July 18, 2022

INFLATION 22

by Adam J. Morgan, CFA, CMT

We’ve all been through a lot together these past several years, from contentious elections and a global pandemic to a war abroad, and now another virus - this one being economic in nature.  While inflation certainly isn’t as bad as the very real and tragic toll waged on humanity by Covid 19, it is a virus of sorts that affects everyone, and in the end will hurt the economically vulnerable the most.

How did this current inflation variant become such a problem? After all, it was only six or seven months ago when the economy was cooking with grease and investor-profits were so great and widespread that some in Congress were discussing the possibility of taxing unrealized capital gains. Now the congressional debate du jour involves a possible tax holiday on gasoline.  You know things are bad when the Federal Government goes from “give us your money” to “well, maybe you should keep some for yourself.” Maybe they have a guilty conscience…

While the dramatic spike in the rate of inflation has been a 2022 story, it was a problem in the making for quite some time. After the financial crisis of 2008, then Fed Chair Ben Bernanke earned the nickname “Helicopter Ben”  when he implemented monetary policy so easy that it resembled, to some, a man throwing money out of a helicopter onto the US economy below. The Fed began an era defined by its zero percent interest rate policy as a solution to the problem that ailed us then: deflation. Mechanically, the Fed maintains low interest rates primarily by buying bonds with the help of the US Treasury. The bond purchases go on the Federal Reserve’s balance sheet and the money paid for the bonds circulates into our economy. This process, while a tad more sophisticated than simply making it rain from a helicopter, serves to keep interest rates low and drive asset values higher.

Bernanke decided to target a 2% inflation rate. His successor, Janet Yellen, and her successor, Jerome Powell, adopted that mission. Where they came up with 2% as a target rate of inflation, I don’t know, but they believe that is the rate of inflation that will best allow our economy to achieve price stability and a robust labor market. Furthermore, they determined that if the long run average rate of inflation is below the 2% target, then we need a significant amount of time where the rate of inflation exceeds 2%. So, to bring the long run average up, they pushed the money supply higher. Now to be fair, Mr. Powell couldn’t have foreseen the numerous Covid variants and the war in Ukraine, but nevertheless he played with matches, and we got burned.

So, what can we expect going forward? Well, naturally as prices rise at the pump, grocery stores and virtually everywhere else, rational economic participants tighten their belts. They don’t actually spend less because they can’t, but the money they do have now buys less stuff.  And that has a downstream effect. Remember when we mailed checks to people who couldn’t work? Well, unfortunately, many of them are now directly in the line of fire. Just think of the things that Americans will do less of when budgets get tight. And then think about the chain reaction as contagion spreads. There is no vaccine for this virus. The only saving grace today is that we currently have a healthy labor market, but that is unlikely to continue. Growth will slow at best, and possibly regress.

As for investors, this is where the story gets tricky. Many people focus on whether our economy will sink into a recession. Whether we do or do not has a lot to do with Fed policy going forward, and even they admit to a high degree of uncertainty in their “wait and see” approach. But the economy and the stock market are not the same thing. The stock market is a forward-looking entity that will not wait for the economy to get better before rising again. The chart below shows how the stock market has behaved going into and out of every recession in the United States dating back to 1948.

As you can see, the average decline in the stock market leading up to the last twelve recessions in the US is 29%. However, the average gains in the market from the trough looking 12 and 24 months out are 40% and 54%, respectively. Furthermore, the average time that it took for the stock market to recover back to its peak was roughly 2 years. At the market’s lowest point so far this year, which occurred in mid-June, the S&P 500 was down almost 25% year-to-date, meaning the market has already begun pricing in a recession. What this data is describing is a favorable asymmetric risk return dynamic for investors who are willing and able to wait.

Unfortunately, digging deeper into the data may tell a less optimistic story. The longest period of time the stock market took to recover from a recession-induced bear market was 5.8 years, which occurred after the market decline in 1973-74, a time that also saw runaway inflation and two oil shocks, one from the oil embargo of ’73 and another during the Iranian revolution in ’79. That period was followed by a Fed that aggressively raised interest rates in what was eventually a successful effort to “Whip Inflation Now.” So, by the time the market reached fresh new highs, prices of goods and services had risen for years and purchasing power had eroded.    

It’s important to remember why we invest money. We want to make money, of course, but it must be on a relative basis, relative to the prices of desired goods and services. We want to create purchasing power, which means that we want to grow our investment with an after-tax return greater than the rate of inflation. That obviously hasn’t occurred for nearly anyone in 2022, and it didn’t occur for a long period of time in the 1970’s. The reality is that there are important economic similarities between now and the 1970’s, and there are great differences, not the least of which is the massive advancement in the technology sector, which has produced a litany of innovations between then and now that are broadly thought to be a disinflationary force.

I cannot predict the future. My industry is full of charlatans who will try, but you and I both know better. At the same time, I am not one of those people afraid to take a position. I believe you deserve better. Good investment management involves using current and historical data along with experience and some intuition to make the best decisions possible at the time. At this time, I favor high quality stocks to those with the risk tolerance and time horizon to withstand a higher-than-average degree of volatility. I spend a lot of time reviewing our portfolio companies and where we’re invested in individual stocks, I see strength. It may take more time than we would all like for stock prices to recover to where they once were, but I do believe that the economy will recover and the companies that we’re invested in will prosper.

For anyone who would like to have a conversation about a few examples of where we see value, or would like to discuss anything aforementioned, please reach out to your advisor and let us know. My door is always open. Until then, be well. —A. Morgan

Nothing contained in this post is intended to constitute legal, tax, securities or investment advice, nor an opinion concerning the appropriateness of any investment, nor a solicitation of any type and does not guarantee future results. The information contained in this post should not be acted upon without specific legal, tax and investment advice from a licensed professional. Past results are not indicative of future performance.