I was interviewed by the advisory team this week to talk about markets and answer tough questions on our outlook for 2023. We transcribed the conversation below.
Is inflation really falling?
Inflation is a currency phenomenon. It’s too many dollars chasing too few goods. That’s why the chart below is so interesting1. It shows that M2, which measures how much money is in the “system,” leads the inflation rate. When the money supply rises [blue line], inflation rises with little lag [red line].
Look at the blue line in 2020. That’s when the Fed decided to explode the money supply by over 40% in two years. The country hadn’t seen anything like that since World War II, and now we’re dealing with the aftermath. This relationship again confirms one of the most fundamental concepts in economics. Increase the supply while keeping demand relatively fixed, and the value of dollars falls. There’s no better way to visualize this concept than this other chart from First Trust [below]. One dollar in 1980 was worth 30 cents as of a year ago.
If inflation is a byproduct of supply and demand for dollars, one or both must fall for inflation to come down further. Demand for dollars worldwide appears to be going nowhere, so it’s likely the supply side from here. But we have property rights, meaning the government can’t just go into our bank accounts and take back those stimulus checks. Hence, supply will have to fall over time via a lower growth rate.
As in, the spike we saw in 2020 through 2021 was way above the long-term growth rate, so to get back to normal, we need a period of below-average growth. The good news is that the money supply chart shows that the blue line is now growing at the slowest pace in four decades.
How long will it take to get back to normal?
It depends on the tenacity and grit of our fearless leaders in D.C. If they stick to this current growth rate, then maybe next year. But money supply growth also correlates with popularity, so I’m skeptical that politicians will remain disciplined with another presidential election approaching.
That being said, we don’t need to get back to 2% inflation before the Fed pivots. They just need to see inflation solidly moving in that direction, and there’s already plenty of evidence that it’s happening.
It's interesting that you didn’t credit rising interest rates for falling inflation.
Few things fire me up more than misusing data and statistics, and since most pundits and politicians misuse data and statistics, I’m fired up most of the time. But there are instances when causality gets confused with correlation, and it’s ok.
That’s how I feel about the Fed’s “progress” so far. There’s an old saying that raising interest rates is a blunt instrument, and for the most part, I agree. Aside from housing, I’m not sure how higher interest rates have done much to temper inflation. For example, how are they moderating global shipping rates?
So, the Fed has had no impact so far?
No, they have. Last year, the value of the dollar relative to pretty much every other currency on the planet surged higher because the Fed panicked. Since most commodities are priced in dollars for global trade, it’s more expensive for foreign entities to buy stuff. So, demand probably got hit. How much is hard to estimate.
But that doesn’t change the fact that the Fed suffers from “the law of the instrument.” They have a hammer – interest rate policy - but problems like disrupted supply chains, wars, and Taylor Swift concert tickets aren’t nails. They can’t be solved just by hiking interest rates.
And you’re saying it’s ok for the Fed to think they are doing a good job, even if their tools aren’t that effective?
Let’s go back to Econ 101. It also teaches that we are all self-interested, and not one person at the Fed is immune to this basic desire. They want to feel like they’re doing a good job and crave just as much social validation as anyone else would seek after screwing up so badly. Perception is reality, so if they want to think their hammer is surgically fixing inflationary pressures, then so be it. They call the shots.
In fact, I fully support the FOMC’s decision to move their meetings to whatever alternate universe they’re in right now. Keep thinking you’re doing a good job, pat each other on the back, and use this correlation - not causality - to justify a pause.
So, the ends will justify the means?
In a way, yes. Inflation is falling, and this is indisputable. If the Fed wants to take the credit, then I don’t care. But if you want to know where inflation is headed, look at trends in the money supply more than the price of a dozen eggs.
You bring up an interesting point. Inflation may be falling, but most Americans that buy eggs might disagree.
Yes and no. Used cars and gasoline are back down to earth. So is lumber and a myriad of other commodities. But it will take time for grocery stores to adjust because of other inflationary pressures like wage growth. Despite the slowing economy, we’re still at the lowest unemployment rate since Woodstock2. Furthermore, many producers lock in prices for 6-12 months, so they don’t feel the benefits of lower input costs right away.
Back to the Fed. If they take credit for inflation falling, does that mean they could stop raising rates soon?
Yes. They appear to be raising rates next week by only 0.25%. That’s down from 0.50% in December and 0.75% in November. My guess is they do the same in March and then pause. The market tends to agree based on what’s been priced in and is even expecting a rate cut later this year.
