The Fed Gets Serious
Checking in on the most pressing economic issue
As before, please continue to consider donations to Ukraine. 3.5 million Ukrainians are now displaced, the number increases every day. This AP story about the siege of Mariupol is a vivid example of the awful conditions on the ground. You can find the link to UNICEF Ukraine here
While the Ukrainian army achieved its first territorial gains amidst increasingly belligerent domestic Russian rhetoric, recent economic data brings back the issue of inflation for Western economies. With much delay, the Fed has become more serious in its fight against it. This post picks up on recent developments, and provides some specific framing on what more forceful Fed action could mean going forward. It concludes with a brief review of the opposing arguments
To start, let’s briefly recap how inflation works. Simplified, the sources of inflation can be broken down into two categories:
Demand-shock: In this instance, new money is “printed” and distributed, e.g. via stimulus cheques. This increases demand as people spend it. To balance the excess money with available goods and services, first, businesses try to boost production. When that has reached its limits, prices increase until equilibrium is re-established
Supply-shock: In this instance, the amount of money in circulation remains the same, but businesses have to reduce their goods and services, e.g. because an external shock restricts raw materials. In this case production can’t be expanded, but again, prices increase until money and goods/services return to equilibrium
Following COVID-19, we experienced both
The US fiscal stimulus added an excess ~$2 trillion1 to the economy
At the same time, COVID-19 restrictions temporarily decreased productive capacity, a modest supply-shock
Given the monumental stimulus size, US inflation is largely demand-driven
Because of the dominant US-weight in the world economy, a spike in global energy prices ensued2. This created supply-shock inflation for energy-import dependent Europe, which was further exacerbated by the war in Ukraine
For this reason, European inflation is largely supply-driven
Turning to the US, in a demand-shock, production and prices adjust upwards. Sounds like a one-off event, so far so good?
Unfortunately not - something else happens: With explosive demand, the labor market goes from a balanced state into an overheated state
To fulfil demand, companies staff up substantially
At the same time, some job seekers leave the labor market, e.g., because of asset price gains, or plenty of job offers that remove a sense of urgency
Companies respond to this with substantial salary raises. In an overheated labor market, this sets the dreaded price-wage spiral in motion
While higher wages first sound like a good thing, the same companies then increases their prices to compensate for the higher cost
Because they just received wage increases, consumers can pay these higher prices
As consumers’ cost of living goes up, they demand higher wages. Companies accept these demands because they are desperate to hire
Amongst other behavioral changes3, this is the reason why demand-shock inflation is of an accelerating nature
By now, there is plenty of anecdotal and statistical evidence that in the US, the price-wage spiral is in full swing
This is different in Europe, where inflation is supply driven. However, in a global economy, Europe imports inflation from the US (1) via higher commodity prices and (2) via a weaker Euro, which increases import costs
Once inflation is in the system, it can be resolved in an orderly or disorderly way
The orderly way: Central bank use their power to restore balance between money and goods/services by decreasing the amount of money available. This occurs via interest rate increases and/or a process called Quantitative Tightening (I’ve previously discussed QT here)
The disorderly way: Inflation keeps running unchecked. Prices for commodities, which form the basis of all physical goods, run out of control and become unaffordable for large parts of the population. Distribution conflicts ensue, bad actors with commodity supplies are emboldened, eventually the economy crashes
At the moment, we are somewhere in between
Locked-in by their public forward guidance, the Fed was very slow to react to the increasingly obvious inflation issue
This has caused much damage already. It is no coincidence that Russia’s attack on Ukraine occurred at moment of spiking commodity prices, just like the Saudi oil embargo in 1973, which caused a similar supply-shock to the Western world
In fact, the parallels are somewhat eery. Take Jimmy Carter’s speech from 1977, where he asks to US citizens to turn down their thermostats. The same proposals circulate again, just as the car-free Sunday which was introduced in Germany in 1973
Under increasing pressure, the Chairman of the Fed, Jerome Powell has made it clear that he wants to go down in history as the man who fixed the mess, even if it comes at a cost
At a congressional hearing last week, he described his predecessor Paul Volcker, who successfully tamed inflation in the early 80s with aggressive rate hikes that caused a recession as the “greatest public servant” of that era
At the same hearing, he was asked whether, like Paul Volcker, he was prepared to do whatever it takes to reign in inflation, even at the expense of economic growth
Please keep in mind, historically, inflation has never been tamed without a recession. Powell implicitly acknowledged this in a speech yesterday where he stated a “soft landing” to be a “challenge”4. In the same speech, he also reiterated his resolve to become more aggressive against inflation
Summary: We may be close to peak inflation. But not because it’s about to roll over naturally, the contrary. We may be close to peaking because the Fed is now very actively determined to bring it down, and likely to act much more forcefully soon
Ok, so we can expect some decisive action. But what does that mean in practice? By how much would the central bank need to raise rates?
For that, we need to look at the concept of “real rates”. These are nominal interest rates minus inflation, the real cost, so to speak
If real rates are negative, credit is extremely cheap. That is because, all else being equal, the “real” value of your loan shrinks over time. Who wouldn’t love that?
And unsurprisingly, with real rates deeply negative, there is now strong loan growth in the US, +5% for the first quarter
And even though mortgage rates have increased by 2% since the beginning of the year, there is absolutely no respite in the US housing market - the cost of a mortgage is still lower than the pace of inflation, so why not lever up and buy a house?
