Likewise, the construction of a new factory is out of the question if you have plenty of idle capacity in one of your existing factories. Until all this “slack” is used up, higher rates of inflation may not be sustained.

Why is this question so important for investors? Well the answer is obvious for bond investors. If you thought inflation was set to blow out you would not be buying long-term bonds, no matter who the issuer. If you thought that global oversupply is the larger force, you might step in to buy long-term bonds if and when rates spike up (like in recent weeks). The impact on stock investors could be just as significant. The answer to the inflation question would determine whether or not you stick with the high-growth, high-momentum technology stocks for which the cost of ownership increases as interest rates increase. On the other hand, if a powerful economic rebound is at hand coupled with a meaningful increase in inflation, you would want to own cyclical stocks and value stocks that would benefit more from the improving backdrop. These types of stocks would also benefit from a rotation out of bonds and into equities.

There is a third way . . . a way to avoid making a bet on the inflation question. High-quality, blue-chip stocks with great balance sheets, no dependence on the capital market, reasonable valuations and solid dividend yields are about as inflation-neutral as you can find these days. Though obviously not immune to the risks described above, we believe these types of stocks can produce positive inflation-adjusted returns over time, even from today’s lofty stock-market valuations.

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