It’s been said that the only thing a person needs to be a successful stock investor is knowing what the inflation rate is going to be.
So it must not be that easy.
The Federal Reserve, depending on time periods under review, gets it wrong either some or all of the time.
In a strange way, this reality was actually somewhat comforting when repeated Fed pronouncements of the “transitory” nature of inflation conflicted so clearly with observable phenomena and complex, global economic and demographic interactions.
While we’re no better than others at point estimates of inflation, what’s important is getting the direction of change in inflation rates reasonably correct.
Then using that anticipated direction of change, figure out what—if anything—we should do differently in managing investment portfolios or providing financial advice.
What follows is our view of the broad demographic background, which is unlikely to be very useful in decisions about timing, but which helps with direction.
Most importantly, we’ll also discuss the way we think inflation affects individuals and how it should inform individual decision-making.
The current backdrop
It is clear that both the developed and developing worlds are aging, both in having increasing numbers of older people requiring health care and financial support, and relatively fewer people of working age to support growing GDP.
Nowhere is this more prominent than in China, which has served as the primary deflationary source of global production.
Several hundred million people moved from rural to more productive urban environments over recent decades.
China’s ill-considered one-child policy has led to the well-known statement that “China will get old before it gets rich.”
In inflation terms, such aging means that we’re moving toward more consumption (demand) and less production (supply).
Whether we’ve reached the tipping point is unclear, but global deflationary conditions supported by low-cost Chinese production are at least near to reversal.
Some say that the global trend in aging will be deflationary, since there will be lower demand for goods by older, established households.
We believe this will be more than offset by higher demand for services—such as:
- healthcare generally,
- eldercare facilities specifically,
- home health,
- entertainment, etc.
At the same time, supply will be constrained by fewer entrants into the labor force and increasing retirements.
The deflationary effects of rapidly increasing productivity could be offset through technology, which would increase supply, but we’ve not experienced that yet.
MP3: Creating demand without accounting for supply
Bridgewater Associates, the world’s largest and arguably most successful hedge fund with over $150 billion in assets, has come up with the concept of MP3.
MP3 represents how governments are now coordinating monetary and fiscal policy. In essence, what we are currently experiencing.
Both MP1 and MP2 are monetary policies manipulated by the Fed to stimulate the economy:
- MP1 stands for interest rate cuts
- MP2 is quantitative easing
At this point, both have pretty much exhausted their effectiveness.
Enter MP3, which is envisioned more about managing spending rather than the investing and saving targeted by MPs 1 and 2.
Governments implement these policy levers to stimulate spending in both the public and private sectors.
In Bridgewater’s words: “The mechanics of combined monetary and fiscal stimulus are inherently inflationary. MP3 creates demand without creating any supply.”
MP3 is typified by very low-interest rates and stimulus funds paid directly to consumers—rather than running through the banking system as was the case during the Great Financial Crisis—have created a demand shock.
Since we’ve not been allowed out of the house to use services, way too much money is now attempting to buy goods.
This could, of course, disappear—depending on the path of the pandemic and governmental and personal responses to it or other exogenous shocks.
The importance of supply chains
Pundits often use shorthand for this kind of demand shock: supply chains.
Many believe that these issues will be sorted out soon, though the forecast dates seem to keep extending further into the future.
But we believe that supply chain challenges will continue for longer than expected and that they will be exacerbated by fundamental supply shortfalls.
Globalization trends, while far from moribund, have run into global competition politically and militarily.
This is likely to lead to more onshoring for critical (strategic) manufacturing and higher costs.
In the short run, production of many goods—as well as their transportation—is also hampered directly by the pandemic as critical facilities are crippled by labor shortages.
The squeeze on labor supply will continue to fan inflation
The longer-term imbalance is likely to be on the supply side, more particularly labor.
Although the phenomenon is not well understood, what is being called “The Great Resignation” has roiled labor markets nationally.
An unprecedented number of workers have quit jobs and are sitting out the current “We’re Hiring” frenzy.
It appears this is a combination of workers’ confidence in a tight labor market and a desire to evolve from low-wage occupations.
So far, this is leading to significantly higher wage offers, which in turn is likely to become embedded in higher prices for consumers.
Lower-wage employees have a much higher propensity to consume: they spend a higher proportion of any pay increase immediately, whereas higher income employees tend to save more—reinforcing demand pressure.
With our increasing longevity, we expect to see transitions into and out of the labor force become more frequent and more accepted.
Best guess: This will be a feature, not a bug, of our new economy.
Housing costs, and the way they are included—not nearly enough—in Owner’s Equivalent Rent, are pushing hard on CPI (Consumer Price Index) and PCE (Personal Consumption Expenditure) numbers.
Such costs are being felt more intensely than official figures would indicate. Inflation expectations are rising; these tend to be self-reinforcing and difficult to derail.
For all the reasons above, we believe we are shifting from a deflationary to an inflationary regime globally.
Traditional government responses hold a weak hand
What are the traditional responses from our government to put the inflation genie back in the bottle?
Well, they have historically made use of both fiscal and monetary restraint.
Both forms of restraint carry negative political consequences and neither seems likely to be applied currently including:
Fiscal
We’ve already experienced direct stimulus greater than anything since World War II.
Proposed legislation for programs “costing” either “nothing” or $1.5 trillion are being pushed even in the face of independent calculations that the actual cost is somewhere between $4.5 and $4.9 trillion.
As this is being written, there are indications that true costs will sink this proposed legislation.
Whatever one’s judgment about the necessity or desirability of the programs, they do not fit neatly into the category of fiscal restraint.
Monetary
The Fed is already at negative real interest rates and nearly at the zero bound for nominal rates.
Could they be more aggressive in increasing short rates and controlling inflation? Sure.
But every bit of increase also increases the deficit and restricts other policy choices.
Our acceptance of rising deficits has at least partially been dependent on low rates, making the cost to carry the deficits much lower.
As homeowners, most of us have refinanced our home mortgages to historically low rates to experience dramatic cash flow savings.
So, too, the federal government. The next few weeks are likely to give some idea of the pace of tapering in Fed purchases of securities; other approaches are waiting in the wings.
If history is a reasonable guide, the government will delay administering unpleasant medicine as long as possible, then react ferociously when forced to do so.
Until then, we expect to experience continued jawboning aimed at stabilizing the economy without really solving underlying imbalances.
See part 2 of this post “What to Do About Inflation in 2022”.
Disclosure:
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser located in Long Beach, California. Registration does not imply a certain level of skill or training. Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com. This blog is provided for informational purposes only and should not be construed as personalized investment advice. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. The information provided does not constitute any legal, tax or accounting advice. We recommend that you seek the advice of a qualified attorney and accountant.
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