Another Bad Inflation Number…and Why You Shouldn’t Care
Last week, the government released the May inflation report. The news wasn’t good – and markets sold off. On top of that, we are apparently in one collective bad mood, at least according to the well-respected Michigan Consumer Sentiment survey. The lowest sentiment number ever recorded was just released in the most recent survey.[1] It’s hard to blame consumers when there is a gas “scoreboard” broadcasting the pain on street corners everywhere and, like the Progressive Insurance commercials, you find yourself turning into your parents by discussing grocery store price increases. But there is some good news under the surface that you might not be hearing about. And with a properly designed financial plan, you’re ready for whatever markets throw at us.
Recession, Stagflation, or Soft Landing?
Assuming no more shocks to the system, it’s widely assumed that things will likely go one of three ways: one, the Federal Reserve (the “Fed”) engineers a “soft landing” as we return to 2% inflation while maintaining positive economic growth; two, the Fed is unable or unwilling to control inflation, and we end up in a sort of elevated inflationary period with weak or even negative economic growth (i.e., “stagflation”); three, the Fed follows through on their recent tough talk and sends the economy into recession by significantly raising interest rates to get inflation under control (a recession is generally defined as consecutive quarters of negative economic growth).
Now, as a long-term, patient, and disciplined investor – with goals set within your financial plan that have investments matched to that time when you will need that money – can I please remind everyone: who cares which way this goes! There is nothing to be done about it. And only a novice would try to time markets by withdrawing capital from investments at just the right time (and that time has passed) and then hope to be correct a second time by deploying capital back into investments later on when stock prices bottom out. Stock prices will turn up well before the data show that everything is getting better. The only way that we can be sure of capturing the superior returns of stocks is by staying invested, period. A great way to impair your progress – permanently – is to try to time markets.
Recessions come, recessions go. It’s a natural process in a capitalist system that washes away the excesses of prior decisions that, in retrospect, seem rather dumb. Assuming you don’t need your capital from stocks when the recession arrives – and you certainly shouldn’t with a proper financial plan – then let markets do what they will do. An average recessionary bear market typically cuts about 35% off the S&P 500 index. As of this writing, we are well over halfway there, assuming that’s indeed where we’re headed. If the Federal Reserve breaks inflation with a recession, then stop and think about the other side of that. In the five years from August 1982 to August 1987 (after the Fed broke “The Great Inflation”), the S&P 500 tripled![2] So maybe the real risk is missing out on a 300% gain rather than on another 15 to 20% decline.
Inflation
Now that we’ve established that no action should be taken that will permanently impair your progress, let’s soberly assess our inflation problem and why it might stubbornly persist for a while.
There are two main problems with inflation. First, there is too much money in the system from the enormous amount of fiscal “stimulus” that the government injected into the economy. Second, we have a supply problem, most obviously with energy, labor, food, and other niche things like semiconductor chips.
The Amount of Money in the System
There is about $4.8 trillion of excess money sloshing around out there. For perspective, there is a total of about $22 trillion of money, or what is called “M2”. This money has caused a classic “Economics 101” scenario to unfold: too much money chasing too few goods and services. This will take time to fix. Critics say the Fed is responsible for buying too many government bonds to finance government spending and keeping interest rates too low for too long – both of which led to more money creation. They’re probably correct.
The Federal Reserve can lower the money supply by discouraging borrowing. They do this by raising interest rates. Less borrowing means less money creation. For how money is created, see my March 18th post. But for now, the Fed is nowhere near “tight” with monetary policy – we’re still sitting on a one percent short-term interest rate versus 8.6% inflation.[3] That’s the furthest thing from tight…meaning a recession is probably not on our doorstep. But the Fed’s tough talk combined with higher commodity prices appear to be tightening monetary conditions without drastic action by the Fed.
So now the good news: these tighter conditions already seem to be impacting the supply of new money, as the growth rate in the money supply substantially slowed over the last three months.[4] Frankly, I’m surprised at the turnaround in this number. Perhaps we can now claim that there is a light at the end of the inflation tunnel. If the money supply continues to cooperate, then that should help bring down inflation later this year or next (there is typically a lag on inflation following money supply changes).
