The return of the inflation spectre

Growing worries about the return of a long-forgotten bugbear highlight increasing risks for savers

Martin Wolf

      © FT montage / Bloomberg


A spectre is haunting investors: the return of inflation. 

But is it a plausible threat? 

And what would it mean if it did return?

These are almost certainly the most important economic questions investors confront. 

Unexpectedly high inflation would raise interest rates, destabilise exchange rates, ignite unrest in labour markets, push the highly indebted towards default and destabilise asset markets.

At present, significantly higher inflation seems a remote risk. But, after four decades of well-controlled inflation, the monetary and fiscal policies unleashed by the pandemic, as well as longer-term structural changes in the world economy, might ruin this comfortable perspective.

If we are to work out what this possibility might mean, we need to start by journeying into history.

The last time inflation exploded out of control in high-income countries was the 1970s. The UK was very much in the forefront in this story. In August 1975, year-on-year retail price inflation reached 27 per cent. In April 1980 it spiked, once again, to 22 per cent (see charts).

The two oil shocks were important causes of soaring inflation. Yet there was a crucial domestic side to the narrative. A vicious spiral of high inflation, wage controls and labour militancy characterised the decade. In January 1974, in response to a strike by coalminers, Edward Heath, the prime minister, even declared a three-day week.

The UK appeared to be on the verge of turning into Argentina, a country notorious for worker militancy and high inflation. But it was not alone. Italy’s inflation experience was as bad as that of the UK. Other high-income countries suffered too.

Among today’s Group of Seven leading high-income countries, Germany did much the best: its average rate of consumer price inflation in the 1970s was below 5 per cent, against the UK’s 13 per cent, while that of the US was 7 per cent. Germany’s relative success helped strengthen the case for an independent central bank and a counter-inflationary anchor for monetary policy.

The 1970s were an era of stagflation — high inflation and low growth. 

They were also, as a result, an era of terrible performance for asset prices.



For the holders of bonds, mostly older people who relied on them for security in old age, a decade of high inflation was a financial disaster. Stocks did terribly, too. 

The cyclically-adjusted price/earnings ratio (CAPE), developed by Nobel laureate Robert Shiller, collapsed from 24 in 1966, to 8 in 1974 and 7 in 1982.

US market valuations nearly fell back to levels seen in the Great Depression years of the early 1930s. 

The ratio of the value of the stock market to UK gross domestic product fell to a low of 11 per cent in 1974. In the US, the trough was 21 per cent in 1982.

At these valuations, the stock markets were saying that capitalism was finished. What had caused this disaster?

First, came the inflationary fiscal and monetary policies of the late 1960s and early 1970s, the surge in the price of oil, labour unrest, failed controls over wages, price controls, and squeeze on profits, made worse by the failure to adjust taxation for the impact of inflation. 

Later, came the tight monetary policies of the early 1980s of Paul Volcker, chair of the Federal Reserve, in the US and Margaret Thatcher and her chancellor Geoffrey Howe, in the UK.

After these painful years, control over inflation moved to centre stage. The notion that inflation was a price worth paying for lower unemployment was rejected as a failed theory. Initially, the alternative was the monetary targeting recommended by Milton Friedman.

When this turned out not to work as well as hoped, policymakers shifted from the targeting of an instrument, money, to the targeting of the goal, inflation. 

Formal targeting of inflation began in New Zealand in the early 1990s and spread, along with central bank independence, to much of the world, notably including the UK.

The successful control of inflation coincided with the beginning of a prolonged and remarkable boom in asset prices.

The extended bull market in bonds was an automatic consequence of rapidly declining inflation. 

That was further strengthened by a collapse in real interest rates to today’s negative levels. 

It was not hard for a manager of bond funds to seem a genius.



Much the same was true for equity fund managers. 

In the US, the CAPE rose to 44 in 2000, an all-time high. 

The only bull market that came close to this one was that of the 1920s. 

The ratio of the value of the stock market to GDP soared to 162 per cent in the UK and 157 per cent in the US in 2000. Capitalism was triumphant.

The peak of 2000 in the “dotcom bubble” was followed by a crash and then yet another one after the financial crisis of 2007-08. 

