Stagflation: From Monetary Policy Afterthought to Center Stage

Stagflation: From Monetary Policy Afterthought to Centre Stage

?Recession is coming. Even Cardi B knows. The American rapper and songwriter recently tweeted “When y’all think they[‘re] going to announce that we[‘re] going into a recession?” ?Readings on the economic barometer are materially different than the beginning of the year when the World Bank cheerfully pointed to 4.1% economic growth and 3.3% consumer price inflation for the global economy for the year.

Since then, Russia’s invasion of Ukraine coupled with China’s strict covid lockdowns and a world struggling to shake off the pandemic, have impacted energy markets, supply chains, food prices, financial markets, and the price of Bored Ape Yacht Club NFTs. ?The forecast for world economic growth has been lowered sharply to 2.9%. ?And although economic activity is still positive, and even buoyant in places, there is a growing worry that this could come to a sudden stop, led by the world’s biggest economy going into recession. The University of Michigan Consumer Confidence Index slumped to a 50-year low of 50.2 in early June, and just over half of the 1,500 Americans surveyed by YouGov think that the US economy is already in recession. Reflecting global trends, China’s original economic growth target of 5.5% for 2022 was once viewed as readily achievable; it is now seen as ambitious – and possibly beyond reach. In late May, Premier Li Keqiang, speaking to government officials, indicated that the short-term goal is to prevent the world’s second biggest economy from contracting in the second quarter of the year.

Adding an Inflation Insult to the Economic Growth Injury

Adding to the economic growth injury, the rate of consumer price inflation has stepped up smartly across markets. Consumer price inflation is now running above the target range in all 12 advanced economies that target inflation. The same goes for 27 of 31 emerging markets that have inflation targets. While post-pandemic global demand, extreme weather, tightening food stocks, supply chain bottlenecks, and export restrictions have been straining markets for two years, energy prices and oil firms have primed the world for higher inflation. Consumer price inflation is running at 8.6% in the US – a 40-year high – and a record 8.1% in the euro-zone economy. The pain inflicted by inflation provoke US president Joe Biden to jibe that “Exxon made more money than god.”

?You can try to run from inflation, but you can’t hide from the data – and the big idea that inflation is “transitory” and that it will soon pass has seen the term flagged for the swear jar of business news channels. Inflation is here and – if history is any guide – recession is coming. There is a temptation to reach for the fruit of the wisdom tree and suggest that the most dangerous words in investing are “this time is different.” However, there is good reason to believe that this time is different – but not in a good way. Circumstances are more stressed than the 1970s when the world economy was last locked in the jaws of the stagflation vice. Government balance sheets are strained, with the ratio of government debt to gross domestic product (GDP) twice the level it was at the end of the 1970s; worldwide corporate tax rates are half the level of the early 1980s; and the Greenspan put has been exhausted. Stagflation has moved from the appendices of monetary economics to center stage in the theater of capital markets and central banking; and the policy levers of easy money and free spending are – well – spent. ??

?Always and Everywhere a Monetary Phenomenon

Yet markets and central bankers seem to be far more sanguine. The Federal Reserve Bank of St Louis’ T5YIFR series, which is a measure of expected inflation over the five-year period that begins today, suggests that consumer price inflation in the US will average 2.4% over the next five years. However, the last two years has seen the US money supply (M2) grow by a little over 40%. Given Milton Friedman’s famous dictum that “inflation is always and everywhere a monetary phenomenon” it is hard to reconcile the pace of printing in the US with this benign inflation outlook. ?

Source: Federal Reserve Bank of St Louis (2022)

Further, although central banks as far afield as Australia, Brazil and Canada have started to tighten monetary policy, the punch bowl has been on the table in the world’s biggest markets for a decade or more. The Taylor Rule, which proposes how central banks should change interest rates to account for inflation and other economic conditions, suggests that the Federal Reserve (Fed) should be targeting an interest rate of around 6.5%. Although the Fed has just raised interest rates by 75 basis points – the biggest increase since 1994 – and Chair Jerome Powell signalled interest rates would rise even further this year, to 3.4% by December and 3.8% by the end of 2023, the Fed is still far behind the curve. With this comes the risk that policy makers lose control of inflation altogether, as it moves from “too much money chasing too few goods” to entrenching itself in the psyche, behaviour, and beliefs of people.

We cannot be certain of any economic forecast, but it seems that the die is cast for a period of low economic growth and high price inflation. The implications are significant. Writing 100 years ago, John Maynard Keynes observed that “there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency” and “the process of wealth-getting degenerates into a gamble and a lottery."

Investing in a World of Debauched Currencies, Gambling and Lotteries

For investors, there are important implications. The first implication is to underline Keynes’ point that the greatest destroyer of wealth is inflation. Whilst an extreme example, the case of Brazil makes the point. Having experienced an average inflation rate of 90% per annum over the past 40 years, the Brazilian real today buys one trillionth of what it bought in 1980. Inflation eats while people sleep.

