Managing Ambiguity

“Neurosis is the inability to tolerate ambiguity.”

-Sigmund Freud

Transitory is an ambiguous term. Nothing is permanent, everything changes. Yet if everything is transitory, how can we understand the concept as used by the US Federal Reserve (Fed) in the context of supply, demand and inflation?

The best central bankers use ambiguity strategically. Former Fed Chair Alan Greenspan famously turned opaque communication into an art form. His aim, however, was clear. By veiling his message, Greenspan kept his options open, which is a valuable currency for a discretionary decision-maker.

Current Chair Jerome Powell, on the other hand, is a trained lawyer. Lawyers generally stay away from ambiguity. Or as the late Supreme Court Justice Antonin Scalia wryly observed, “The main business of a lawyer is to take the romance, the mystery, the irony, the ambiguity out of everything he touches.”

Sure, we are poking fun. But there is also a serious point to be made. 

Powell’s use of the term “transitory” in the context of the US inflation outlook is unqualified and stated with confidence. His aim is to reassure through conviction. His terminology seems to be that of a policymaker more worried about setting expectations and reducing uncertainty than he is in limiting his options by eschewing ambiguity.

All will be fine and well if Powell’s words and the Fed’s actions promote a full recovery without a big spike in inflation. They will not be so great if inflation overshoots or any blip overstays its welcome and becomes sustained. In this case, the Fed will likely have to slam on the brakes, which is an outcome markets and society are ill prepared for.

The problem is that we are all in uncharted territory. The pandemic has altered the economic landscape. How much? For how long? We do not know.

Indeed, these will be the central questions occupying investors for the remainder of this year, and perhaps well into 2022. To address them, we must consider three relevant factors—demand, supply and inflation expectations.

Of the three, demand is most readily understood. Following a year of being cooped up, all around the world, people are using vaccination and falling infection rates to venture forth. Bolstered by pent-up demand, soaring household savings rates and transfer checks, US consumers are returning to their national pastimes of shopping, dining away from home and traveling. Globally, the International Monetary Fund estimates that governments have committed over US$16 trillion in fiscal stimulus, which adds to the spending spree.

In normal circumstances, rising demand would elicit higher production and employment. Prices and wages might tick up as well, acting as signals to spur output and to attract resources to alleviate scarcities in markets for materials, semi-finished goods and labor.

Today, however, bottlenecks in production, transportation, distribution and employment appear more widespread and, possibly, more difficult to overcome than in past cycles.

For instance, the most recent Federal Reserve “Beige Book” noted, among others, that:

• Light vehicle sales remained constrained by tight inventories
• Factory output is experiencing “supply chain challenges”
• Manufacturers are reporting “widespread” shortages of materials and labor
• Homebuilders have had to “limit sales” due to supply shortages
• Supply chain disruptions for non-residential construction have “pushed prices higher”
• In job markets, it remains “difficult for many firms to hire new workers,” with many resorting to signing bonuses to attract employees
• Some businesses are “passing through much of the cost increases to their customers”

Similarly, the latest Institute for Supply Management (ISM) survey noted:

• Its highest order backlog since the ISM began collecting data in the late 1980s
• Rising new orders accompanied by falling production and weaker employment, suggesting that the elasticity of supply is constrained despite strong demand
• Anecdotally, respondents reported “record-long lead times,” “wide-scale shortages of critical basic materials,” “rising commodities prices” and “difficulties in transporting products.” They also reported “shutdowns due to part shortages” and “difficulties in filling open positions.”

 Pinch-points are global, with shortages of intermediate and final goods reported in Europe, Asia and South America. Shipping is part of the problem. Freighters are reporting wait times of over two weeks to dock at US West Coast ports, delays unheard of in the past. Onshore, less than a third of US workers have returned to onsite work, according to employer surveys.

It is unclear how long bottlenecks may persist. In the US labor market, for example, the labor force participation and employment-to-population rates remain below pre-pandemic levels, despite strong job gains in the most recent monthly employment report (nonfarm payrolls up 559,000 in May), a falling unemployment rate and widespread job vacancies. Rising wages, up 0.5% month-on-month in May following a 0.7% advance in April, suggest that employers are having to pay up to lure workers back.

Shifting attitudes about work might be transitory. Once extended unemployment benefits expire, more Americans might go back to work the old-fashioned way—on the job, for stagnant wages.

In short, the jury is out on how quickly supply, across various dimensions, will respond to increased demand. Shortages may lift prices and wages even more and for even longer, beyond what is already underway.

That could matter because inflation begets inflation. Economists disagree plenty, but they agree that when it comes to inflation, expectations are decisive. Once workers, consumers and businesses expect prices and wages to go up, they change their behaviors, accepting price increases more readily, but also demanding them from employers and customers.

There is considerable disagreement among economists about how inflation expectations are formed. In abstract models, agents anticipate price and wage shifts based on rational assessments of the future. In the real world, ordinary people probably form their inflation views on what is happening around them.

The risk, therefore, is that bottlenecks limit supply responses for longer, leading to more sustained increases in prices and wages, which in turn beget self-fulfilling expectations of more to come. That feedback loop is not what most of us would consider “transitory.”

Markets are not anticipating a sustained inflation overshoot, with two-year bond yields exceeding Treasury Inflation-Protected Securities (TIPS) yields by a larger amount than equivalent five- or ten-year bonds. With bond yields being low relative to history, there is an appeal of equities as a source of total return. However, with real (inflation-adjusted) yields being negative across advanced economies and equity valuations at above average levels, there is not much cushion if the Fed or other central banks have to tighten monetary policies, slow growth and dent earnings. 

For investors, coping with the unexpected requires actively managed strategies. Adding inflation hedges, including commodities or inflation-protected bonds to broader holdings of stocks, bonds and real estate makes sense. Diversification, sound financial planning and patience will allow investors to accept short-term volatility with an eye toward long-term achievement of their goals.

Accepting ambiguity is healthy. As Freud pointed out, living with ambiguity is foundational to sanity. Prudence, planning, diversifying and not overreacting to short-term volatility is also financially sound.

Of course, it might also be advisable for the Fed to consider a bit more ambiguity in its messaging. Investors can cope with uncertainty—they don’t always need their hand held. As for the rest of us, we are more likely to be reassured by humility, not false bravado.

As always, it is important to gain many views when making investment decisions. For truly independent views on where the future is headed, see:  

US: “Why Our Managers Disagree On Inflation, Rates and Growth”, our latest Global Investment Outlook: “Inflation, Rotation and Opportunities” and our latest Macro Perspectives: “Growth, rates and inflation”  

Non-US: “Why Our Managers Disagree On Inflation, Rates and Growth”, our latest Global Investment Outlook: “Inflation, Rotation and Opportunities” and our Macro Perspectives: ”Growth, rates and inflation”  

WHAT ARE THE RISKS?

 All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the portfolio’s value may decline. In general, an investor is paid a higher yield to assume a greater degree of credit risk.  Investments in lower-rated bonds include higher risk of default and loss of principal. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed.

Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.

Past performance does not guarantee future results. Diversification does not guarantee profit or protect against risk of loss.