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Inflation Will Call the Market Tune for 2022

Inflation is a much more embedded problem than the Fed and politicians have been indicating. Shifts in the social system driving redistribution politics, the Fed’s easy monetary policy, and a pandemic have collided together to drive a very dangerous wave of wage and price inflation into the economic system. We have not seen this type of inflation set up since the 1970’s Stagflation crippled the U.S. economy.

The Current State of the Economy

The Fed’s very accommodating policy over the last 10 years is solely responsible for avoiding a deeper and more permanent financial crisis post-2008. The government has also played a critical role in avoiding an economic collapse, due to COVID, by flooding the economy with stimulus. Both the Fed and government have distorted the normal capital allocation and functioning of the economy and markets. Pandemic-induced shutdowns have disrupted supply chains around the world. Shortages in every stage of production cause prices to increase as companies are forced to pay more for materials and wages.

The politics driving a dramatic lift in the national minimum wage and high persistent pandemic unemployment/stimulus payments caused millions of workers to opt out of the employment ecosystem. Working from home has become the norm, and employers demanding a change back to in-office attendance is a deal breaker. Millions have chosen early retirement and millions more are opting out of work while they rethink work-life balance. This has led to a qualified employee shortage that is crippling the ability for many companies to expand and grow. To attract employees, the price of poker is rising dramatically and has increased the economy’s wage levels permanently.

Consumer spending has been more robust than is normal because of stimulus. Demand has increased at the same time COVID supply chain disruptions are limiting supply. This imbalance in supply/demand tends to exacerbate inflation.

The good news is that growing consumption, easy Fed policy, and stimulus spending is lifting economic growth to levels we have not seen in decades. This growth is critical to breaking through the deflationary economic quicksand we were stuck in after the Financial Crisis. The bad news is the Fed is so far behind the curve in managing inflation they will likely have to move more aggressively than they would like in tightening monetary conditions.

What Does This Mean for the Markets?

Let’s not forget the strong economic growth we are currently enjoying is due to zero interest rate policy, capital support to the markets, and stimulus. As the Fed shuts down their bond buying program, liquidity will dry up, bond pricing will fall, and interest rates should rise. The shift to higher interest rates will likely spook stock investors causing a bear market decline. Strong consumer spending has also been dependent on Fed policy, stimulus, and the positive trend in home prices and the stock market.

Once the Fed starts raising rates, the party is over. I fear the Fed will not be able to reverse course as quickly as they did in 2018 and 2020 to forestall a major bear market decline. Inflation will cause them to raise rates too high for too long which could torpedo economic growth. The idea that the Fed can engineer a soft landing is a comforting thought, but a soft landing under these circumstances has never been accomplished.

The Silver Lining

The good news – the economy is strong, and companies are doing well and making money. The supply disruptions are slowly being resolved, pandemic conditions should fade, and the result of all of this will be a mid-course correction with a foundation of strong growth. We will also likely have a fiscal stimulus plan that will help keep the economy chugging along at a pretty fair clip. Let’s also not forget we are in the midst of a world-changing technology advancement cycle. Another technology revolution will create opportunity for investors to be rewarded by investing in new products and industries yet only imagined.

The Time for Risk Management is Now

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Unless otherwise indicated all performance is sourced from Bloomberg.

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