Brace yourselves - Winter is coming. For the market and the economy as a whole.
If you follow the economy at all, you’ve likely heard a lot about inflation lately. Heck, we even discussed in length in our June Newsletter. The main argument has been whether inflation is transitory or not. In case you missed it, we have always been in the camp that inflation is here to stay. There’s no way you can print trillions of dollars, nearly 35% of all dollars ever were printed in the last year and a half, and not expect the dollar to lose value.
The other side of the argument believes that the inflation is just a blip on the radar as the economy recovers from the pandemic and things will settle down. The flaw that we have always seen in this argument is that once prices go up, they don’t come back down. That alone makes it impossible for inflation to be transitory.
But the economists and the Fed know better, right? You know, the same people who keep missing on economic estimates week after week. And not by small numbers. They aren’t even in the same ballpark lately. But we should definitely trust what they have to say.
Anyway, we think it’s safe to say they are starting to realize that inflation is here to stay. Many have begun to acknowledge the high inflation rates and believe it will remain at least until next year. Aka they either lied or really have no idea how to do their job. Either way, they are hurting the lower and middle class.
But what makes this inflation story really interesting is that for the past few months, GDP growth was rather significant as the economy reopened. In fact, the US GDP was 6.5% in the second quarter of 2021. For all intents and purposes, when that’s the case, inflation is ok. At least according to all of the economic textbooks.
But what happens when GDP growth slows and you still have high inflation? You guessed it - stagflation!
And what are we starting to see? You guessed it again! A slowdown in the GDP. The Atlanta Fed changed its Q3 GDP forecast from 5.3% to 3.7%. That’s a 33% reduction in GDP forecasted, aka the economy is slowing down.
Granted, the delta variant plays a huge role in the slowdown. But we believe the reopening is starting to die down as well. Think about it. We were locked up for a year. Once we got the vaccines, it was like releasing caged animals. We went wild. We spent money like never before. We traveled, went out with friends, bought houses, cars and whatever we missed out on for a year to treat ourselves. You name it - we spent money on it.
There’s only so long that could have lasted. Summer is ending. Our saving accounts are depleted. The huge growth is over. But the inflation isn’t going away. The US has only seen this one other time - the 1970s.
For those who weren’t around in the 70s, let me tell what it was like. Porn staches, bell bottoms and muscle cars baby. Just kidding, that was way before our time. But we are students of history. After all, history may not repeat itself but it often rhymes.
Prior to the 70s, Keynesian Economics was the basis for many economic beliefs. John Maynard Keynes theorized that growth in the money supply promotes economic growth and decreases unemployment. Therefore, when there is a slowdown in the economy, unemployment rises, but inflation should fall as well. So, to promote economic growth, the central bank could increase the money supply to drive up demand and prices.
The 70s saw high inflation and high unemployment, which was not inline with Keynesian economic theory. Many believe an oil supply shock resulted in an increase of the price of gasoline, which drove the prices of everything else higher. This is known as cost-push inflation. Some blame Nixon’s actions at the time; placing tariffs on imports and freezing wages in 1970 in an effort to prevent prices from rising, or fully removing the US dollar off of the gold standard in 1971.
The consensus seems to be that a combination of the above mixed with the central bank using excessive stimulative monetary policy to counteract the recession caused a price/wage spiral. The Fed increased the money supply by 13% in 1972 alone. Aka the so-called “experts” added fuel to the fire and almost burned down the entire house, but yes let’s definitely trust them.
Fast forward to today and let’s see if we can predict the outcome, using history as our baseline. We had a major event bring the economy to a screeching halt. You know, the pandemic. Coming out of the pandemic, we are seeing supply shocks across the board. This can be theorized to be causing the inflation, similar to the oil supply shock of the 70s.
As seen in the chart above, the Fed has increased the M2 money supply by 33% over the past year. And they refuse to taper and continue to purchase $120 billion of equities, corporate debt and mortgage backed securities month after month. Perhaps adding fuel to the fire? We'll see.
Lastly, after seeing a steady decrease in unemployment as the economy reopened, we are starting to bottom. The current unemployment rate is 5.2%. Prior to the pandemic, unemployment was 3.5%. That means unemployment is 49% higher right now.
So we have high inflation, moronic monetary policy and increased unemployment. Sounds like the formula for stagflation.
For those curious, this chart above shows the S&P 500 price over the course of the 1970s. There were multiple drawdowns and the market essentially traded sideways for the entirety of the decade. The index rose 17.2% over 10 years, or an average of 1.7% per year. For comparison, the market has averaged nearly 10% annualized returns over the past 100 years.
If stagflation does happen, the market could rhyme with history. Past performance is no guarantee for future results, but this is something we are watching closely. Time will tell.
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