Issue 10 - The Inflation Apocalypse

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The Inflation Apocalypse

Once upon a time, back in the ' Not so Swingin' Seventies ', we experienced a phenomenon called inflation. This was an age when there were no cell phones whilst P.C's and cassette tapes were relative novelties and the internet was no more than the far-fetched theory of a crazy scientist.

Most present-day traders were not around during that era & certainly not as active participants in the financial markets. They were more likely outside, playing ' Cowboys & Indians " or indoors watching ' Scooby-Doo ' on the single-channel, black & white, manually operated TV. Consequently, the ' Institutional Memory ' of inflation is not that strong and I fear that this may have repercussions for current-day financial markets.

As human beings, we rely on our memory as a suite of reference points. When something happens, we remember what the consequences were, the last time it happened. We recall how painful it was & we remember what was the required action to mitigate or prevent it.

So what happens when, as a group, we have no meaningful memory of something? Most likely, we take a complacent perspective. We underestimate the threat. We can't immediately bring to mind the tools & weapons required to tackle it and invariably we risk letting it become out of control.

This is where we are, right now, with inflation. Thanks to massive negligence from the Federal Reserve & the implementation of the most reckless monetary policy in the history of the state, allied with unprecedented government spending, we have ' let the inflation genie out of the bottle ' where it had laid dormant for 40 years. The Fed has not been called to account for their misbehavior as most of the people who are about to be impacted are completely unaware of the damage that this heretofore ' hidden dragon ' of inflation, is about to unleash upon them.

Not only is the Fed deeply complicit in the inflation problem we now face but chairman, Jay Powell, deeply misled us into believing it was ' transitory '. Any student of economics knows that inflation is a lagging indicator, in the sense that it is the result of actions taken 12 to 18 months earlier. Therefore, if you want to tackle the risk of rising inflation, you need to ' nip it in the bud ' before it actually happens. So, once it shows up in inflation expectations or in the cost of primary commodities or in wholesale prices, a competent central bank would already be tightening policy.

However, America no longer has a competent central bank and we now have an inflation rate of 7.5% which, most people would acknowledge, substantially underestimates the actual increase in living costs for the average man or woman.

So that's how we got here. More importantly, what are the likely consequences over the next few years and how will they likely play out in the financial markets?

Given that I'm not always ' The sharpest tool in the box ', I have taken a variety of perspectives, as recently reported by the insightful scribes at Seeking Alpha, before adding my analysis.

Market turmoil:?" We'll see a return of the volatility that was prevalent for most of January in the wake of this [CPI] report," said Brian Price, Head of Investment Management at Commonwealth Financial Network. " Investors may want to buckle up for a rough ride until inflationary data starts to abate & I expect that it will, as we move through the year."

It's everywhere:?" What started as pandemic-specific inflation has broadened across many categories on the goods & the services side," explained Kathy Bostjancic, Chief U.S. financial economist at Oxford Economics. " It reflects supply constraints in the goods market & the labor market & still strong demand, particularly from U.S. consumers."

Consumer sentiment:?" This survey is showing that there's a lot of financial anxiety caused by inflation, market volatility & uncertainty coming out of the pandemic & the impact that it has had on everyday lives," added Celeste Revelli, Director of Financial planning at eMoney.

Hard on the wallet:?"A lot of people are hurting because of high inflation. The average U.S. household is spending an additional $276 a month - That's a big burden," estimated Ryan Sweet, Senior Economist at Moody’s Analytics. " It hammers home the point of " What is the cost of inflation? "

Wage-price spiral:?" If consumers & workers believe that inflation is not going to be transitory, they're going to start demanding higher wages so higher inflation becomes embedded in the system," declared John Briggs, Head of Strategy for Americas at NatWest Markets.

Let it play out:?" I certainly can relate to how people are feeling. I am somewhat optimistic though," announced Dr. Michael Greiner, Economist at Oakland University. " While we're seeing a jump, the amount of the jump is actually decreasing. Over the long-term, this is really going to be a short-term problem."

The White House:?"According to Nobel laureates, 14 of them that contacted me & a number of corporate leaders, it ought to be able to start to taper off as we go through this year," President Biden said. " In the meantime, I'm going to do everything in my power to deal with the big points that are impacting most people in their homes."