Nevertheless, the US market recovered: at the end of 2020, the US CAPE was the second highest on record and the stock market was worth 187 per cent of US GDP.

The move to free-market economics

The success in controlling inflation was far from the only force driving this great bull market. It was part of a broader swing away from the regulated post-second world war economy towards free-market economics: the weakening of trade unions; tax cuts; trade liberalisation; financial deregulation; and the opening up of capital flows.

In a classic analysis, published in 2004, Harvard University’s Kenneth Rogoff argued that this increase in competitive pressure, some of it coming from China’s entry into the world economy, was a key factor behind the success of the disinflationary policy.

One might add that these changes — disinflation, deregulation and globalisation — also led to a fundamental swing in economic and political power, away from labour and towards the owners of capital. This, too, promoted the bull market.

An important question is why the inflation-disinflation cycle — indeed, so much of what has happened economically — was so similar across high-income countries. The answer must be that they are both exposed to shared ideas and connected through commerce, capital flows and monetary policy.

Another salient characteristic of the past four decades has been expanding debt, initially mainly private debt, driven by financial deregulation. After the global financial crisis in 2007 and 2008 and the eurozone crisis that followed, government debt also soared.



The debt accumulation has also been the consequence of structurally weak demand across the world economy. 

In 2005, former Federal Reserve chair, Ben Bernanke, called this phenomenon “the savings glut”. More recently, former US treasury secretary, Lawrence Summers has termed it “secular stagnation”.

The result of this has been falling and ultimately negative real interest rates and, given the low inflation rates, as well, near-zero or even negative nominal interest rates, especially in times of severe crisis.

The Asian financial crisis of 1997-98 and the bursting of the dotcom bubble in 2000 were just intimations of what might happen. The big shock to the system was the global financial crisis, which was met by a huge monetary and fiscal response.

Some worried then that this would end the era of low inflation. That fear turned out to be misplaced. 

Premature fiscal tightening and a weak monetary policy response, especially in the eurozone, led, instead, to a disappointing recovery and persistently sub-target inflation in the US and eurozone.

The lesson learned from this disappointing experience was that the response must be quicker, bigger and more determined next time. 

Covid-19, a quite different kind of shock, turned out to be that “next time”. It was met by extraordinary fiscal and monetary action, to stabilise the economy and people’s incomes.

Is this second huge shock in 12 years going to trigger what the global financial crisis did not — the shift towards high inflation, which many on the right then feared, and the revolt against capitalism, which many on the left then desired?

This is certainly not what markets now expect. They expect a healthy recovery. 

Bond markets merely indicate a modest and desirable rise in inflation expectations and inflation-risk premiums, especially in the US. Stock markets also remain confident of future profitability.

The dominant concern of central banks, notably the Federal Reserve, is still to raise inflation, not keep it down. 

Central banks hope that, with higher inflation and inflation expectations, they would be able to raise interest rates well above zero. This would give them more room for manoeuvre in future, in response to negative shocks.



Furthermore, central banks believe that, in today’s economy, the response of wages to unemployment is very weak. 

This means they are able to run economies “hot”, with little fear of an unduly strong rise in inflation.

Politics has changed, too, especially in the US, with the election of Joe Biden as president. 

The ideas of “Modern Monetary Theory” — the view that the only constraint on monetary financing of government is inflation, which, in turn, is best controlled by fiscal policy — has won much intellectual favour on the left. 

So, too, has the conviction that there must be a rebalancing of the relationship between labour and capital, in favour of workers.

These new perspectives have now come to fruition with the passage in the US of a $1.9tn fiscal stimulus programme supported by an expansionary monetary policy expected to last at least until 2024, even though the Fed forecasts US GDP growth as high as 6.5 per cent this year. 

The administration is also thinking of a further $3tn in spending on longer-term priorities, including the green economy. In total, these programmes would amount to almost a quarter of US GDP. That is transformative policymaking.

Summers has criticised the approach, telling Bloomberg: “These are the least responsible fiscal macroeconomic policy we’ve have had for the last 40 years.” 

