Dear Valued Clients and Friends,
There was plenty of talk about Russia/Ukraine in DC Today this week as well in the unreliable news cycle, and there really isn’t any “new news” to report. I am not sure we will be talking about Russia/Ukraine in six months, but I am very sure we will be talking about inflation, the Fed, and interest rates in six months. I want to do my best to make those six months (and more) of conversations be as worthwhile as possible.
The Dividend Cafe is here to help that effort.
We are going to look at what some of the right questions are to ask today and let it go from there. I believe this discussion will give you some better information than you might find elsewhere, but it also puts me out on a limb with some actual forecasts. The very concept of forecasting bothers me, usually because those who do it are charlatans and grifters. But I have nothing to gain in these forecasts; rather I am trying to point us towards a context and understanding that will likely not prove exactly right in the details, but I think more helpful than thinking about 2021’s battles during 2023’s war.
Jump on into the Dividend Cafe …
What is the right question to ask about inflation?
From the vantage point of financial markets, the question is what the forward inflation rate will be in a year. Why? Why are we supposed to care about the inflation rate next year and not the rate this year?
The first thing that needs to be noted is I said “from the vantage point of financial markets.” The consumer purchasing a car or a dishwasher next month has every need to calibrate cost considerations here and now. But investors in financial markets are dealing with the prices of assets, and as we have seen, expectations about inflation and expectations about interest rates are key when it comes to asset pricing.
Dramatic effect
This tees up an important point. One can believe that inflation will be 7% a year from now, and they have every right to make that argument. They may be wrong, but it is not illegitimate for one to frame an argument around some economic data points or set of projections. I find the idea reasonably insane, but one can make the argument in good faith and deserve consideration of their argument on it merits.
However, most citing of a 7% inflation rate right now is not being done in good faith or at least is not being done with a serious streak. That the consumer price index is up 7% versus a year ago is not up for debate, but when we talk about what the inflation rate will be going forward, whether it is one year or longer, you either are (a) Distorting things for dramatic effect to imply the price level growth of the last year is the same as the price level growth for next year or (b) You have an argument to make for why it will be. Like I said regarding those in camp b, I am all for hearing the argument. But alas, most know that if they believe prices will rise 3-4% (a very high inflation rate as far as I am concerned!), it sounds less dramatic to say that versus saying the 7% figure. So they clickbait their way to a more sensationalistic story, which is fine as far as their agenda may be concerned, but less helpful for the discernment of financial markets.
Back to the right question
So why is our need in making financial market and macroeconomic determinations to think about these things in terms of where they will be in a year? Because only an incredibly dishonest actor (or incompetent one) believes there is no noise in the data right now – that there are no supply-chain bottlenecks – that there is no market imbalance which will correct. Again, reasonable men and women can disagree on how much of that is impacting the numbers, but some level of price effect is related to these matters.
And why is that the right question for us to ask as asset allocators? Because it most certainly is the main question the Fed is asking! The Fed is not going to set monetary policy in 2022 and 2023 around the consumer price level of 2021. They are trying to be forward-looking, and those making judgments about financial markets need to try and be forward-looking.
Just one problem, though
The problem, of course, is the challenge of looking into the future. The Fed’s “dot plot” of forward rate assumptions has been awful. Most bond market analysts have made rate assumptions that have been awful (and I will add, always always always by assuming rates will be higher than they have been).
This isn’t a criticism of bond market analysts or even central bankers, and it certainly isn’t a criticism of the 10,000 times clients have asked me what we were going to do about “rates that we know are going to go higher” the last 20 years, as they’ve steadily done nothing but go lower and lower and lower. It is a simple comment on the painful task of forecasting the future, particularly with the reality of counter-intuitive forces.
You do you boo
I am happy to offer my fallible take on where things will be in a year because I am not trying to set the price level on the world economy with my prognostication. In other words, there is no power in my assessment; just banter and perhaps marginal opportunity cost in a portfolio. The central banks have real power – and that is a different deal entirely.
But I will join the fray of those forecasting, simply to say that I believe the “consumer price” levels we use as inflation benchmarks will be looking at much-moderated levels a year from now as the host of factors contributing to the data will be moderated themselves. I wish I knew when, and by how much, but at some margin, there is price escalation impact from supply chain disruptions, inadequate access to parts, inadequate completion of products, delayed deliveries to ports, inadequate workers to process deliveries, a shortage of truck drivers to transport products, and a continued escalation of demand for all the things that are facing supply challenges. Will these things experience enough relief in the next 6-12 months to cut half of the inflation level from what we see now? More? Less? I can’t speak with precision here, but I do assume there is material change coming in these aspects of the price level
So then what?