This is highly inflationary. First, because it distorts the housing market and second, every new loan is newly created (“printed”) money. Banks only need to hold a fraction of equity against it
For this calculus to stop, real rates need to be visibly positive. One metric to assess this is the 10-year real rate, which includes inflation expectations over the same time frame, not just today. It currently tracks at -0.5%
For 10-year “real rates” to be visibly positive, say at 1-3%, the 10-year nominal rate would have to rise to 4-6% (4-6% - 3% 10-year inflation expectations = 1-3% 10-year real rate). It currently trades at 2.15%
For Europe, the corresponding interest rate would be ~2-3% for the German 10-year Bund. It currently trades at 0.45%
Please see the Addendum for a discussion on whether the economy could stomach higher rates
I’ve discussed in several prior posts how these higher rates affect all asset classes, with the rule of thumb - the more “duration”, the more downside. But for now, let’s see what a US 10-Year government bond yield at 4% would mean for US equity market valuations
Remember, as discussed, all Western “risk” assets are priced off the yield on US government debt. This is because the Western economic system is built around the US Dollar, thus US government debt represent the ultimate “risk-free” rate
As such, we can derive the fair value of the S&P 500, by decomposing its valuation between the safe US 10-Year, and a % premium on top for the higher risk that equities represent (“Equity Risk Premium, ERP”)
Over the past 7 years, the ERP hovered around 3%. Let’s add 4% for the US 10-year. This equates to a 7% earnings yield, or a 14x PE ratio. Applying 14x to the current 230 earnings estimate for the S&P (“EPS”), gets us to ~3,300
Please keep in mind the following when assessing these numbers:
This assumes no recession occurs. In case of a recession, the 230 EPS estimate is too high
Irrespective of the fact that historically no inflationary period was brought down without a recession, if Russia doesn’t return to global commodity markets soon, a recession is almost a mathematical certainty
On the other hand, inflation has shown to be very good for corporate earnings. In case of a soft landing (I think unlikely) and a timely resolution of Russia, the earnings estimate is too low
One may also have the view that rates stay at, say 4% only briefly and settle at a lower level after inflation is tamed. Please see the Addendum for my view on where rates could settle in the long run (I think they stay higher)
You can apply the same mechanics apply to all asset classes. I’m simply using the S&P 500 as most prominent example
What does that mean for markets?
A note at this point - as you may have noticed, these posts reflect the research process for my own investments. With this in mind, rather than making explicit recommendations, I try to provide context that you might find useful for your own decision making. Nevertheless, this section is always included as a way to “connect the dots”
I had described in the last few posts how very negative sentiment provided the ground for a bear market rally, and we’ve seen the Nasdaq now up ~13% from its recent lows
I think it’s likely that this is now closer to its end than its beginning, and the downtrend likely to resume again soon. I would use the opportunity provided by this to sell, or go short long duration (e.g., Nasdaq-100)
Keep in mind, if asset prices rally much further, they increase inflation. The Fed will work hard to avoid that - “Don’t fight the Fed”
Commodities likely continue to squeeze until either they create demand destruction, or until the Fed cools off demand. We are getting closer to each, but aren’t there yet (well, in fact, for Diesel we seem to be there). I had mentioned oil services before in this context (ETF:OIH)
Over the medium term, the combination of higher rates and a recession represents significant downside for all risk assets - Cash is King
Cash can be used for consumption or liquidity purposes. The former is impacted by inflation, the latter by asset prices
In a declining asset price environment, cash held for liquidity purposes does not lose its value
ADDENDUM - A BRIEF REVIEW OF ARGUMENTS AGAINST HIGHER RATES
The biggest argument against higher rates is that there is too much debt and the US economy couldn’t handle it. This argument is, in my view, invalid for the following three reasons
First: The US private sector has massively delevered over the past 15 years. The government less so, but government debt is not of the same quality, the US government can never default on its own-currency debt. It’s the private sector that matters (I discussed this in more detail in “The Blind Spot”)
Second: Corporate debt, private mortgages and government debt have all been refinanced to longer maturities. Take corporate debt as example, the average maturity has doubled over the past decades. This means it takes a long time until the existing stock of debt has entirely been replaced, at higher rates
Third: The interest rate sensitivity of the economy has gone down. Debt-financed, capital-intensive sectors are less prevalent, and modern formats such as IP-based businesses play a bigger role
That leaves the question, where do interest rates go in the long-run?
I believe the biggest driver for low inflation and thus low interest rates was globalisation and the access to a huge, low-wage labor force in China and other emerging markets
With wage levels in these markets much higher today than in the past (e.g. China 1/25th of US wages in 1980s, today 1/4th), I’m not sure one still needs the much discussed de-globalisation for this dynamic to have run its course
The below chart provides perspective on this, and how the labor market - until recently - was kept loose by globalisation for decades
Demographics was never a convincing argument for me, or I at least I frankly don’t understand it. Old people consume less, but they also leave behind a smaller labor force, so arguments can be made in both direction. For anyone interested, I highly recommend this recent review on the inflationary impact of demographics by former Bank of England economist Charles Goodhart
See post from August ‘21 “A Flashing Warning”
ESG-motivated restrictions in commodity supplies without a corresponding reduction in commodity demand also play a role (see “The ESG Time Bomb”). However, this would be a much smaller issue without the $2 trillion additional US demand
Other behavioral changes include pulling forward consumption, or acquiring real estate as inflation hedge but then leave it unoccupied, all of which furthers inflation
Powell mentions 1965, 1984 and 1994 as examples where the Fed engineered a “soft landing”. However, all of these periods share that interest rates were raised before inflation started to take off
" History is just one damn thing after another ". Bad news is the norm, but miracles do occur quite often in this messy and imperfect world.