Furthermore, “it’s fundamentally driven by intransigence on the Democratic left and intransigence and the completely irresponsible behaviour in the whole of the Republican Party”.



The likelihood, then, is that there is going to be a huge expansion in spending and little in the way of additional taxation. 

Given the monetary expansions, too, the chances of an inflationary overshoot have substantially increased.

If this happens in the US, worldwide spillovers are quite likely, not least in the UK. 

But in other high-income countries, too, household savings are high, fiscal deficits large and monetary policy expansionary. 

The kindling needed to light an inflationary fire can be seen almost everywhere.

Distorting the economy

In the 1970s, the British economist, Charles Goodhart, propounded what came to be called Goodhart’s law: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” 

This “law” could help explain the failure of monetarism.

This law may have a corollary: “A statistical relationship, once ignored, will become relevant.” 

If so, the Phillips curve, which links unemployment and inflation, or the relationship between broad money and spending might come back to bite us.

So what would it mean for investors if inflation were to rise well beyond 2 or 3 per cent? The initial effect would be to increase profits and so be good for equities, but the inflation would be terrible for bond markets.

High inflation tends to distort the economy, partly because taxes are imperfectly adjusted for inflation. It will raise long-term interest rates. 

That will undermine the solvency of many debtors, including corporate debtors, as debt is rolled over.

Above all, an inflationary overshoot will trigger a disinflationary response from central banks. That will mean much higher policy rates. 

That could lead to waves of default far more pervasive than in the early 1980s, when the big story was the debt crisis in developing countries. 

This time, the debt crises could be almost everywhere, because there is so much more debt.



These risks could also interact with the structural threats laid out by Goodhart and Manoj Pradhan in The Great Demographic Reversal. 

The economic regime that began in the 1980s is, they argue, coming to an end, with rising protectionism and rapid ageing in all the important economies, including China.

As labour forces shrink, this book suggests, the number of consumers will rise relative to the number of producers, thereby raising prices. 

Fiscal pressure will rise inexorably, as the population ages. 

If governments have to choose between inflation and fiscal tightening, they will choose the former. 

Finally, if interest rates rise too high for comfort, governments will force central banks to lower them.

Ultimately, then, these pressures would end in another era of high inflation. 

Some will note, against this view, that this is not how things have ended up in Japan, where decades of easy money has failed to ignite inflation.

Maybe, that will now happen in the world as a whole: we will all end up Japanese. 

Certainly, history never repeats exactly.

The stagflation of the 1970s, especially the squeeze on profits and stock market collapse, were due to features of the economies of that time, especially the political strength of labour. 

So, things may play out quite differently this time.

Inflation has not come back. 

It may never do so. 

But the political and shifts we are seeing today, after Covid, together with the longer-term changes in the world economy, have raised the chances of an inflationary shock of some kind. 

Investors must take this possibility into account.

SISYPHEAN PRINTING WILL KILL DOLLAR & BONDS

By Egon von Greyerz


Understanding four critical but simple puzzle pieces is all investors will need to take the flood that leads to fortune.

Why then will the majority of investors still take the wrong current and lose their ventures?

Well because investors feel more comfortable staying with the trend than anticipating change.

Understanding these four puzzle pieces will not just avoid total wealth destruction but also create an opportunity of a lifetime.

The next 5-10 years will involve the biggest transfer of wealth in history. Since most investors will hang on to the bubble markets in stocks and bonds, their wealth will be decimated.

As Brutus said in Julius Caesar by Shakespeare:

“There is a tide in the affairs of men,

Which taken at the flood leads on to fortune.

Omitted, all the voyage of their life

Is bound in shallows and in miseries.

On such a full sea we are now afloat.

And we must take the current when it serves.

Or lose our ventures.”

FOUR PUZZLE PIECES TO CLARITY

So what are the four puzzle pieces that will lead to either fortune or misery.

They are:

1. Stocks

2. Currencies

3. Interest rates

4. Commodities

Just put these 4 pieces together and the conundrum of the direction of markets and the future of the world economy will be very clear.

But sadly most investors will find it difficult to join up the 4 pieces.

