The ongoing debate over the duration of inflationary pressures confronting the U.S. economy has occupied an inordinate amount of space. Will they be temporary, quasi-permanent, or permanent? While expansive fiscal and monetary policies have fostered rapid growth, shortages created during the pandemic have left many parts of the economy in various stages of “catch up.”
The sustainability of these trends is unclear. With enhanced unemployment benefits scheduled to lapse in September, we are likely near the high point of government stimulus. However, the residual effect of policies, past and present, will still create an economy that is far from what it was pre-pandemic and what it will be a couple of years from now.
Trying to project the immediate trajectory of the U.S. economy seems impossible. I believe the more important questions are: What will the U.S. economy, and for that matter, the world economies, look like in 2024? And, what will be the most likely outcome of growth and inflation?
There is no doubt that economies have benefited enormously from the creativity made necessary to survive the pandemic. Systems and decisions have been pulled forward quite dramatically. The lessons learned will provide a major boost for future productivity growth. On the negative side, there is risk inherent in a globalized economy. For example, our ability (and willingness) to rely on “just-in-time” inventory management has certainly changed as a result of the pandemic-related shortages we’ve experienced. Companies will either bring their supply chains back to the U.S. or find countries other than China to provide the needed work. But China is not easily replaceable as a source of production, and trying to be less dependent on the world’s largest exporter will have a cost. Companies will need to reconfigure delivery systems, but I still believe profit margins and productivity will be positives for the U.S. economy going beyond these next few years.
So what does this mean for inflation in the year 2024 and beyond? I stick to my thesis of the last 30 years, that inflation will be very subdued. Once the economic systems around the world adjust to the new normal, there is no reason that post-pandemic inflationary pressures will not go back to their long-term trend of 2% or less.
Some want to compare our situation today with that of the 1970s, when out-of-control inflation threatened the health of the U.S. economy. Those years were driven by cost-push pressures: the price of oil nearly quadrupled between late 1973 and early 1974. The fear was that dramatically rising prices would be a long-term drain on the system. As we now know, a seller is always dependent upon a buyer, and it became very clear that no one wins if the buyer is bankrupted. In the end, between the new efficiencies of consumption and sellers reducing their prices, we were again able to find balance and prosperity. It was a painful period, driven by escalating costs (cost-push inflation). That scenario is totally different from today’s situation.
Today we are experiencing demand-pull inflation caused by pent-up demand and a shortage of goods. There is an inordinately high rate of savings today driven by the government’s massive infusion of stimulus and the consumer’s relative inability to spend during lockdown. As we emerge from the pandemic, an extraordinary demand for goods and services has been created (demand-pull inflation), which will dissipate as the economy normalizes.
This is why interest rates have risen only modestly. The bond market, in its sophistication, is looking beyond these next few years. Much criticism has been directed towards Federal Reserve officials, arguing that monetary policy should be tightened earlier than “planned,” but committee members need to be concerned about the long-term health of the economy. Chairman Powell would love to see inflation hit his target of 3%, as he is still fearful of deflation. If the recovery is cut short, whether by moving rates too high or too fast, Powell knows that the tools at his disposal to revive the economy are limited. He will err on the side of being too late, rather than being too early, to avoid the risk of inhibiting the recovery.
One of the risks of keeping interest rates too low for too long is the emergence of speculation. But at these low nominal yields, the multiples on stock values are quite attractive. As earnings rebound this year, the S&P 500 multiple might drop from the present 20x earnings to 15x or 16x earnings. This equates to a 6% cap rate (internal rate of return).
Take a moment to reflect back on how the stock market discounted the pandemic. After the initial shock, it took the market only three months to find its footing. In its infinite wisdom, it viewed the crisis like a tsunami or a hurricane: however difficult the experience of living through it would be, it would pass. Remember, in those early months no one knew that the pharmaceutical companies would achieve a scientific miracle and create an effective vaccine within a year. Yet the stock market began to recover long before a vaccine was announced.
The lesson, learned over and over again, is that the collective wisdom inherent in capitalism gives it the incredible ability to correct itself. That is not just foolish faith or Pollyanna-speak. Unlike any of us who are slow to adjust when faced with a new reality, the capitalist system responds quickly.
I encourage you to not get stuck on the question of how the economy will play out in the next two to three exceptional years. Find comfort in the conviction that normalization will occur over this time period, bringing us back to a place very like the pre-pandemic years.
I encourage all of us to stay the course and continue to have diversified portfolios. There will be wonderful opportunities ahead as investors overreact to the volatility of the next few years. Use those moments with confidence, knowing that they are only temporary, and invest as others get bogged down in minutia. Stay above the fray and you may be well rewarded.
Harold G. Kotler, CFA
CEO, Chief Investment Officer