Supply chain:?" While we're hopeful prices will begin to decline in the coming months, prices at grocery stores & restaurants may take longer to adjust downward," noted Jonathan Silver, CEO of Affinity Solutions, which tracks consumer purchasing habits. " We're unlikely to see a full correction in the supply chain until later this year or even 2023."

Policy error??" The first error occurred on Nov. 30, when the Fed finally retired ' Transitory,' " pointed out Mohamed El-Erian, Chief Economic Adviser at Allianz. " Now, the policy error would be to slam on the brakes because they didn't take their foot off the accelerator early enough."

Forex watch:?" If the Fed is to step hard on the monetary brakes, we would favor the dollar against the low yielders backed by central bankers who have firmly placed themselves in the dovish camp," said Chris Turner, Global Head of Markets at ING

So, what will happen next?

Firstly, we need a sense of perspective. Last week's movements on the bond market have caused many market participants to become stressed about ' massive volatility '. Seeing the 2-year rate rising by 1.2% has been a major shock to them. This reaction bemuses me as I was an active trader during the Volcker era, where we experienced volatility on a far greater scale. I can remember the Fed making interest rate hikes of 50bp in successive weeks, every time the M2 money supply exceeded its designated target.

So we people complain about volatility, it always brings this scene to my mind.

Most pundits & financial experts see inflation moderating substantially over the course of the year as supply chain problems ease and recession beckons. They see the Fed Funds rate peaking at 2%, partly because they believe that the Fed will blink once the stock market swoons and will put all tightening measures on hold until the financial storm abates.

I may be an outlier but I see things differently, especially with regard to the likely inflation outcome and most likely with regard to interest rates also. Every person, who is bold or brazen enough to put a forecast out there, should be able to back up their perspective with a substantial, well-founded rationale - so here's mine :

• The supply chain will take 2 years to materially resolve. The resolution will come from two primary sources - elimination of labour shortages at the ports of exit & entry &. ' onshoring ' of substantial production facilities. This requires building new plant including site acquisition, planning approval, build completion & staffing up. Intel estimates 3 to 4 years before it's new microchip plants will be up & running. Microchips are the most important of all items in terms of fixing the supply chain.
• The whole ' Green Energy ' initiative is adding substantially to energy costs. Similarly, Russia is becoming more political in its energy policy. Neither of these elements is likely to change anytime soon. A recession will eventually impact energy prices but this may take a while.
• Monetary policy takes 12 to 18 months to take effect. The Fed is only beginning to start to tighten policy and it's miles behind the curve.
• Normally, it requires interest rates ABOVE the rate of inflation to impact sufficiently for material inflation reductions. As the current gap is a full 7.5%, that would require over thirty 25bp rate hikes or fifteen 50bp rate hikes. This is simply not going to happen and even if it did, it could take over 4 years even with a rate hike at every FOMC meeting.
• Inflation is already everywhere - in basic commodities, in wholesale prices, in retail prices, in wages. Most wage agreements last 2 to 3 years so they cannot simply be reversed at the first sign of recession.

So I see inflation remaining above the Fed's mandate 2% target for a number of years and maybe even substantially above. The Fed's current year-end forecast of 2.6% is just as laughable as their previous forecast that inflation would be ' transitory '

Accepting that inflation does remain high, one then has to calibrate how that development will manifest itself in terms of stock & bond market outcomes as that is ' where the rubber meets the road '. This is where things become exceedingly difficult as a judgment needs to be made as to where the Fed's ' pain point ' is, as well as to what extent they are willing to abandon their ' inflation-fighting credentials ' in order to save the stock market and/or the economy.

Jay Powell has a Rubik's cube that has no solution. Taming inflation will crash the economy and the stock market. There is way too much low-rate debt out there that is not sustainable under a materially higher interest rate regime. Most market participants believe that the Fed will blink when the stock market starts to crash & that they will effectively restore the ' Fed Put ', albeit at a lower level.

My perspective is that although the Fed peddles the illusion that it is ' all-powerful ' and ' in control ', this has never actually been the case. It has relied on the belief of market participants and the world at large which, so far, has been on its side but will likely now start to dwindle.

The Fed has enabled a fake world of billion-dollar companies that will never be profitable, SPAC's that have no value and many of whom are fraudulent, cryptocurrencies with massive valuations that are essentially worthless, NFT's that will prove to be the most idiotic purchase of all when the economic history books get to be written.