ETERNAL PRINTING

Have governments and central banks conditioned investors to eternal happiness by their profligate policies?

Yes, they most probably have. But happiness in this case is ephemeral and will end in “miseries”.

Central banks are now caught in Sisyphean task of printing money to eternity.

The more they print, the more they need to print. When Sisyphus came to Hades, his punishment was to roll a big rock up a hill. 

Once he got to the top, it rolled down and he had to roll it up again and again and again.

And this is also the punishment that the Fed has received. As I pointed out in my article about the Swiss 16th century doctor Paracelsus, everything is poison, it is only a question of the dose. 

The US has for decades received a toxic overdose of “free” money and once hooked the only remedy is to continue to inject the poisoned patient (the US economy) with more of the same.

On the one hand, the Fed can never voluntarily stop the printing as this would lead to instant collapse of stock markets, bond markets and the financial system.

But on the other hand, the incessant printing also has consequences.

It will destroy the dollar and it will destroy the treasury market and eventually lead to inflation and hyperinflation.

Destroying the bond market means substantially higher interest rates which is something that neither the US nor the world can afford with $280 trillion of debt and rising fast.

So there we have it. The US and the world have both their hands tied and whatever they do will have dire consequences for the world.

So let’s come back to the 4 puzzle pieces which investors should have imprinted in their brain.

PUZZLE PIECE 1: COMMODITIES

Since Nixon closed the gold window 50 years ago, the world has experienced unprecedented credit growth and money printing.

Gold backing of the currencies kept the central banks on a short leash, but since 1971 there has been a free for all monetary bonanza in the US and most of the world.

Since 2006 the money creation has gone exponential.

The pure definition of inflation is growth in money supply. But until recently, only asset classes such as stocks, bonds and property have seen major inflation. Normal consumer prices have officially only increased by marginal percentages even though most of us are experiencing much higher inflation than the official figures.

But now commodity prices are warning us that inflation is here with a vengeance.

For example, agricultural product inflation is up 50% since last May. This hasn’t yet reached consumer prices in a major way but it soon will.

If we look at commodity prices in general, they are up 100% since the April 2020 bottom.

And looking at commodity prices to stocks, we can see in the chart below that commodities are at a 50 year low with a massive upward potential which is an advance warning of a major inflationary period lurking.


Most commodities will go up dramatically in price, including food and energy.

GOLD – THE KING OF METALS

Investors who have been reading my articles will know that the best investment for benefiting from inflation and simultaneously preserving wealth are precious metals stocks as well as physical gold, silver and platinum.

Gold is the king of the precious metals and since it broke the Maginot Line at $1,350, it is now on its way to levels few can imagine. 

Any correction, like the current one should be taken as an opportunity to add more gold.



Gold is today at historical lows in relation to money supply and at the same level as in 1970 when gold was $35 and in 2000 when gold was $290. See graph below.

This means that the price of gold has far from reflected the massive creation of money in the last few decades. So that is still to come.

PUZZLE PIECE 2: DOLLAR – CURRENCIES

The accelerating deficits and debts in the US will continue to put downward pressure on the dollar.

When I started my working life in Switzerland in 1969, $1 bought 4.30 Swiss francs. 

Today you get only 0.89 Swiss franc for $1. That is an 80% fall of the dollar against the Swiss. 

The next significant target is 0.5 Swiss franc for $1. 

That would be another 44% fall from here.


Admittedly, the Swiss franc has been the strongest currency for over 50 years. 

But even if we look at the troubled EU, it has recently broken out against the dollar and looks very bullish.



But we must remember that all the currencies are in a race to the bottom and there is no prize for being first.

Just look at the gold against the dollar which has lost 85% since 2000.



As I have pointed out many times, all currencies have lost 97-99% in real terms, against gold, and in the next few years, they will lose the remaining 1-3%.

We need to understand that those final few percent fall means a 100% fall from today. And the demise of the current currency system as von Mises predicted.

CURRENCIES DEMISE ARE DETERMINED THE DAY THEY ARE BORN


The very nature of fiat currencies means that their demise is determined the day they are born. Since governments throughout history have destroyed every single currency, it is ludicrous to measure your wealth in a unit that is destined to become worthless.

