There is a famous scene in the comedy movie “Meatballs” when the great Bill Murray preaches to his colleagues and fellow campers who face overwhelming odds that everything they confront “just does not matter.”
It is one of our favorite movie scenes of all time. It’s a classic scene that we do not see much in comedy these days.
It feels a little like the equity market the past few weeks. The economy is officially in a recession. For the past 1oo years, a recession has been defined as an economic contraction taking place for two quarters or more. Well, here we are. Naturally, the government will not admit they stuffed it up and admit the economy is falling. They point to employment which is holding up, as their excuse. But a first-year econ student will tell you employment is a lagging indicator and does not fall in the front half of a recession. It collapses in the back half of a recession.
A key measure of economic activity fell for the second straight quarter. This is the very definition of a recession. Gross domestic product, adjusted for inflation, fell 0.2 percent in the second quarter, the equivalent of an 0.9 percent annual rate of decline, the Commerce Department said Thursday. Someone must remind the government that “de-Nile” is not just a river in Egypt. To be fair, this is not a rapid decline. However, we fear it is just a matter of time before the economy falls at a 5% annual rate.
The consensus view is that this recession will be short and mild. The consensus view also believes the Fed will change monetary policy to help economic growth, even though the inflation rate is 3.5 times the short-term interest rates. While this is madness, it offers a lesson to investors.
When trading, you are doing so against other people. Models matter in the long term, but they are of little help in the short run. If the average investor thinks we are at the end of the monetary tightening cycle, they buy stock. Reality be damned. This is the place where we find ourselves right now. The average person does not realize the Fed has already printed enough money to finance hyperinflation. The reason why it has not happened yet is that people have confidence in the system. They still have time to fix their mistake. That said, we should look forward to a hot boil of inflation for years to come.
The money injected into the system puffed commodity and housing prices. The price increases are now rotating into labor rates. So to get more specific, one should expect the Department of Labor to report 9 to 10% inflation rates for the next few years. We think the next big price move we will read about will be food. Time will tell if we are right.
But let’s keep it real. A 2.75% Fed Funds rate in a 9%+ inflation rate environment suggests the Fed is not serious about stopping inflation. At least not yet. They are playing a game of hope.
With that backdrop in mind, we think passive investors should buy TIPS. These are government-issued inflation-protected government securities. If you want to look at a mutual fund, check out VTIP, the Vanguards TIPS fund. You will not make much money in terms of growing purchasing power, but you will keep up with the inflation rate over the long-term. Short-term, these securities bounce all over the place. Be warned.
So why do we hold this view? The chart that gives us this conviction is shown above. It is the amount of money the Fed has created divided by GDP. In short, it has grown by a factor of 6. This tells us that inflation is embedded in the system, and we should expect prices to rise for as long as the eye can see. The only way to stop rapid inflation is to take money out of the system. They might take some but not enough to bring inflation back to 5%, much less to zero.
Here is the dilemma for investors. If hyperinflation is in our future, you want to own stocks as they represent tangible assets. They will rise in price as the value of the dollar falls. But hyperinflation will end the Fed, and many federal employed will become unemployed. Therefore, we think the Fed will do what it takes to defend its reason to be, which means higher interest rates. Higher interest rates mean lower stock prices. But we think the Fed will delay instituting a tighter monetary policy for as long as possible.
