You Can't Get There From Here

"You can't get there from here," is an old saying used in Maine to describe a remote destination where the route is hard to describe.  With the COVID-19 pandemic fading from the news headlines, I've noticed a lot of the self-appointed epidemiology experts who knew exactly how to best combat the virus have taken up a new subject - monetary policy.  With the Federal Reserve Bank ending the accommodative policy it seems like I am meeting a lot of people who know exactly how many rate increases Jerome Powell should make to bring inflation under control.  I personally have no opinion on whether the next raise should be 0.25% or 0.50% or if they should raise rates 6x or 8x this year.  What I do think is the phrase "you can't get there from here," is the most appropriate.  We know where we want to get, but the route to reach our desired destination is very difficult to describe.  But let's give it a try.  

Inflation is a bit of a mystery, we know how to define it, we know what causes it, but our ability to create it or tame it within desired targets is incredibly difficult.  Let's start with the basics, inflation can be defined as a sustained increase in prices.  And the legendary economist Milton Friedman explained "inflation is always and everywhere a monetary phenomenon." What he meant is that historically, we cannot find inflation without a prior increase in the money supply.  Which means inflation is government created and why I called it a regressive tax in my May 2021 letter Inflation.  If we know what inflation is and where it comes from, why can't we create it or more importantly control it? 

We should first look at Japan which has tried unsuccessfully to reach a 2% annual inflation rate for more than two decades.  They have tried every trick possible by juicing the economy with cheap money, huge public works projects and lowering the borrowing rate to nearly zero.  And yet, prices declined 0.2% last year while the US saw prices climb 7%.  Economists' explanations have ranged from consumers expect stable prices, to cheaper goods via globalization and an aging population that reduces aggregate demand.  However these conditions largely exist in the US and Europe and yet Japan remains an anomaly.  But there is a glaring difference that is worth pointing out.  The end result of Japan's stimulative monetary policy is a debt-to-GDP level that is nearly double the United States.  It appears Japan's effort to use monetary policy to overcome faltering economic conditions has produced the opposite of the intended effect.  They have actually slowed economic activity.  In the US the Federal Reserve has been accommodative with monetary policy since 2008 and it too has failed to produce a 2% inflation rate.  Until now, and the rate has surged way beyond the 2% target, causing the worst economic misery since the financial crisis.  Two nations using the same playbook have produced two starkly different outcomes.  What we can take away from these examples is that there is no user manual to manage an economy with central bank tools.  

The Rent Is Too Damn High Party's Jimmy McMillan at the NY Governor Debate

"The Rent is Too Damn High!"
You may remember Jimmy McMillan, the karate expert candidate who ran for Governor of New York several years ago on a simple platform, "the rent is too damn high" in New York City.  The Gubernatorial debate was so entertaining, not even the writers at Saturday Night Live could have dreamed of a candidate like Jimmy McMillan.  For years, we all accepted that rent has always been expensive in NYC but why is it too damn high everywhere now?

There are two camps that attempt to explain our current malaise.  The first is led by Lawrence Summers, the Secretary of the Treasury under Bill Clinton.  His premise is simple, the government printed too much money and now it is chasing after too few goods.  Essentially robust consumer demand is pulling prices higher.  During COVID-19 the US government printed enough money to offset 300% of the estimated lost economic activity.  With all that extra cash consumers are demanding more durable goods which we can see from the severe backlog of containerships sitting outside our nation's ports and cars selling above MSRP.  With $2-3 trillion in excess savings, Mr. Summer's believes the present inflation rates will persist for a considerable period of time.  

At the other end of the spectrum, we have Federal Reserve Chairman Jerome Powell who believes prices are higher because the US consumer temporarily shifted their spending on services to durable items due to COVID-19 restrictions.  Supply chain challenges further contributed to the supply-demand mismatch which have been slower than expected in returning to equilibrium.  These factors have resulted in rising costs which have pushed prices higher.  Mr. Powell believes inflation will start drifting lower and eventually normalize as the worst of the pandemic fades.  

Who is right?  I don't know, the truth as usual is probably somewhere in the middle.  But we still have a question to solve, can the Federal Reserve effectively control inflation?  They have one-tool, control over the money supply, which is managed through the price of money - i.e. interest rates.  So let's review a few historical examples by comparing the Federal Reserve's interest rates with inflation.  

In April 1977 the Fed Funds interest rate was 4.73% and the rate of inflation was 4.75%.  When those two numbers are equal, it is considered a 'neutral rate' and is the desired level for the Federal Reserve.  In 1977, the inflation rate exploded and it took until February 1981 and an increase in rates to 16% before inflation began to ebb.  It is also worth pointing out that rates topped out six months later at 19% and caused a severe recession before the Fed finally realized their efforts were working.  For those keeping track, it took 47 months and a 14.25% increase in rates before the Fed had any effect on inflation.  It then took the Federal Reserve until 1992 (15 years later) to return to the 'neutral rate.'  