Remember that gold is the only money which has survived for 5,000 years.

PUZZLE PIECE 3: INTEREST RATES

Interest rates worldwide are at historical lows. In Switzerland for example, you can get a 15 year mortgage at 1.1%.

It clearly sounds like the bargain of a lifetime. You can buy a house for 1 million Swiss franc and just pay 11,000 francs in interest. If you rented the same house, the annual rent would be 3x the interest. So there is a clear disconnect which is not sustainable.

The emerging inflation will push interest rates up and we have already seen the 10 year US treasury rise from 0.39% in March 2020 to 1.34% today. Technical and cycle indicators confirm that the monthly closing bottom in July 2020 could have been the secular bottom.

If that is correct, we have seen the end of the bear market in rates and bull market in treasuries since the Volker high at 16% in September 1981.

There is nothing natural in this 40 year suppression of interest rates.

When Volker became Chairman of the Fed in August 1979 the 10-year Treasury was 9% and he quickly hiked it to 16% in 1981. When Volker left in August 1987 the 10 year was back at 9%, the same level as when he took over 8 years earlier.

GREENSPAN – GREENSPEAK & LOW RATES

Then Greenspan entered the scene with a Fedspeak that nobody understood but both politicians and Wall Street actors loved his actions that spoke much clearer than his words. During his 13 year tenure, the 10 year halved from 9% to 4.5% in 2006.

Every subsequent Chair after Greenspan only had one policy, accommodate more by endless printing and lower interest rates.


And that is the 40 year saga of US 10 year treasury rates – from 16% in 1981 to 0.4% in 2020.

PRINT UNTIL YOU ARE SKINT

Clearly, the management of US rates seems more like desperation than policy.

In a free and unmanipulated credit market, supply and demand would determine the cost of borrowing. As demand for money goes up, so will the cost of borrowing, thus reducing demand. And when there is little demand the cost goes down which stimulates borrowing.

This would be the beauty of a free and unregulated credit market. Supply and demand for credit affects the cost of money and acts as a built in regulator.

But Keynesian policies and MMT (Modern Monetary Theory) have done away with sound money.

UMT (Unsound Monetary Theory) would be a more appropriate name for the current policies.

Another suitable name would be Print Until You Are Skint!

The current policy of low rates has two purposes.

The first is to keep stock rising. Because high stocks gives the illusion of a strong economy and strong leadership. Thus it is the perfect tool to buy votes.

Secondly, with a US debt of $28 trillion, free money is a matter of survival for the US. Imagine if rates were determined by supply and demand.

Every president in this century setting a new record. Bush almost doubled US debt from $5.7 trillion to $10t over 8 years. Obama doubled it again from $10 to $ 20t and Trump set a new 4 year record with a $8 trillion increase.

With debt going up exponentially, an appropriate market interest rate would be nearer 10% than the current short term rate of 0%.

A 10% cost of the US debt of $28t would mean $2.8t which would virtually double the already disastrous US budget deficit.

And if we take total US debt of $80 trillion, a 10% interest rate would cost the US $8t or 40% of GDP.

So a colossal task here for the Fed to suppress rates against the natural market forces.

In my view they will fail in the end – with dire consequences.

It looks like Powell is going to be the first Chair of the Fed since Volker who will actually preside over rising rates although he will fight against it.

The interest rate cycle has most probably bottomed. This will be a major shock to the market which forecasts low rates for years. Initially inflation will drive rates up.

Thereafter a falling dollar will lead to yet higher rates. The panic phase will come as the dollar collapses, and debt markets default. That will lead to hyperinflation.

PUZZLE PIECE 4: STOCKS

Warren Buffett started in the investment business in 1956. The Dow was then 500 and has since gone up 63X. Since he started, Buffett has achieved an average annual return of 29.5% year on year.

Clearly a remarkable record achieved over a 75 year period. It is very likely that Buffett and all stock market investors will see stocks not just fall but crash.

BUFFETT INDICATOR – MASSIVE OVERVALUATION OF STOCKS

Buffett’s own indicator of stock market value to GDP is now giving investors a very strong warning signal.

