Welcome to Stagflation

In an era of high inflation and low growth, is it the 1970s again?

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Ryan A. Hughes
June 03, 2022
WELCOME TO STAGFLATION

No doubt, inflation is on everyone’s mind. We feel the pain everywhere; the gas pump, the grocery stores, the housing market, etc. According to Google Trends, interest in inflation has exploded over the past several years.

I wrote about the risk of rising inflation as early as October 2020 as money printing began to reach unprecedented levels. As with all things, actions have consequences, and there is always a price to be paid. Unabated monetary stimulus has its effects, and we are experiencing it now. As a reminder, inflation is not caused by a backlog of inventory or supply chain issues (though these certainly only help to exacerbate the problem). Instead, inflation is caused by a more rapid increase in the quantity of money than the quantity of goods or services produced during the same time period.

In other words, if the nation’s printing press produces money at a greater rate than what its economy can grow, the result will be higher levels of inflation. Inflation will continue only until we stop printing money. There is no other way to contain rising prices. 

The good news is that M2 growth (the amount of money in our economy) has recently started to decline. The Fed has started to raise interest rates and implemented its quantitative tightening (actions that should’ve started last year). However, we do not know when this action will have its intended effect. It took about a year for inflation to show itself within the U.S. economy once we started printing money in March/April 2020, so perhaps it will also take a year for declining inflation to take hold? We can only hope for sooner rather than later. 

The cost of quantitative tightening is that it will most likely push the U.S. economy into a recession. If the current economic trends continue on the same path, we are predicting a recession to occur by March 2023.

Stagflation

Stagflation is the combination of high inflation and low economic growth. It is usually characterized by a weak job market and low production. 

The last time the U.S. experienced stagflation was during the 1970s. This era experienced limited economic growth, primarily due to high inflation (the fall of the Bretton Woods system had a lot to do with this), but also due to the energy crisis and the Vietnam War.

We have yet to experience a weak job market in today’s high inflation setting, though I expect the unemployment rate to rise soon. The unemployment rate is a lagging indicator, and it typically begins to increase during a recession. Unfortunately, wages are sticky, and they do not keep up with inflation, putting strain on consumers, thus causing a recession.

The Inflation Cycle

The U.S. passed and spent nearly $5T in pandemic-related stimulus packages, the most significant flood of federal dollars in recorded history.

US pandemic stimulus funds
Source: New York Times

The initial effects of the $5T seemed great. The increased money supply allowed those that had it to spend more. The number of jobs increased (the unemployment rate reached new lows), corporate revenues rose, and everything seemed to be going great, at least on the surface level.  

However, prices of just about everything began to rise, and workers soon found that their wages were not keeping up. I believe that this is the current state of the inflation cycle. It is becoming more and more difficult for these companies to buy the same products and/or services. Their costs (raw materials, labor, etc.) are also going up, which forces them to raise their prices, compounding the problem. Things that seemed great before now seem to have taken a wrong turn.

The government now has a strong temptation to increase the money supply again to ease the pain and keep their political favor. After all, isn’t it a normal reaction to want the government to do something to fix all of this? However, government actions (under both parties) caused this mess, and I would be very hard-pressed to look to the government for a solution.

Ending Inflation

This cycle will not end unless we do one thing: stop printing money. The cure for inflation may sound simple, but it is far from easy. Stopping the printing presses will cause temporary pain to the economy, but it will undoubtedly be the best long-term solution. Lower economic growth and higher unemployment will occur immediately after slowing/stopping the printing press, though it will be necessary, and I suspect this is what we are currently experiencing. 

We will likely experience a period of slow growth for several years as the Fed attempts to tame inflation. The central bank is very much behind the curve, and there is quite a bit of catch-up to be made, so expect volatility to reign for the near term. However, once inflation falls back down to a more moderate level (3%), economic growth will return, and jobs will return. In the end, it will lead to a far healthier and more sustainable economy.

The Coming Recession?

We expect a recession to occur within nine months (March 2023) as leading indicators are starting to flash their recession signals. There are many different leading indicators, and not all are 100% accurate. This is because every recession is different. However, if we take a composite approach, we see that weakness is starting to take hold of the economy, and there is a high probability it will spread to the job market. Note that an incalculable number of factors influence the economy, and all of this can change quickly, for better or worse. 

