On inflation, growth, and the Fed’s tapering

11-24-2021
On inflation, growth, and the Fed’s tapering

Q&A from Tyler Mordy’s road trip

 

Come before those battles lost and won.
This life is shining more forever in the sun…now let us check our heads

                                         – Red Hot Chili Peppers, “Road Trippin’” 1999

After a 20-month lockdown in British Columbia, we are back on the road visiting clients. The Red Hot Chili Peppers’ fully acoustic song seemed a fitting soundtrack for our first foray back into the in-person business world. Runner ups included “Day Tripper,” “Born To Run,” and if your musical tastes lean more middlebrow like mine, “Back In Black” from AC/DC.

Thankfully, clients were eager to engage. But a long pandemic exile had shaken up the time continuum. Having been shielded from regular human interaction for so long, some fundamental life skills had noticeably withered. Travel routines and hacks were rusty from disuse. Any savoir faire once held by this author had clearly atrophied. Conventions have changed too. How best to greet someone today? No one knows. But, in practice, it typically goes like this: approach the other person, circle warily before attempting a touchless handshake and finally settle for a clumsy elbow bump.

For those yet to disconnect from the Matrix and step into the light, be aware that new rules now apply. It’s a social minefield out there. And while most recognize that the pandemic has thrust a new reality on us, exiting the lockdown time machine is bumping most back to earth. Admittedly, this is an awkward place. Even though the world may be on the verge of breaking through to some other side, there is also another sense – that we are caught in a liminal space between the before and after.

To say it has been a strange few years is an understatement. And it continues to be strange. The economy is ripping, yet consumer confidence is hitting new lows. Predictions of stagflation have surfaced. Twitter boss Jack Dorsey goes further and tells us hyperinflation is coming. Billionaires are taking vacations in space. And now Facebook CEO Mark Zuckerberg, evidently eager to move on from congressional oversight, has shifted his focus to creating a parallel virtual world called the metaverse (most people haven’t the foggiest idea what that might look like, but my 10-year-old son seemed to capture it best: “The headset and avatars look cool but it would suck if the power went out”).

Needless to say, our clients were spring-loaded with questions. Below, we provide answers to the most common ones.

Will inflation be transitory or more sticky?

This was the biggest concern on client minds. And, indeed, it is the key macro battleground among global asset allocators. Central bankers have claimed that currently high inflation can revert serenely back to its previous course. Quite the gamble. Actually, we are somewhat sympathetic with their perspective. Much of the recent inflation is pandemic-driven. We have just witnessed the largest demand surge since World War II, caused by post-Covid reopening, and the largest supply collapse the world has ever seen, caused by Covid lockdowns. Base effects and bottlenecks are contributing to a surge in prices. Yet the world economy is rebalancing quickly as the recovery process broadens out and various sub-sectors adjust. Inflation should start to moderate somewhat in 2022 (see our recent podcast discussing supply chains).

But team transitory only focuses on the supply side. They are entirely missing the other main cause of rising prices — excess aggregate demand. Here, the kindling needed to light a blaze in global demand can be seen almost everywhere. This can be viewed through a consumer, corporate and government lens. Household balance sheets in the major economies are in very decent shape, capital spending is booming and governments have completely abandoned austerity (see “Inflation: has the force awakened?” for further insight).

All of this suggests inflation will be far more sticky than central banker forecasts. In fact, while global central banks consistently overestimated inflation in the post-2008 period, we will now see the opposite: policymakers, conditioned by years of inflationary false alarms, will now likely underestimate price pressures in the next decade. Real yields will stay deeply negative for years.

October’s 6.2% jump in U.S. consumer prices supports this view. Not only was it a 30-year high, but more tellingly, the data showed a broadening of inflationary pressures – away from categories confined to the economy’s reopening and a more general rise in prices. The same story can be seen across the globe.

Are you worried about the Federal Reserve’s recent taper announcement?

Quantitative easing is set to wind down by the middle of 2022 in America. We are not deeply concerned. First, Fed Chair Jay Powell’s announcement earlier this month was, without hyperbole, the most well-signaled policy announcement in history. Forward guidance has been taken to new heights.

Of course, the concern is that tapering will cause a market tantrum, as it did in 2013. But today’s economic and investment climate is entirely different. Economic growth is ripping. The Fed’s own forecast for GDP this year is at 7%, to be followed by 3.3% in 2022. The timeline for policy normalization is being accelerated simply because the economy is making rapid progress towards the Fed’s goals. This is all more evidence that we are quietly moving away from an era of secular stagnation.

Market valuations and positioning are also far different than 2013. Back then, the U.S. dollar had just concluded a decade-long bear market. The currency was under-loved, under-owned, and primed for a multi-year rally. The taper was just a catalyst. Emerging markets suffered most and the U.S. dollar’s surge also contributed to a collapse in commodity prices, generating a double blow to the resource-rich EM nations.

A repeat of the above is highly unlikely. Today, strong underlying forces favor a weaker U.S. currency. Similarly, in 2013 commodity prices had just finished their “super cycle” and were vulnerable to a multi-year correction. Today, commodities, although significantly higher than last year’s Covid low, remain deeply depressed compared with historical trends. In 2013, global asset allocators also remained wildly optimistic on EM prospects, with EM bourses trading at similar multiples as developed markets. Capital inflows were strong. Today, EM equities trade at a massive discount to Western markets and remain deeply out of favour. The EM rate hiking cycle, which has been with us for the last year, is also closer to the end than the beginning.

But the last difference is the most important one: Monetary policy is no longer the only game in town. Fiscal policy is a far more important driver of growth now. Investors may debate the size and efficacy of government spending. U.S. spending plans are now getting watered down. But investors should not lose sight of the ongoing regime shift (Biden did manage to sign a $1.2 trillion infrastructure bill this month— something neither Trump or Obama were able to do). More accommodative fiscal policy, the missing policy lever from the post-2008 slow-growth recovery, will result in higher growth for several years. Monetary policy normalization becomes far easier to engineer in this environment.

Next time: More Q&A on prospects for the S&P/TSX, global growth, and cryptocurrency.

Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article first appeared in Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

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