·Structural Changes within the Economy Call for Much More than Rising Interest Rates to Cure Embedded Inflation
·Massive Trend Toward Deglobalization Is Beginning and Wall Street Needs to Pay Attention
·Why The Financial Markets Are Giving the Fed a Headache
·Complacent Financial Markets Should Not Treat Fed Policy as the Be-All and End-All
©February 17, 2023
Daniel L. Ascani
Inflation is here to stay for much longer than most anticipated, but a good number of investors don’t seem to want to embrace that reality. Nor do they seem to want to get fully behind the Fed’s hawkish messages.
After wrongly concluding in 2021 that it was a transitory phenomenon, our nation’s central bank – the Federal Reserve –revised its erroneous disposition toward inflation in 2022, finally recognizing that the current bout of inflation is not transitory but is instead becoming embedded in our economy so much that interest rates are going to have to remain high for a long time.
Soaring interest rates are normally bearish for equities, but this year stocks have slugged higher nonetheless—despite the Fed’s repeated admonitions—as many institutional and retail investors cling to an almost desperate hope that the Fed will pivot and end its tightening cycle merely a few months after it began.
But those clinging to that hope may be in for more surprises in the coming months—surprises that aren’t necessarily related to rising interest rates, but instead, are likely to occur when it’s discovered down the road that higher rates haven’t cured our inflation problem.
That’s because the Fed’s policy of raising interest rates to combat inflation addresses the demand side of the equation but not the supply side. Moreover, almost a year into the Fed’s latest tightening cycle, the labor market remains strong, as does consumer spending. If the Fed is banking on a big slowdown in the economy to reduce demand and, therefore, inflation, we all may have surprises yet to come when inflation refuses to stay down.
So what’s the issue, and why is the Fed’s approach to combatting inflation by itself not likely to work over the long run?
Deglobalization: The Economy Is Beginning a Massive Structural Change
The answer, in part, to the question of why inflation has become so bad lies with the trillions in stimulus the government injected into the economy as a result of the pandemic lockdown. When you overstimulate the economy, demand accelerates and inflation results.
The new trends also promise to give the Fed and the financial markets a headache for some time to come if the solution of choice remains one that relies almost exclusively on a monetary regime of rising interest rates and the Fed’s so-called Quantitative Tightening to slow the economy and, subsequently, demand. And that headache may turn into a migraine if investors continue to lap at the door of the Fed—hoping for a pivot that’s not likely to happen and remaining overly-focused on extreme short-term remedies to quickly solve the inflation problem and end the bear market in stocks.
But perhaps flying under the radar of most investors and economists in terms of its importance to the solution to embedded inflation – and to what Wall Street should be more focused on – is the massive structural change now beginning as a result of a turn toward deglobalization and a return to Cold War geopolitics. These new trends promise to spawn long-term changes, and constitute a complete about-face from a few decades of the opposite trend: globalization.
The new trend toward deglobalization is a sharp reversal from the prior globalization movement that began in the early 1990s and lasted until the end of the pandemic lockdowns of the world’s economies in 2022 when China placed its Zero Covid Policy on ice and Russia changed the world by invading Ukraine. Compounded by the situation in which most of the world’s semiconductors are manufactured in Taiwan—the country everyone knows China may invade –corporations that currently send manufacturing offshore to reduce manufacturing costs and raise efficiency now perceive that strategy as too risky in the face of a global environment more like that of the Cold War of a few decades ago. And opening business locations in China and Russia are already almost things of the past that are now perceived as simply too risky and too vulnerable to the political whims of those authoritarian governments
Deglobalization & Higher Interest Rates Require Adjustments to Investment Models
Bringing manufacturing back home during the process of onshoring is now perceived as the safer way to go, and worthwhile for many U.S. corporations despite the higher labor and manufacturing costs associated with domestic production. This is in stark contrast to offshoring trends of the past 30 years, when manufacturing overseas to cut costs was less risky.
Corporations now must begin to adapt to a future in which higher interest rates join the trend toward higher labor costs from onshoring, and during which planning for a possible recession in the meantime cannot prudently be ruled out. And Wall Street money managers and investors must strongly weigh and anticipate new metrics affecting portfolio allocations and investment choices.
Wall Street’s Own Structural Changes Are Here to Stay Whether Investors Believe it or Not
The thirteen or so years during which the financial markets became dependent on the Fed’s Zero Interest Rate Policy, or “ZIRP,” monetary regime since the crash of ’08 and ’09 have created such a dependency on that free-money environment that investors just don’t seem to want to give it up despite evidence pointing to more difficult, higher cost times ahead. Continuing to insist on pushing up the equity markets too fast based on the hope that the Fed will pivot while ignoring the writing on the wall is sure to lead to more disappointment later.
The relatively high interest rate environment is likely here to stay for a while, absent the Fed and Treasury’s dovish reaction to any future Black Swan event. This environment is likely to lead to the structural changes invited by deglobalization that, in turn, leads to Wall Street’s own structural changes to its strategic investment models that must incorporate higher interest rates – or at least a “non-ZIRP” monetary environment—slower growth, lower corporate profit margins, and the return of competition from the fixed income arena that now delivers interest rates high enough to compete with yields attainable from the stock market.