I think it is also noteworthy that the rate hike cycles in the mid-1990s and mid-2000s lasted several quarters and produced a de-minimis impact on inflation.  Judging from the last 50 years, it is apparent the Fed rarely achieves a 'neutral rate' and their actions have a considerable lag before taking effect.  Now, how do you feel now about the Fed's ability to manage the economy with precision? 

The Fed has been unsuccessful since the financial crisis to spur their target 2% inflation rate and Japan has been trying since the 1990s to generate inflation with no success.  If Mr. Summer's is correct, interest rates will have to increase to 8% before reaching neutral status.  And if Mr. Powell is correct rates will have to reach mid-single-digits to be considered neutral.  Both are well above the 2.5% rate in the market consensus.

Mr. McMillan gets it, those who do not own assets (renters) are being punished by bearing a disproportionate share of the inflation tax.  They face a rising cost of living while not receiving any benefit of higher asset prices.  The best way we can preserve the purchasing power of our savings is through owning hard assets like equities, real-estate and commodities.  The "Misery Index" is a rough measure of the pain endured by the average American.  It contends that a point of inflation is as painful as a point of unemployment.  By this measure we are presently enduring as much pain as the peak of the financial crisis over a decade ago.  


"Toto, I've a feeling we're not in Kansas anymore." (Judy Garland Wizard of Oz  1939) 

Rates on US government debt are the standard by which assets are priced.  When rates go lower, it pushes the prices of stocks, bonds and other assets higher.  And when rates go higher it pushes the value of investments lower.  Since the early 1980s, interest rates have steadily marched lower.  Over the past 40 years, Wall Street and the Financial Adviser Community were able to prescribe a 60% stock / 40% bond portfolio and it worked remarkably well with the tailwind of falling interest rates behind them. Now we face a starkly different environment and bonds are no longer serving as a nice risk reducing component to the average portfolio.  I have reviewed a number of readers' employer sponsored retirement plans recently and the Target Date funds and general options available in these plans are all based on the 60/40 prescription that worked well over the past 40 years.  I continue to believe holding bonds of medium and long-term duration is unwise as the rate of interest paid is not commensurate with the potential risk from rising rates.  As an example, the Vanguard Aggregate Bond fund (BND) presently offers a yield of 1.95% and is down 8.31% year-to-date, which means holders of this fund lost years of income over the past few months.  I believe the probability of rates continuing to rise is greater than the probability of them remaining stable or moving lower.  I think investors will have to be more nimble in this environment and sitting in the old formula could be trouble.  

Thoughts on the market
What has me deeply concerned is the confidence embedded in market valuations that suggest we will have a "soft landing" which means the Federal Reserve will thread the needle and tame inflation over the next 12-18 months without causing a recession.  The central banks across the globe have all used the same tools and we have seen divergent outcomes.  While their actions are well intended, the results are far from certain.  In the US we have strong economic growth with high inflation, Europe has seen low economic growth and with slightly lower inflation and Japan has seen no economic growth and no inflation.  Same process three different outcomes.  How can we have confidence in our ability to manage the economy with monetary and fiscal policy?  I am neither confident in that time frame or their ability to avoid hurting the economy.  It is a bet I do not want to make. 

Many of you have asked what should we do with the recent volatility?  Personally, I would reduce long-duration bonds, increase short-duration high-grade credit and be patient for more attractive equity valuations.  Despite having a cautious outlook, I have not sold a single share of any equity holdings.  It is unwise to try and time the market.  Being nimble will require using other methods of managing risk in place of long-duration corporate bonds.  We are in a rising rate environment for the first time in 40 years and the unfortunate reality is like the Federal Reserve, we too face a "we can't get there from here" situation.  The path forward is difficult and hard to describe, but we will do our best to adapt in these changing times so that we all reach our desired destination. 

Note:  I provide exact portfolio holdings and other additional letters/advice to people who have joined "To The Front Partners."  Please contact me if you are interested in joining the partnership.

Cautious Investing, 

To The Front

This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice.  Past performance of any market result is no assurance of future performance.  The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

A little Easter Egg for those who made it through the whole letter.  Starting May 1st, I-Bonds available through the US Government available on https://www.treasurydirect.gov/indiv/products/prod_tipsvsibonds.htm should start yielding approximately 9.6%.  That is the best investment option I can offer at this time.