The US market is now 228% to GDP. 

That is 88% above the long term trend line and substantially above the 1999-2000 valuation when the Nasdaq crashed by 80%.



STOCKS TO ENTER AN AIR POCKET

With an 88% overvaluation the Dow can enter a very big air pocket at any time.

The Dow/Gold ratio is a very important measure of relative value between real money and stocks. This ratio peaked in 1999 and fell 89% to 2011. Since then we have seen a correction which finished in 2018. 

The next move in the ratio will reach 1 to 1 as in 1980 when the Dow was 850 and gold $850. Lower levels are likely thereafter.


A 1 to 1 ratio in the Dow/Gold ratio would mean that the Dow will lose 94% from today against gold. That is a very realistic target. 

Remember that the Dow fell 90% on its own in 1929-32 and that it took 25 years to recover to the 1929 level. And on all accounts, the situation today is much more severe than in 1929.

The secular bull market in stocks is very likely to finish in 2021. This turn could be at any time. Just like in 2000, it will all happen very quickly and this time it will be the start of a very long and vicious secular bear market.

Real assets like gold, silver and platinum will be investors’ life insurance.

To hang on to stocks and bonds will totally destroy your wealth and your health.

New Age of Chinese Nationalism Threatens Supply Chains

Assumption that China and East Asia offer multinationals a stable security environment must now be revisited

By Nathaniel Taplin

Taiwanese navy troops conducting a drill in Kaohsiung, Taiwan, in January./ PHOTO: RITCHIE B TONGO/SHUTTERSTOCK


Relations between China and the West are off to a rocky start in 2021. 

Observers watching China and the U.S. trade accusations in Alaska, and Europe and China trade sanctions days later can be forgiven for a cold feeling in the pit of their stomach. 

Beijing’s tolerance for economic risk in the service of nationalism has rarely looked higher.

That could bode ill for many, not least Taiwan and the littoral states of the South China Sea. 

The trade conflict between the U.S. and China has metastasized into a broader geopolitical confrontation—while China’s armed forces are nearing parity with the U.S. in the former’s backyard. 

Chinese incursions into Taiwan’s air defense identification zone have at times become a near daily occurrence since late 2020, while the U.S. is busy rallying allies such as Japan to plan for contingencies.

A significant conflict between the U.S. and China in East Asia is still unlikely, but it can no longer be ruled out as an implausible tail risk. 

Companies need to start considering what that could mean. 

And governments need to find mutually acceptable ways to take the temperature down if they want regular business to remain possible.


The most likely scenario is still that the catastrophic potential downsides of any armed conflict keeps minds focused. 

Even “gray zone” tactics like a blockade of Taiwan would be hugely risky for Beijing—Taipei might respond, for example, by cutting off China from all semiconductor sales. 

U.S. and allied trade and financial sanctions would multiply the impact. 

Taiwan alone supplies around a third of China’s semiconductors, including some exclusively produced by Taiwan Semiconductor Manufacturing Co. , the world’s largest contract chip maker.

It is no longer completely clear economic deterrence alone is enough to prevent Beijing from attempting its long-treasured goal of absorbing Taiwan if it perceives distraction or weakness, even leaving aside the rising risk of accidental conflict.

The decision to jeopardize China’s painstakingly negotiated bilateral investment treaty with Europe by directly targeting members of the European Parliament on Monday is only the latest sign of Beijing’s rising willingness to accept big economic risks. 

Hong Kong’s national-security law is the most obvious example, but the U.S. failure to move Beijing on fundamental issues over the course of the trade war can be seen partly in the same light.

Beijing risks boxing itself in through its domestic messaging. 

One possible reason for China’s aggressive response to allied sanctions is that the country’s state media had just spent days playing up China’s muscular stance against the U.S. in Alaska.

One popular People’s Daily social-media post led with two photos: one of China officials facing down the U.S. delegation across the table during talks in Alaska, and one of Europe, Japan and the U.S. facing down China after the disaster of the Boxer Rebellion in 1901, an episode that Beijing views as part of its “century of humiliation” at the hands of Western imperialists. 