Those odds seem at odds with what the Fed is saying these days.
They are if you take the Fed at their word. But it’s one thing to talk tough, and it’s another to stay tough if the economy does dip into a recession as inflation falls further. The Fed also has a long history of saying they’ll do something and then not doing it.
Are you implying the Fed could achieve a soft landing?
Soft landing is moderating inflation without dipping the economy into a recession. The answer is “yes.” It’s like the Godfather 2 - difficult, not impossible. If you think about it, that’s what’s happened so far. Inflation is down, while employment remains strong relative to prior cycles. Now they need to pump the brakes and hope their timing is impeccable. Difficult, not impossible.
Employment may be strong, but we’re in earnings season, and so far, it’s been a mixed bag. Companies are beating but signaling headwinds. Thoughts?
Sentiment is bad right now. Here’s a chart showing that earnings revisions are about as negative as we’ve seen in a long time. Leading into the New Year, analysts cut estimates by 6.5%, while over the last five years, the average cut has been 2.5%3. Talk down expectations for investors so that companies can beat them when they report. It’s an old game on Wall Street.
That’s why roughly 70% of companies reporting so far have beaten. Given the economy's direction, I’d wager we see a lot more “under promise and over deliver” going forward.
That doesn't sound good.
I’d say it’s more irrelevant than bad. Earnings are a measure of what has already happened. That may matter for day traders, but long-term investors need to focus more on where earnings will be 12 to 24 months from now. If the economy continues to slow down, then earnings will fall. The question is if they fall more or less than what’s already been baked into expectations, and as you can see, expectations are low.
It's hard to tell if you are bullish or bearish.
I was reading a book to my daughter the other night, and there’s this lizard character. That one that can point one eye in one direction and the other eye in a different direction. It occurred to me that this is a pretty good analogy for how I think investors should position for 2023.
Keep one eye on the economy because it will likely slow down from here. Expect to see more headlines of layoffs at mega-corporations. Stuff like that. The Fed will primarily focus on employment trends this year, so investors need to do the same.
But don’t lock both eyes on the economy because the stock market, for example, tends to anticipate the economy by 6 to 9 months. By the time we hit the bottom in the economy, it’s almost certain that stocks will have priced that in and already begun pricing in the recovery.
This is critically important to remember because the early innings of a stock market recovery tend to be very important. Missing out here because both eyes are focused on just the economy could risk a financial plan.
So, to answer your question, I’m bearish on the economy out of an abundance of caution and the reality that it is slowing down. I’m bullish on some markets, like bonds, which I haven’t said out loud since before the financial crisis. But these yields are becoming too attractive to ignore. Stocks are more challenging, but I’m more bullish than Wall Street consensus.
So, you’re saying one reason you are more bullish is that everyone else seems so bearish?
Pretty much. That’s the whole idea behind contrarian investing. If everyone is looking to the left, I want to peek to the right and understand why so few are doing the same. Rewind the clock to March of last year. Everyone knew that oil was headed to $200/barrel. It was a foregone conclusion on Wall Street and in the media. What happened next? Oil ended the year down almost 5%.
There’s an old saying that goes something like, “Wall Street is the only place where a sale is announced, and everyone runs out of the store screaming.” Here’s some evidence of just that.
Goldman Sachs estimates individual investors have sold all of the S&P 500 stocks accumulated during 2019-2021. If so, this is unfortunate because a lot of people could miss out on those early innings.
It’s not just mom-and-pop investors. Sentiment indicators for institutional investors are just as bad. But history has shown that these tend to be the best buying opportunities in the economic cycle.
How does all this factor into your investment strategy this year?
First, prepare for a recession but don’t bet the farm either. As I said, there is a chance that the Fed can pull off a soft landing, and if so, too bearish of a stance could risk missing the early innings of a recovery.
Second, own high-quality assets when possible. Last year was all about inflation and interest rate risk, and this year will likely be more focused on the third key risk factor for bonds, which is credit risk. Also, avoid concentrated positions in individual stocks unless there’s a compelling reason. Stocks that miss expectations or cut dividends during economic downturns can be landmines. On the flip side, strong balance sheets and consistent revenue are often handsomely rewarded.
Third, lean into diversification rather than abandon it. Last year was an anomaly. It’s exceptionally rare to see all asset classes move together. So, we are introducing new asset classes and strategies that have the potential to offer principal protection, upside participation, and liquidity all at once. We’ve recently rolled some out and expect to launch even more. Very exciting from that perspective.
2 Bureau of Labor Statistics.
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance