How to profit from inflation
The market got a wakeup call last week that the US Federal Reserve’s consensus for loose monetary policy is shakier than believed. Initially there was aggressive selling, which has been followed by a rebound earlier this week, all on significant volume, which is leaving many confused.
In this artlce we look at the actual risk that inflation poses for markets, discussing the macro picture with regard to the history of monetary policy. Then we look at what this means for investors and how to make money out of this uncertainty.
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The key components to the Fed’s monetary policy is its $120bn a month bond buying and near zero interest rates for the foreseeable future. That changed last week with the Federal Reserve’s projection showing a fracturing within its ranks as inflation fears bite. The Fed’s “dot plot” projection for interest rates skewed towards a view that hikes in official interest would occur in 2023 rather than 2024 and that a tapering of its bond buying was on the cards a year earlier. In a television interview the president of the St Louis Fed, James Bullard, said the first rate rise could come next year. Notably Fed Reserve Chair Jay Powell has been spending a great deal of time walking back such statements.
What’s scaring the Fed? Annualised monthly inflation data has been at multi-year highs, in the region of 4-5%. But the market reaction says that there isn’t as much to be scared about. There was some selling of cyclical stocks and buying of technology. Selling of short bonds, buying of long-dated bonds was of more importance. The big dogs of the investment markets are saying inflation is not a concern but “transitory” which is the Fed’s official line.
Three important points
The first is that the bond markets are taking this “annualised” data with a grain of salt because there is too much volatility to take it seriously. When you analyse one month of data you are simply multiplying it by 12. In contrast the RBA takes a more conservative approach and looks at quarterly data, both against the previous quarter, and against the same period a year ago.
The second is that there is a great deal made by employer groups around the labour shortages causing inflation. This is far from the case. In fact, the biggest cause of inflation is money supply (Milton Friedman’s great insight) and there is some evidence that this bond buying is having an effect, but it the jury is far from out here.
The third is probably the most important, which is the political will for monetary tightening and the consequent reduction in demand (and loss of jobs) is very low. A recession would hurt workers in low paying jobs in cyclical industries the most.
To understand the last point, history is important. The 1970s was a decade hit hard by inflation due to oil price shocks. This turned into stagflation – rising inflation and unemployment – causing widespread pain.
It was a policy error by the Fed to keep interest rates low for too long, because they didn’t take inflation seriously enough. Interestingly, back then the minutes of the board meetings showed that the consistently talked about “transitory influences”, which is what today’s board members talk about.
In 1979 US President Jimmy Carter appointed Paul Volcker as Fed Reserve Chair. He realised the need to break the psychology of inflation by rising official interest rates higher for longer. This brought about a recession in the early 1980s but most importantly, conquered inflation. Australians would be aware of the same circumstance happening in the late 1980s where the RBA’s Bernie Fraser did the same thing, creating in then PM Paul Keating’s famous words, “the recession we had to have” in the early 1990s.
Central bankers often talk about how well inflation expectations are “anchored”. This refers back to the hard work Volker and then Frazer did. It remains to be seen how well at anchoring those expectations their policies turn out to be.
We are indeed in a fascinating period and possibly on the cusp of a regime shift from one of over two decades of falling to low inflation towards expectations of increasing inflation. But there is not enough evidence at this stage to know whether we are at an inflection point.
What this means for investors: Value provides security
When Volker and then Frazer embarked on monetary policy tightening it was no accident that “value” investments outperformed. Why? Because investors crave certainty in an uncertain world and companies paying out dividends and returning capital to shareholders represents that.
The clearest evidence of investors looking for such certainty is the rallying in that ultimate safe haven, the US dollar, also highlighting the “exorbitant privilege” of that economy, to quote the American economist Barry Eichengreen.
Two factors should not be ignored: that there is a great deal of money that is washing around, which is pushing up asset prices; and that there is the associated giant debt, overhanging collective and individual balance sheets.
The best thing to do is to find good companies that you trust and will grow into their valuations. That is, those companies that have pricing power. Porter’s “5 Forces” remain our go-to for analysing a company’s business model.
It’s important to realise that pricing is not static, which is why our team looks consistently and frequently at all the companies we cover, assessing their performance in relation to expectations. Fundamental analysis has never been more important.