Also, note that this does not suggest a deep and painful recession will occur. The last two recessions have been quite severe. The GDP decline during the 2008 crisis was -5.1%, and the 2020 GDP decline was a staggering -19.2%. However, if you are younger than ~45 years old, these two recessions are probably the only two recessions you may remember.

image 1

During the 2008 and 2020 recessions, the economic contractions were extreme and not normal. The early 1990s recession resulted in a -1.4% GDP decline. The 1981-82 recession, a -2.7% decline. The 1973-75 recession, -3.2%. There is no reason to think that the upcoming recession will be worse than these recessions. Perhaps, it will be a run-of-the-mill recession. After all, the average consumer is not over-levered and quite financially healthy. And, believe it or not, a recession might be a good thing.

The Benefits of a Recession

There are a lot of negative aspects to a recession; job loss, declining asset prices, home loss, and more. However, recessions are a necessity for our economy, and there is a lot of good that comes from them. 

First, excess ‘fat’ is removed from the economy. Companies that are poorly run have a minimal chance of surviving a recession, while those that are better run have a much higher chance of surviving. Bloated companies with small or negative margins are washed out. Better run companies that survive will take market share, thus providing consumers with a better experience (price and service). In the end, the average consumer benefits the most. 

Second, consumer behaviors change for the better. During boom times, people tend to put themselves in a precarious financial situation, often burdening themselves with too much debt. During the 1920s and the mid-2000s, the average consumer definitely over-extended themselves assuming that the good times will continue forever. People purchased luxury assets that they could not sustain over the long term. The subsequent recession/depression washed them out and helped individuals change their behavior for the better. Americans who lived through the Great Depression (and WWII) learned that frugality and resourcefulness during difficult times cannot be easily forgotten. Today, the same cannot be said. Perhaps many Americans should think twice before buying a $100K Tesla or a 5,000 sq/ft house, especially when a recession looms. Saving your hard-earned cash is perhaps the more prudent decision. 

Third, bargain hunters receive an opportunity to buy quality assets. Those that can keep a cool head during an economic slowdown benefit the most. Buying stocks, real estate, etc., at rock-bottom prices is a smart decision. However, most people panic during difficult times, and it is much easier said than done. Our innate response during stressful times is to hoard our assets, not to buy risky investments that are in free fall. However, research has proved time and time again that buying quality assets at distressed prices is a good idea. 

Take the Long-Term View

While it is tempting to worry about today’s economic and geopolitical climate, it is far better to take a step back and consider the long term. Assets, particularly stocks, have a really good habit of climbing the wall of worry. Asset prices have always gone up with periods of sharp declines. This is normal. Market pullbacks are normal.

Volatility is the price one must pay for higher-than-average returns. There is no way around this.

If you stayed invested during periods where asset prices have fallen, you have likely performed very well over the long term. However, if you were to panic during periods of volatility, you probably did not.

Furthermore, the market has a knack for unexpectedly rebounding, especially when nobody is expecting it. This is why I discourage those hoping to sit in cash until ‘things get better.’ Usually, when things get better, it is often too late and the market has recovered.

The smarter strategy is to stay invested, stay disciplined, and to buy additional assets at discounted prices (buy stocks when they are cheap). Nobody has ever regretted buying quality assets at distressed prices, though people have certainly regretted selling at distressed prices.

As you may know, we have positioned our client portfolios to be pro-inflationary. This has helped to soften the market selloff. As suggested earlier, I do not expect this recession to be as painful as the 2008 or 2020 economic contractions, but who knows. I am not even certain that a recession will occur at all. All I can do is to follow the data and the data is pointing to an economic slowdown, primarily caused by inflation, but also by the Russian invasion, the Shanghai lockdowns, and others. Predicting geopolitical events is extremely difficult and often foolhardy, so I try to refrain from doing so. The safe bet is to stay invested, stay diversified, and to lean into different market segments (E.g., pro-inflationary assets) given the current market environment.

As always, if there is anything we can do to assist, please do not hesitate to contact us. We are happy to help.

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