Is This as Good as it Gets?
Modern monetary intervention and fiscal stimulus show no signs of letting up, even in the face of stronger-than-expected inflation. At last count, the Fed’s balance sheet has expanded to over $8 trillion, and a third fiscal package later this year will likely push COVID fiscal stimulus above this level as well. The combined effect is equal to a supplement of approximately 76% of GDP, which is why economic growth appears so strong right now.
The consumer price surges we are seeing are being called transitory, which allows the policy doves to continue unabated in their quest to smooth out the economic cycle and boost the post-COVID economic recovery. What time frame does “transitory” represent? By definition, it should only mean a few months at the most, but we think the Fed is really in the dark regarding how long this inflation will last. One of the most important things I learned in my first macroeconomics class was that “prices are sticky to the downside”—they go up easily, but not so much in the other direction. At the commodity level, we could see some relief from these transitory price increases, but on the labor side, once wages move up, there is a good chance it’s permanent. We have not seen wages push inflation in decades, but the environment is as ripe as I have ever seen it.
Why then are we continuing to stimulate in the face of rising prices? The transitory excuse could be completely legitimate. Clearly, the Fed has the best data out there and they sincerely believe the benefits of loose policy outweigh the risks. Maybe the root cause is more insidious and lies in the larger issue of central bank confidence that they can smooth out the market cycle. Booms and busts have been an essential aspect of capitalism for the last 300 years, but since the Great Recession, central banks around the world have been emboldened that they can play puppet master using modern monetary policy to ensure full employment and maintain economic growth. Is it possible to keep this going in perpetuity without the unintended consequences like rampant inflation or extreme valuations of risk assets?
We think central bank confidence in their ability to print money unabated could last serval more years, so it’s difficult to step in front of this train. The sacrifices necessary to get back to a normalized interest rate and liquidity environment might just be too extreme a proposition, and therefore, we could stay in this liquidity-driven mania for an extended period of time until some external shock occurs.
Speaking of sacrifices, imagine the difference being born in 1900 versus 1975. If you were born in 1900, we were engaged in a World War in your mid-teens, struggling to fight a flu pandemic that killed 50 million people by the time you turned 20, went through the Great Depression during most of your 30’s and fought another World War for half of your 40s. Contrast that with the person born in 1975. Notwithstanding the Iraq War and the Great Recession, we have lived in an unprecedented era of peace and prosperity unlike any other in modern history, and policy makers seem intent on perpetuating that regardless of the potential long-term consequences.
How to manage risk in this environment becomes more complex, and having the proper asset allocation tools is critical. Most professional asset management shops are at the very high end of allowable equity exposure. It’s been the right place to be, but the downside could be painful and fixed income remains the conventional hedge vehicle. As mentioned in previous updates, we are using gold and gold miners as an additional defensive vehicle, as well as private debt to take advantage of the illiquidity premium and floating rates that should continue to rise. In addition, we are closely eyeballing a general commodity fund allocation, although that train may have left the station
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