Indeed, the higher cost of money drastically changes the metrics of the low-interest rate carry trade (borrow virtually free, then invest at a higher rate of return than the cost of borrowing). Not only does a 6-month Treasury Bill Rate, now at 5%, directly compete with expected returns from the stock market, but those expected returns are declining due to the very restructuring inside the economy that is bringing about higher labor costs, onshoring expenses, and declining corporate earnings.
And it doesn’t seem like Wall Street is willing to pay attention until forced to do so.
Fiscal Reform is Needed to Permanently Lick the Inflation Problem
The last major economic restructuring occurred in the 1980s when Ronald Reagan’s supply-side approach to taxation and economic policy broke the back of inflation soon after the Paul Volcker Fed jammed up interest rates in a similar attempt to curtail the high inflation rate of the time. And that’s the point: It took not only higher interest rates to cure inflation in the early 1980s, but also the structural changes necessary to incentivize the private sector to beef up supplies in order to meet demand over the long term. That approach helped provide a long-term protective coating of sorts to the new post-inflation economy such that inflation did not materialize again… until now.
Today we find ourselves in a similar situation to the 1980s in that a strong and committed fiscal policy in from the government is needed to incentivize corporations to increase the supply side of the equation. The Fed’s quest toward higher interest rates by themselves aren’t going to do the job. It’s going to take measures such as tax incentives and regulatory reform to permanently increase supply enough to match the ongoing post-pandemic demand explosion and put the supply-demand equation back into equilibrium. Only then will we be more assured that inflation won’t diminish, then quickly spring back again.
In Summary: Don’t Ignore These Three Structural Changes as Another “New Normal” Arrives
So we have three structural changes to deal with – deglobalization, a restructuring of Wall Street’s strategic investment models in the wake of the end of the Fed’s ZIRP environment, and restructuring of the way corporations and portfolio managers manage risk in the new Cold War environment.
It appears that it’s time for another version of a “new normal.” The old “new normal” that arose in the wake of the 2008-2009 collapse is dead. For Wall Street, the new “new normal” is emerging from that long period of zero interest rates and the Fed’s Quantitative Easing into one in which the equity market must stand on its own feet, shaking off the days of addictive lapping at the feet of the FOMC like a baby crying for its next feeding.
Solutions Involve Incentives to Increase CapEx and Business Productivity
The next steps?
Stop waiting for more free money, for one. Even if the Fed pivots in a big way and returns to its pandemic-like solutions to economic shock, it will only be because it was forced to do so by some sort of Black Swan event or the Cold War turning kinetic. Not a good scenario.
Second, embrace the structural changes that have begun and get with the bandwagon by restructuring business, fiscal, and investment models to flow with the new environment instead of fighting it. Indeed, those not embracing such structural change are making the same mistake the Fed made when it concluded inflation was transitory. Otherwise, how can one accuse the Fed of making such a mistake when the very refusal to embrace the changes that lie before us is effectively saying that inflation is transitory as the Fed made the mistake of concluding?
Structural changes this massive require big revisions in both policy and attitude. This requires a sort of “woke” attitude needed to embrace such changes, lest lagging corporations and investors be left behind when they finally accept that inflation is indeed embedded in our economy until the ensuing structural changes solve the supply/demand imbalance causing the worst inflation since the 1970s.
And whether or not one agrees with supply-side economics, take the cue from the 1980s by realizing that it took more than higher interest rates from an intimidating Paul Volcker to lick inflation for the long term. You don’t have to be a pure supply-sider to recognize that the supply side of the equation does need to be addressed for effective long-term solutions.
The changes back in the ‘80s incentivized corporations to invest in CapEx, thereby increasing business productivity. That increased productivity led to a more efficient supply of goods and services to the economy. Inflation cooled, interest rates declined, and the new economic structure went global.
Today we are faced with a similar situation, albeit one that is nonetheless a bit more challenged because of the newest trend toward deglobalization. While the financial markets hang on every word the Fed utters and every inkling of a hint that interest rates may stop rising, inflation remains embedded and the stock market rebound from bear market lows to-date risks becoming transitory itself.
If Wall Street, corporations, and the government really sit down and figure out how massive the structural changes really are going to be – and factor in a recognition that the 2008-2009 crash meant that our financial system failed and needs to be restructured itself – then the inflation problem can be cured.
The solution, therefore, lies half in recognizing and embracing such change, and in the other half taking action, and that action to incentivize our economic infrastructure to increase business productivity can pay off big time.
Output per hours of work is productivity, and it’s going to take a big increase in productivity that sticks for years to combat the strong potential for a wage-price spiral from the still-strong labor market. That increase in productivity will free up workers in this tight labor market to fill in gaps created by its very tightness.
That increase in productivity has to come from CapEx – the critical investment in infrastructure needed to increase productivity to the point at which supply is permanently able to meet increased demand, like in the 1980s and 1990s.
One thing companies can do is already occurring – they’re embracing AI. AI can help this economy spring forward in leaps and bounds such that productivity does the same. While not the entire solution, it is an encouraging development nonetheless.
The rest has to come from fiscal policy such that corporations have an incentive to make those needed capital expenditures. Until then, financial markets that rise on even a hint that the Fed may pivot from its newly-tightened monetary policy regime merely serve to give the Fed – and all of us – a headache.
It’s not that we don’t want the financial markets to rise. It’s that if they rise too far, too fast prematurely, while at the same time looking only for lower-cost or free money, the headache will only grow worse when another repricing – possibly worse than that of 2022’s bear market – occurs.
Here’s to a voluntary adaptation to the new environment, rather than a forced one. 