The probability is that this, totally unstable, ' house of cards ' is likely to collapse soon. The Fed may be able to keep things levitated for a while longer if they ' pump up the money printers ' one last time but the era of free lunches is about to end. If one looks at the level of insider sales over the last 12 months, the ' smart money ' has already ' left the building.'

Chuck Prince famously said, in 2006, " As long as the music's still playing, I'm still dancing "

The record is starting to scratch

?Life Lesson #10 - 1989 - The House always wins

I mentioned in a previous issue that traders love to gamble & I was certainly no exception, especially in my younger days. Sport is a great vehicle for gambling as there are so many events & so many possible outcomes and of course, we are all experts - or so we think.

I was a soccer fanatic and most of my bets revolved around football as I usually felt that I had an edge due to my extensive knowledge. However, as time went by, I became aware of the attractions of betting on golf. Tiger Woods had not yet arrived on the scene and golf was a sport that invariably had the widest possible number of potential winners. After initially placing bets on individual golfers in major tournaments, a light bulb went off in my head, one day and I decided to ' run a book ' on a full tournament, in this case, the 1989 U.S Masters.

As the ' book runner ' I was essentially taking bets from everybody. Being part of a community of like-minded traders, it was easy to attract a large selection of bets on different golfers. At this stage, I had become astute enough to understand the concept of ' arbitrage ' ie. the idea that one could make a closed bet with a guaranteed profit and I worked out that if I took in enough bets to cover my largest possible individual exposure, I was essentially in a ' no-lose ' position. So, I worked, by varying my prices, on attracting a variety of bets on a wide range of players and avoided too large an exposure on any single golfer.

By the time I had ' completed the book ', I had taken a total of 60 bets across 16 different golfers. The total amount gambled by my ' punters ' was 2,000 pounds, which, not coincidentally, was the maximum exposure I had on the most heavily-backed golfer.

So far, so good. An exciting tournament proceeded on the beautiful fairways & greens of Augusta National in sunny Georgia. The first 3 days were relatively uneventful with no clear leader ' emerging from the pack ' and we reached the final day with six players still in contention. The good news was that only one of the six had been backed with me. That one golfer was Nick Faldo and he was way down in 6th place, 5 shots behind the leader. So what could possibly go wrong?

Anyway, let's not get ahead of ourselves. I sat down, in front of the T.V, to enjoy the final round of the Masters and was already mentally ' counting my winnings. ' My darling wife went to my briefcase to grab the newspaper and out fell this massive list of bets. " What's this ? " she asked. Having been totally rumbled, I explained the story to her, noting that I had no risk to lose any money and I ' threw in a sweetener ' by telling her that she could buy a new outfit with part of my winnings.

So now, even though she had zero interest in golf, she sat down to watch the last round, whilst contemplating what latest fashions she could acquire in the local boutiques. Bear in mind, that we live in Ireland so this was an evening start for us with the likelihood of it being well past midnight before the tournament was over.

As it happened, it was 2am (GMT ) before the tournament finished as it required a play-off. That British bas***rd, Nick Faldo, despite still being 5 shots behind with 7 holes to play, ground his way closer & closer, hole-by-hole until he passed the overnight leader, Ben Crenshaw & equalled the new leader, Scott Hoch, on the 18th hole.

But wait for it, it gets worse. In the ultimate play-off hole, Hoch had an 18-inch putt to win the Masters. Let me say that again EIGHTEEN INCHES !!!! Hoch stepped back, looked and assessed this tiddly putt from forty-seven different angles and then missed it.

So my wife, who hates golf, had watched almost 5 hours of it until way past bedtime, only to find that there would be no shopping in Dublin's finest boutiques and that her husband wasn't as smart as he thought he was.

Nick Faldo went on to win six major tournaments, thus becoming one of the all-time greats of the golfing world. Scott Hoch, thereafter nick-named ' Scott Choke, ' never won a major. John Coffey ' cried into his soup ' for a few more days and then got on with life.

So, what's the moral of the story? Well despite my failure to win, the point was that I hadn't lost and but for one of the most incredible comebacks in the history of golf, allied with what is commonly regarded as the greatest miss in golf history, I would have profited handsomely. I ran books on a couple of other golf tournaments subsequently and also on a few horse racing events. I never lost and a few of them turned out to be quite profitable.

I gave up running books after that as I became extremely busy at work and accumulating such a large number of bets was pretty time-consuming but I never forgot that the house always wins.