Keep Calm and Carry On Redux
“Economic progress, in a capitalist society, means turmoil.”
Joseph A. Schumpeter
April was a brutal month for investors. Both equity and fixed income were down. The headlines tell the tale-- Inflation, Ukraine, and COVID globally and, more particularly, in China. While Ukraine is inarguably the worst of the lot, for investment markets it really does come down to inflation.
Inflation has two facets, and we are seeing both. Inflationary pressures build when there is too much demand for the current supply of goods and services. It can be solved by reducing demand or by increasing supply and the solution usually involves both. Inflation in the U.S. has been building for a while. The pandemic reduced the supply of labor and disrupted supply chains. To protect the economy from a pandemic induced recession, massive fiscal and monetary stimulus was applied. People had money to spend. They wanted new cars. Shortages of parts meant auto production ground to a crawl. There you have it—inflation.
Supply chains are being unsnarled. Even semiconductors, the poster child for this, are starting to show signs of increased supply. But it is messy. China’s zero-tolerance policy for COVID is slowing the supply chain recovery and lengthening the return to normalization.
Another big factor in the pandemic driven source of inflation is the labor market. The labor market is tight but does show some signs of moderating as labor force participation creeps up. As inflation raises costs and savings dwindle some folks who thought they “retired” are likely to reenter the labor force. Whether the lure of higher wages and the threat of cost increases is enough to rebalance the current dramatic misalignment is an open question. The alternative labor market solution, decreasing demand from employers, is the other less positive solution.
If the pandemic related supply shocks may be winding down, other inflationary factors are not so readily reversed. Rising energy and food costs started before the war in Ukraine but are now magnified exponentially. Policy makers can work on the margin to address some of the impact, but these are global markets and the stresses do not show signs of abating. While food and energy take a smaller share of the average American household’s budget, for some this is truly a hardship.
With the insight that comes from hindsight, the policy response to the pandemic was perhaps too much. Coming on the heels of the policy response to the Great Financial Crisis, which is now perceived to have been too modest, it is not surprising. Policy makers were not going to do that again and they didn’t. Now they have the unenviable job of trying to back off while the pandemic effects are still impacting some segments of the economy. After years of the Fed being focused on the employment side of their dual mandate, they now have an inflation problem.
They have only one tool—interest rates. (Yes, they have several mechanisms, but they all are different ways to impact interest rates.) Interest rates have been so low for so long that we, consumers and other borrowers, may have lost track of what normal looks like. 2% mortgages are not normal. 2% mortgages in a time when homebuyers were flush with cash and increasingly homebound, was a recipe for a housing bubble. The Fed is going to try to use interest rates to reduce demand for labor, goods, and services. Less demand means we don’t buy as much, means corporations don’t sell as much and maybe don’t earn as much. In times of less stress the Fed has engineered a slower but still growing economy to tamp down inflation. They may not have that luxury this time.
There is a lot of talk of a recession. The odds of recession are increasing. Recessions can be a good thing for the long-term benefit of the economy. They tend to rebalance excess such as bringing the housing market back in balance. There is an expression for this: “creative destruction”. Recessions can be a force for much positive change that wouldn’t happen in better times. They are part of a long-term healthy economy.
What does that say about the market? Usually in the economic cycle, markets react to changes in conditions or threats of changing conditions, and we have a “correction” in markets as well as in the economy. The timing and duration of that correction is uncertain. It usually comes sometime in the middle of the recessionary process and is over well before the recession is, sometimes before it starts. We have already seen a pull back that has improved equity valuations as prices fell and corporate earnings continue to grow. A recession may come, but using the timing of a recession to time the markets is a fool’s game. Staying focused with a well-balanced diversified portfolio is the key to long term returns. Looking beyond the recession to identify the drivers of the economic rebound is a much more productive endeavor.