If the inflation rate is materially reduced a year from now and is expected to be such by the powers that be, then I believe the more dramatic expectations of rate hikes will prove, once again, excessive. Therefore, rather than the five, six, or seven rate hikes some are predicting, I imagine the Fed will get to three or four, and then pump the brakes.
And why would they do that if inflation is still elevated?
Because I believe those who have played into a 7% inflation story will now be diminished in their outrage at a 3-4% inflation rate, even as that sits 1-2% above the Fed’s own target. Why? Because an inflation rate that is down 3-4% from prior levels sounds much less scary than an inflation rate is 1-2% above its target level. The math is still the same: a 3-4% inflation rate is unacceptable. But an inflation rate down half from its peak will not create the same outcry the Fed is managing through now and will facilitate a return of the doves.
It’s always political
I am not saying the Fed makes its decisions around what is good for one party or the other, but I am saying it is always political. No central banker has ever wanted the presiding party to be upset with them. The national mood has an impact on policy decisions regardless of who is in power, and that translates into Fed biases and decisions as well. Much like Supreme Court justices known for wanting to “protect the institution” whether their ruling lines up with those on the right or the left, Fed governors do not want to be seen as upsetting the apple cart. Severe actions – let alone ones that invert the yield curve or facilitate recession – are not popular ones to make, and that is true of the Fed whether a Republican is in the White House or a Democrat.
2022 is the Fed’s year to get off the zero bound. Most believe there is little by way of surprise coming in the 2022 midterms (meaning, there is a certain outcome expected, with the primary debate being what the margins will be, not the outcome itself). It is not a Presidential election year. And the headlines of 7% consumer price inflation give ample cover to a decision to go do what has to be done, for now.
And what is it that has to be done exactly?
At bare minimum, the Fed needs to get off the zero bound. I would feel much better at a 2% fed funds rate in the near future but I would settle for 1.5%. I will be shocked if we get even that. But also at bare minimum, the Fed needs to get $2 trillion off its balance sheet. I would prefer $3 trillion (and I think the Fed would as well – a pre-COVID level net of the reverse repos gets you to about $3 trillion of reduction).
I do not believe the Fed will be able to do both. $2-3 trillion of tightening AND 1.5-2% of rate hikes will not be able to happen without two things blowing up on the Fed:
(1) Skyrocketing deficits if the government’s cost of borrowing exploded
(2) Vomiting credit markets if their over-levered balance sheets had to absorb that much impact to liquidity and cost of capital
The final unknowable prediction
And this leads me to what I really can’t forecast, even beyond the unknowability of forward inflation and forward interest rates:
The level at which credit markets revolt.
I know the level of debt built up in the levered loan space. I know the EBITDA of companies that have successfully accessed the high yield space. I know the amount of M&A and LBO’s that have taken place on the backs of today’s frothy credit (all of which includes some great deals, and some terrible ones). And I know there is some level at which credit markets revolt.
The Fed’s high wire act is to try and get off the zero bound and down from current asset levels, and then see natural inflation levels moderate, all before credit markets revolt.
And if they pull all that off they will feel very good.
And if they pull all that off I will feel very lucky. Very lucky indeed.
Chart of the Week
Quote of the Week
“If the Federal Reserve pursues a strong dollar at home while the dollar becomes more competitive in global markets, we can achieve both price stability and a more balanced path of economic growth.”
~ Martin Feldstein
* * *
I wrote a review of Ben Bernanke’s memoir several years back where I criticized the victory lap he was taking over how he managed the financial crisis. Don’t get me wrong – they did a lot right, and they did a lot of unpopular things that many people don’t understand, yet probably saved people from much worse harm than they understand. But they did a lot of experimental things, too, including experimental things that I was (and am) critical of. My comment on Bernanke’s book was that it was too early for a victory lap – we hadn’t “undone” the emergency measures yet, so we couldn’t say with confidence how it would all play out.
It’s February 18, 2022, and I am here to say, the experiments of the last 15 years are not done, they do not yet have a conclusion, and I can’t say with confidence how it will all play out.
The Bahnsen Group will be here to manage through the ongoing experimentation. To that end, we work.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
www.thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
