Inflation levels in the U.S. have the potential to fall sooner than most expect as money supply growth, shipping costs, housing, and commodity prices have all retreated from their all-time highs. If this happens, this will change the entire economic and investment landscape.
At some point, these will undoubtedly translate into lower inflation levels, though the real trick is knowing when.
For those of you who follow my work, you know that I sounded the alarm on inflation early when the U.S. government decided it would monetize its debt by increasing the money supply by 40% and by literally sending checks to everyone.
This, combined with the reopening of the global economy, resulted in a price explosion in assets. Stocks, housing, crypto, and just about everything else soared.
As with all things in life, there is always a price to be paid. And the price is inflation. Consequently, we built in hedges fairly early within our portfolios and have since been well-positioned.
However, we think the narrative is going to change soon. We believe there is an increasing probability that inflation levels have peaked and might begin to fall.
The Falling Forces At Play
It almost seems heretical to be writing about deflationary forces at play while inflation continues to rage across the country and globally. However, I wouldn’t be doing my job well if I chose to ignore the glaring inconsistencies that are out there.
The primary driver of inflation is the growth of the money supply (M2) within an economy. If M2 is no longer growing but shrinking, then this now becomes a deflationary force. As mentioned earlier, the money supply within the U.S. peaked in March 2022 and has since decreased slightly.
Container shipping rates have fallen by over 60% from their highs.
Costco, which relies heavily on shipping rates, hopes these lower shipping prices will translate to lower prices for the end consumer. This is true for many other retailers besides Costco.
Used car prices are also (finally) starting to roll over.
Commodity prices, such as corn, lumber, beef, and gas, have also significantly declined.
Peter and I discussed last week how housing prices are highly overvalued and how we think they will fall soon. We think this can seriously impact not only inflation levels but also GDP figures.
Additionally, there is a strong likelihood that a U.S. recession will take hold before March 2023, which is a deflationary event.
When Will This Happen?
With all of these deflationary forces beginning to percolate, the question is when these price declines will translate into lower inflation rates. Who knows. Even the Federal Reserve cannot forecast something this complex.
However, once it does begin to reveal itself in economic data, the Federal Reserve will, at some point, have to back off its hawkish stance and become more accommodative.
Wall St. Expectations
Currently, most of Wall St. expects inflation to continue to rage in the near-term, with long-term inflation running low. We think the inverse of this is more likely. We expect near-term inflation levels to moderate, with longer-term inflation levels to be elevated.
This is because we believe Washington has a strong incentive to monetize its debt. Put simply; it is easier to inflate away the country’s debt rather than to be fiscally responsible and pay it off the ol’ fashioned way. It is easier for politicians to print more money than to raise taxes or cut government programs.
Everyone is Bearish
Most investors are positioned for a global recession (which we think is coming) and continued high inflation levels.
However, we also believe that these are both largely priced in. Cash balances among many investors are very high. Corporate and consumer balance sheets remain relatively strong, even now.
What if the downside from these levels is muted, especially if inflation levels begin to fall? At some point, the Fed has to stop rising interest rates and begin dropping them. This is a terribly strong tailwind for stocks and other asset classes.
A slight uptick in newsflow will be very bullish. And it will happen quickly.
As stated earlier, we do not know when this will translate to lower inflation levels, then lower interest rates. We expect volatility to stay elevated as these two opposing forces permeate the market.
Thus, we have begun to leg into asset classes that we think will benefit from lower inflation levels, while maintaining a relatively balanced portfolio. We removed inflation hedges such as managed futures, short-term Treasury Inflation-Protected Securities, and reduced our position in high-dividend U.S. stocks. We added to short-term Treasuries as the spread between short-term and longer-term debt is negligible. We also increased our core U.S. large-cap stock positions and added to deep value small-cap stocks.
If you have any questions or if you would like to speak with us, please do not hesitate to do so. We are happy to assist.
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