Supply Problem
Here is where the Federal Reserve is stuck. They cannot create more oil, more diesel fuel, more semiconductor chips, or chicken, beef, eggs, etc. In fact, by raising interest rates, they run the risk of reducing supply even more. Management teams might think twice about borrowing more money to expand supply when the cost of that capital is now higher. Sure, in the right situations, that will happen. The Fed needs to be very careful here. The war in Ukraine and the fallout have pressured supplies even further. Let’s talk energy.
Energy Supply
Things don’t get better here. Most reasonable people are all-in for a carbonless world, but the facts of our energy consumption say that is unrealistic for now. Doing research for this post, I set out to see what the latest trends are from renewable sources versus fossil fuels, total consumption, emissions, etc. Surely, all of these new solar and wind projects have caused fossil fuel usage to go down, right? Unfortunately, no. Even the use of coal remains stubbornly high. Outside of a dip in overall energy use in 2020 (during lockdowns), we remain at or near all-time highs in our total need/use of fossil fuels. Fossil fuels still provide over 80% of our world-wide energy.[5] In other words, we still desperately need fossil fuels, and the renewable energy sources don’t seem to have made even a dent in that demand. To be sure, fossil fuel use would be higher without renewable energy, but we’ not going down in total fossil fuel usage.
Fossil fuels are obviously a sensitive political topic. I will leave that discussion to the energy and other experts. But here’s what I know: when people in power are unfriendly to capital, then that capital will go somewhere else where it’s treated better. It’s hard to imagine that energy executives and investors feel comfortable right now committing capital to long-term oil and gas projects knowing that, once the current crisis resolves, they will be on the wrong end of politics again. Add in shortages of labor, sand, and other materials needed to drill, and here we are. Nuclear power also seems to be a sensible carbon-free alternative, but that, too, isn’t getting much love in policy circles.
Therefore, something’s gotta give, and right now it’s the price of energy. Until we get more supply or “demand destruction” (people buy less at a certain price), energy prices will remain elevated. But over the medium to longer-term, technological advances will contribute to solve these problems. Hydrogen from seawater anyone?[6] It’s hard to know which ideas will prevail to solve our energy problems, but the rewards are huge for big breakthroughs – and this always attracts the brightest minds to solve the world’s most vexing problems. It has continuously been this way for the last 250 years.
Some of the Good News I’m Watching
Besides some recent good news on the money supply, here are some further facts to keep in mind. The dollar has recently strengthened, and that’s positive for inflation. The leading economic indicators remain firmly positive.[7] Consumer spending drives the majority of our economic growth, and the consumer overall remains strong – household debt ratios remain near all-time lows.[8] Our employment numbers also remain strong. Supply chains are finally showing signs of easing.[9] China is coming out of lockdown – let’s hope this holds – as this should help further ease supply-chain problems. We remain in growth territory on important manufacturing and services metrics.[10] And S&P 500 company earnings are expected to grow around 9% this year.[11] There is a lot to like here.
None of these facts are meant to convince you that we won’t enter a recession or a deep bear market in stocks. We might. But a normal recession is usually caused by the Fed having to raise interest rates to slam the brakes on excesses created in the private sector. We can’t blame the private sector this time. Rather, loose fiscal and monetary policies have mostly gotten us into this mess. Therefore, my hope is that the private sector holds up better than many anticipate as we work through things.
Conclusion
Expect short-term pain, but we stay invested, we focus on executing our financial plans, and we anticipate continued problems with inflation. And we do not let markets, inflation, the media, or anything else derail our investment strategy. This too shall pass. It’s an election year, so it’s important to be ever more vigilant to discern facts from hyperbole.
As always, I remain confident that our patience and discipline will be rewarded. I am only a phone call away to discuss any concerns or questions you have. Thank you for your continued confidence and trust.
