Inflation, International and Domestic Threats and Investment Strategy
By Vaughn Woods, CFP, MBA
The United States is now facing one of the greatest inflationary trends of the post-war era. Does this mean the stock market is doomed? Not at all. The complexity of current market uncertainty includes more than inflation. The war in Ukraine has increased market volatility sharply even as the price of oil has spiked. This goes along with my theory that pricing in the oil market may peak by the summer allowing for rebound in the technology sector once the lows of the year have been tested. We shall see.
The Russian bombardment of the Ukraine to subjugate its people has now drawn all of Europe into the conflict along with the U.S. and China. Germany is now sending tanks to Ukraine. The U.S. is now sending long-range artillery to Ukraine. Russia has stopped deliveries of gas to Poland. Russian military setback in Ukraine have given risen to nuclear threats by Vladmir Putin. China and the U.S. have taken different sides, pitting the can-do attitude of western hegemony against a communist model, which waits patiently for western weakness before advancing. Many global leaders expect China to further weaken the U.S. by attacking Taiwan to fundamentally shift the balance of power in the region.
On the domestic front, progressive policy makers and proponents of ESG (Environmental, Social and Governance) are using the threat of global warming to push back against the Biden administration’s recent announcement to resume the leasing of federal lands for oil drilling. Critics call ESG policies intellectually bankrupt and damaging to U.S. and European interests. Proponents call ESG data a “godsend.” Meanwhile, it is hoped that expanding U.S. oil production will lower inflation at the pump while supporting NATO allies in need of more oil and gas and arms to Ukraine.
On the education front, California now leads the nation in illiteracy. Some 23.1% of Californians over the age of 15 cannot read this sentence. Parents are turning in large numbers to charter schools and private schools. Twenty years ago, the Los Angeles Unified School District had 737,000 students. Today projected enrollment is below 400,000. Higher education’s effect on GDP is strong as the spending power of better-educated individuals exceeds that of lesser-educated citizens worldwide.
There are many elements affecting the U.S. economy including crime, the cost of healthcare, the low labor participation rate, taxation rates, and federal spending. Each is part of an interlocked mix affecting inflation. However, inflation poses the most immediate threat to economic progress.
Single parents and retirees find it difficult to navigate higher costs. Inflation wipes out the benefits of higher wages. Fewer first-time home buyers can afford a home. Rents go up. The national debt advances. Moreover, inflation makes it more difficult for those people who don’t employ effective strategies to keep up with inflation.
If the current inflation rate accelerates toward 10%, or worse, for the balance of this year, the stock market will face a rough road (as shown in the chart). However, if inflation appears to be nearing an inflection point and is poised to contract in the coming months (even if it remains substantially above the Fed’s target), not only is the environment for stocks probably not treacherous, but it will likely prove to be very rewarding.
There is growing evidence to suspect that not only is inflation near a top but that the deceleration of inflation over the balance of this year starting this summer will produce flashing signs that inflation abatement will ensue.
For example, freight rates rolled over in recent months. Both the ISM Manufacturing and Services Price Surveys—while still at very high levels—stopped increasing last fall. Moreover, the Core CPI reading for March was below expectations, and the annual wage-inflation rate has trended sideways (near 5.5%) since last October.
In addition, inflation expectations embedded in the bond market (breakeven rates) stopped rising in the last couple of months. Finally, after a surge from the Russia/Ukraine war, commodity prices, including both the S&P GSCI Agricultural and Energy Indexes, while still volatile, have flatlined since early March.
Recently, supply/demand reports also offer some hope for inflation to retreat. A declining trend in real retail sales and a flattening in many housing-related measures suggest that some demand destruction is starting to surface due to both higher inflation and mortgage rates. Perhaps, more importantly, supply issues are improving, as evidenced by a surge in the U.S. labor force over the last five months. (After growing at a pace of less than 0.5% annualized from August 2020 to October 2021, the labor force has since expanded at a stellar 4.2% pace.)
Finally, tighter economic policies were put in place over the last year. A significant drop in real money supply growth is helping. Much lower deficit spending as a percentage of nominal GDP is helping to flatten the yield curve. These programs should soon have a subduing impact on economic activities and inflation because, traditionally, there is a one-year lag before the intended effects of these actions are realized.
This recovery’s excessive inflation has made the stock market increasingly volatile and sensitive to “changes” in the inflation rate. Should the inflation rate climb higher, that represents a risk, but if inflation is near its peak, that also presents a great opportunity for stock investors. Which scenario is more plausible over the balance of 2022? The CPI inflation rate rising to over 10% or falling below 6%? So, with the volatility index now above 33, many of the greatest fears regarding inflation should be baked into the near-term picture, creating a good entry point for those with a higher level of cash.
I am guessing a decline to under 6% (and perhaps closer to 4%) is more probable by the end of this year. Consequently, based upon the historical reaction of the stock market to changing inflation rates, investors may be potentially facing a “fleeting” opportunity. That is, when inflation is this elevated (and likely to decline), it is time to buy stocks using prudent technical and fundamental signals.
Leuthold Group, LLC
Investors should be aware that there are risks inherent in all investments such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA02720.