The message was quite clear: China is back, unafraid and powerful. 

Faced with the unfavorable optics of united Western sanctions a few days later, an aggressive response was perhaps inevitable.

All of this is a worrying signal for the future—especially if, as seems likely, Chinese growth keeps slowing and the leadership keeps leaning ever more heavily on nationalist pride to keep the country behind it. 

Companies need to start thinking about what that really means. 

In the event of a trade or financial embargo imposed on China during a crisis in the South China Sea or Taiwan Strait, would their assets and staff in China be safe from becoming bargaining chips? 

Beijing has actually been relatively restrained in its use of corporate blackmail compared with the levers available to it, recognizing the immense potential collateral damage—but in a real national crisis it is difficult to know how the government would react.

Washington and Beijing both need to find acceptable ways to take the temperature down. 

One possibility might be the sort of confidence-building steps that helped derail the cycle of escalation in the Cold War.

For instance, both countries have a critical interest in keeping chips flowing from Asia, just as the world has long had an interest in Middle Eastern oil flowing smoothly.

 Discrete steps that helped ensure that—for example, a limited resumption of chip sales to Huawei Technologies in exchange for limited, verifiable reductions in Chinese armaments targeting Taiwan—might be one way forward. 

There are no easy answers but creative thinking is clearly needed to find ways to enhance Taiwan’s security while also strengthening deterrence and lowering the risk of accidental conflict.

Meanwhile, companies in the region need to start preparing for contingencies. 

As Covid-19 and the recent chip shortage have both shown, supply-chain diversification and redundancy is expensive—but possibly less expensive than not having it in the end.

Go On, Fight the Fed: Why, and How, Investors Should Gird for Inflation Risk

By Lisa Beilfuss

Producers have been eating cost increases on many goods, but gas prices have been on the rise. Here, a gas station in Mill Valley, Calif., on a recent day. / Justin Sullivan/Getty Images


How long is temporary?

That’s the big question looming over the U.S. economy as it laps data gathered during the height of pandemic-driven lockdowns, setting up year-over-year comparisons that will look either artificially amazing or awful. 

This dynamic matters most, of course, to inflation measures that are bound to get hot.

Over the past two weeks, the Federal Reserve has worked hard to assure investors that upticks in inflation would be temporary, owing more to math than to economics.

“We might see some upward pressure on prices. 

Our best view is that the effect on inflation will be neither particularly large nor persistent,” Fed Chairman Jerome Powell told lawmakers this past week, reiterating comments he has made since the latest, $1.9 trillion stimulus package was signed earlier in March.

It’s easy to see how so-called base effects would make for some superficially high inflation numbers over the coming months, when calculating the year-over-year rates of change include depressed lockdown levels of a year ago. 

But how do you know that price increases are fleeting, especially as prices rise in everything from copper and oil to homes and haircuts?

A $4.2 trillion increase in money supply over the past year, driven by extraordinary fiscal and monetary aid, is reason enough for investors to question guidance that inflation is temporary and due to year-over-year pandemic comparisons. 

Ed Yardeni, president of Yardeni Research, says the 27% increase in M2—a measure of monetary supply that includes currency, deposits, and shares in retail money-market mutual funds—from last year could help create an inflationary boom in the second half of the year as more people get vaccinated and as supply-side inflation lingers.

Looking at a variety of recent economic indicators, it seems prudent for investors to prepare for the possibility that inflation isn’t so transitory. 

More immediately, there is evidence that even potentially temporary price increases are affecting corporate profits.

Consider the spread between wholesale and consumer prices. 

For the first time since July 2019, the producer-price index is outpacing the consumer-price index. 

That’s according to Department of Labor data for January and February. 

While two months don’t make a trend, the shift reflects increasing pricing pressures that many businesses face—while showing that, at least for now, firms are absorbing those higher costs instead of passing them on to their customers.

Recent surveys highlight the strain. 

“Higher prices have ensued,” IHS Markit said this past week in its March purchasing managers index, with prices “running far above anything previously seen in the survey’s history.” 

That follows the highest level of input prices since 1980 in the Philadelphia Fed’s latest manufacturing survey.



Companies eating higher costs fits with the Fed’s view that rising prices aren’t here to stay: If corporate executives see price increases as transitory, they won’t go through the pain of raising prices, says Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. 

But while absorbing price increases instead of passing them on may be a positive macro sign, it’s at the expense of bottom lines.

That’s a problem for stocks, given potential profit margin compression as margins sit near peaks, Shalett says. 

A weaker U.S. dollar isn’t helping, as it’s making the cost of importing raw materials more expensive.

Beyond what is happening on assembly lines, there’s the fact that companies across all sectors face higher financing costs via rising bond yields—especially given the record amount of corporate debt.

“Powell is putting a happy face on the backup in bond yields,” attributing the moves to recovery optimism, Yardeni says. 

“The Fed has decided to let bond vigilantes be the bad guys and do the tightening,” and, he adds, “it’s quite possible bond yields continue to surge.”

The cost of credit doesn’t just affect the cost of doing business. 

There’s also the impact on chief financial officers, says Torsten Sløk, chief economist at Apollo Global Management, particularly in terms of how borrowing costs affect inflation expectations.

Keeping inflation expectations stable at about 2% is crucial to the Fed’s ability to control inflation, as expectations for rising prices can pull spending forward, creating something of a self-fulfilled prophecy.

Several recent indicators suggest that such expectations are rising well above that level. 

The Atlanta Federal Reserve Bank’s March report showed that businesses’ year-ahead inflation expectations jumped to 2.4%, the highest reading since the survey began in 2011. 

And according to the University of Michigan, inflation expectations among those 55 and older are the highest since May 2015. 

That’s particularly noteworthy, as the cohort accounts for roughly 40% of total consumer spending in the U.S., Sløk says.

Markets, meanwhile, are pricing in significant increases in inflation. 

A measure compiled by the Minneapolis Fed shows that traders place a 30% chance that the CPI surpasses 3% for the next five years. 

That’s the market increasingly betting that the Fed is behind the curve as it focuses on the roughly 10 million workers still unemployed and expresses new tolerance for higher-than-normal inflation.

To Yardeni, summer is the point at which it would become clear that building inflation isn’t so temporary. 

Year-over-year readings of 2.5% or higher after June will mean that price increases are indeed a problem, he says, an outcome he anticipates.

“They’ll have to tighten earlier than telegraphed. 

There’s no way they can’t be raising rates next year,” Yardeni says of the Fed, which has suggested that it won’t lift rates before 2024.

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So what is an investor to do as the inflation debate continues, with the Fed and market apparently at odds and inflation data set to spring higher?

Equity strategists at Barclays built an inflation proxy to quantify the exposure of sectors and stocks to inflation expectations. 

Using the proxy, they came up with long and short baskets for investors to consider as market-based inflation expectations rise. 

Their indicator, they say, is long on media, banks, and energy and short on capital goods, healthcare, and real estate stocks.

The bank’s top long ideas include oil-and-gas company Halliburton (ticker: HAL), media company Viacom (VIAC), energy producer Pioneer Natural Resources (PXD), regional bank Comerica (CMA), and electrical-equipment company Emerson Electric (EMR). 

In the basket of stocks to consider selling: real estate investment trust Crown Capital International (CCI), chemical company Ecolab (ECL), and security company Allegion (ALLE).

Elsewhere, analysts say it’s wise to underweight bonds and prepare for declines in emerging market stocks, which have done well amid near-zero interest rates. 

In addition to high-growth technology companies that are more rate-sensitive, analysts say consumer staples and utilities stocks are less attractive amid hotter-for-longer inflation, while cyclical stocks and banks should benefit.

Investors looking to keep their finger on the pulse of the inflation debate should watch wage figures closely. 

Labor, after all, is most companies’ biggest cost, and wage inflation has been missing for a long time.

It is possible the Fed is right and rising inflation will be temporary. 

But given the continuing recovery, massive amounts of stimulus, and clear supply-side pricing pressure, the risk of not preparing for the possibility that the Fed is wrong seems much costlier than the risk of readying for higher inflation and interest rates.