A second implication is that investment impacts can come suddenly. And, at the same time, they can be arbitrary and nontrivial. Consider the ubiquitous 60/40 portfolio, a default investment position for decades. Bank of America calculates that, adjusted for inflation, US portfolios that are allocated 60% stocks and 40% bonds are on pace to lose half their value this year. Far from providing protection by being decorrelated, the correlation between stocks and bonds is now the highest in a quarter-century with the diversification across these two major asset classes offering no meaningful protection.

Third, we can blame war, supply chains, and welfare cheques for price inflation. But this is a convenient truth. The source of inflation is easy money, and the ease with which money has been printed, which started as a cure for corona virus, has morphed into a huge policy mistake. To cure inflation will require bold monetary policy action.

An Inconvenient Truth

Even if the Fed and others wake up to the inflation reality, the key policy instruments used to brake inflation have lags of up to two years. And the effects are uneven across economies. For instance, Australia, Spain, Ireland, Korea, and the United Kingdom are dominated by adjustable-rate mortgages, whereas fixed-rate mortgages are more common in Canada, Denmark, Germany, the Netherlands, and Switzerland. Yet central banks generally are obliged to act in lockstep, which further blunts the tools of monetary policy.

With blunt instruments in the hands of central bankers, investors should not be duped into believing that there is a silver bullet that kills inflation quickly and painlessly. In Europe, Bloomberg’s chief economist for the region, Jamie Rush, notes that the European Central Bank (ECB) is losing control of the narrative around rates, potentially inviting a sovereign debt crisis even before the first hike of the European cycle. The precarious circumstance in bonds markets has the ECB reaching for a monetary bazooka to vanquish “fragmentation” in the Spanish and Italian markets, potentially hosing more funds into the market at the exact moment that inflation dictates that liquidity should be withdrawn. This underlines the reality that while it is tempting – and human – to hope for quick and easy fixes, hope is not a strategy. There is no substitute for tough decisions, circumstances are complicated, and there are hard yards ahead.

There is no time in the past 70 years that inflation in the US has been brought below five percent without causing a recession. To add fuel to the inflationary flame, we entered this period with elevated expectations for corporate earnings growth, and valuations on equities and bonds are meaningfully higher than the last hard monetary lockdown of the 1980s. In that last big stagflation, the S&P500 entered the 1980s on 16?times earnings; it enters this period on 24 times. And 10-year US bonds went into the 1980s yielding 10.7% with inflation running at 13.9%, US bonds entered June 2022 yielding 3.0% with inflation running at 8.6%.?The risks to global economic growth and investment values are high. ?

Source: Genera Capital (2022)

We need a benign outlook if we are to expect conventional approaches, like the 60/40 portfolio, to produce positive real returns over the next five years. This time is different – and not in a good way – which requires a different investment approach. In this setting, it is hard to believe that “more of the same” and “hang on for the anticipated recovery” will cut it.

?More of the Same Won’t Bring More of the Same

?If fair value models have gravitational pull, it would not be surprising to see purchasing power parity re-assert itself after the dollar’s 15-year domination in currency markets. If this is the case, it means an important part of portfolio construction involves holding currencies other than the dollar. Also, a receding greenback would be positive for dollar-priced assets, including gold, precious metals, and hard and soft commodities. That said, the case for commodities is especially tricky because recession can easily take commodity prices off a cliff. Recall the price of oil futures going below zero in early 2020. Arguably, exposure to dollar-priced commodities would be better managed by using long-short positions to capture mispricing, rather than trying to own structural drivers of commodity prices.

Given the vulnerability in credit markets, healthy doses of credit insurance also could pay off handsomely – especially in the BB and C market where yields seem to be far too kind given the economic reality. In this vein, if the toxic stagflation cocktail sets in, asset-backed private credit could be one of the few investment classes that produces equity-like returns. That said, this investment class requires commitments of five years and more, underlining the point that private credit only makes up part of a portfolio in an inflationary setting – or any other setting, for that matter.

A Two-By-Two for Tough Times

A related asset class that could offer portfolio protection, and some capital growth, in the face of stagflation, includes business development corporations. By way of example, Ares Capital Corporation offers a well-diversified portfolio made of up 395?portfolio companies, trading at a discount to net asset value of $19.5bn and yielding 9.4% in US dollars. When the winds of inflation blow hot, and the tide of economic growth goes out, different assets and different business models are needed than the default stance taken since the end of the last stagflation. Businesses with products and services that are relatively insensitive to income and price inelastic – like healthcare firms, software as a service, utilities, and payments firms – could also make for solid investments in tough times.

While policy makers fiddle with economic levers, investors can get a firm grip on stagflation by seeing the danger in the belief that “this too shall pass” and considering assets that are designed for a world in which Cardi B’s tweet becomes our economic reality.