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The Pain Period Will Continue

Published on: Aug 02 2022

We’re in the pain period of the economic and investment cycle. The pain began when inflation accelerated in the first half of 2022. The pain has increased since the Federal Reserve decided it was wrong about inflation and had to tighten monetary policy more than planned. The Fed fell so far behind in dealing with inflation that now it must reduce demand and economic growth to curb inflation.

Economists call this demand destruction. Investment markets always respond to tighter monetary policy before the economy. The more an investment depends on liquidity, the more vulnerable it is when the Fed drains liquidity from the economy.

That’s why growth stocks and digital currencies tumbled the most in the first half of 2022. But almost all assets falter when liquidity is reduced. In other words, there aren’t many places for investors to hide. The economy reacts to monetary policy changes with a lag, and we’re starting to see the affects on economic growth. Some retailers reported lower sales and slashed prices on excess inventory.

Housing sales are down, and mortgage rates increased quite a bit. Some businesses have announced layoffs. But the signs of slower growth so far are modest. Some businesses are suffering because inflation causes consumers to make choices. While compensation is rising at the highest rate in decades, prices are rising faster. Consumers have less purchasing power, because real incomes – factoring in inflation – are declining.

So, consumers must make choices. There’s less demand for goods and services consumers don’t view as the most essential. Consumers accumulated a lot of savings during the pandemic. In 2022, they dipped into savings to sustain spending as prices increased faster than incomes.

That isn’t sustainable, and the latest data indicate consumers stopped dipping into savings to spend. Many analysts forecast that the bear market in stocks is nearing an end. They point out that stock indexes declined more than 20% from their peaks and many stocks are trading at reasonable valuations.

Market prices, especially the breakeven inflation rate, indicate investors expect inflation to be tamed after modest tightening by the Fed. After that, we’ll be back to looser monetary policy with low inflation, low interest rates and rising stock prices. But the Fed can’t change policy until there’s enough weakness in the economy to bring down inflation.

I believe inflation won’t decline as quickly, since it is priced into the markets. The monetary excesses of the last few years ignited inflationary forces. In addition, secular trends that kept a lid on inflation for 20 years and longer are fading.

Commodity prices are high. Globalization and free trade are in retreat. Productivity growth is weak. Labor and products are in short supply instead of being abundant. If inflation doesn’t decline quickly, the Fed will have a tough choice to make. The Fed doesn’t want inflation embedded in consumer and business decisions the way it was in the 1960s and 1970s.

Inflation becomes self-perpetuating when that happens. But the Fed also wants to avoid a recession. The economy still hasn’t healed from the financial crisis, and the Fed has far fewer tools to combat a recession than it once did. A likely scenario is that the Fed opts for stagflation. It doesn’t tighten monetary policy enough to either cause a recession or bring inflation back to its targets. Instead, it loosens monetary policy when inflation declines to 3% to 4%.

Don’t expect the Fed to put a floor under stock prices and rescue investors. There will be bear market rallies in stocks and other assets and occasional declines in interest rates. But those will be temporary trends until high inflation expectations are diminished. There won’t be sustained rallies in stocks and many other investments until it is clear the Fed will loosen monetary policy.

Inflation and Fed policy could turn sooner than I think. That’s why we have several funds with flexible strategies that can change positions quickly with the markets and economy.

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