Equity markets were weak at the start of 2022. For the first quarter, the Dow Jones Industrial Index lost 4.6%, the Standard & Poor’s 500 Index fell 4.9% and the Nasdaq declined 9.1%. Most equity indices did rather poorly in the first quarter, with U.S. small cap stocks (Russell 2000) declining 7.5%, international developed stocks (MSCI EAFE Index) falling 5.8% and emerging market stocks (MSCI EM Index) losing 7.0%. Commodities surged, with the S&P GSCI Total Return Index climbing a remarkable (and unsettling) 33.1%. Bonds were awful in the quarter, with U.S. bonds declining 5.9%, high-yield bonds falling 4.8% and international bonds diving 6.9%. Even U.S Treasury bonds declined, with the Bloomberg U.S. Government Bond Index dropping 5.5% and the Bloomberg TIPS Index falling 3.0%. The bond markets are now just acknowledging the fact that the world’s central banks are well behind the curve on controlling inflation.
Today investors are confronted with several economic and geopolitical conditions that defy easy analysis: 1) the Ukrainian War; 2) the sustainability of the current economic recovery; and 3) the fact of racing levels of inflation, and the future response to this reality by central banks, governments and consumers. Beyond the obvious horrible human toll of the Ukrainian War, the conflict and the U.S.-led response to it have profound economic and strategic global implications that could take years to play-out. Starting at the most basic level, having the largest and second largest grain exporters at war during a time of rising food inflation is destabilizing. A reduced combined crop in 2022, both because of sanctions and impediments to harvesting, will cause shortages, probably starting first in the Middle East and Northern Africa. A replay of the riots and protests seen during the Arab Spring in 2010 is likely.
Russia’s chokehold on Europe’s energy supply is also destabilizing and inflationary. Because Russia supplies a significant portion of both oil and gas demand, this also has food inflation implications. Natural gas is a major input in the production of nitrogen-based fertilizer. Russia, Belarus and Ukraine are also major exporters of ammonium nitrate, potash, phosphorus and urea: all primary factors in fertilizer production. Fertilizer prices have already doubled and will continue to rise. Oil is a major factor in transportation and freight costs. Natural gas is also a major contributor to reliable electricity generation in the European electrical grid. In 2016, the European Union imported 30% of its natural gas supply from Russia. By 2021, that had grown to 47%. Reliable electrical generation is especially at risk in Germany, where the country’s commitment to green energy has resulted in very high levels of investment in solar and wind power generation, while at the same time a decommissioning of the majority of its operating nuclear plants. The inherent intermittency of solar and wind power necessitates redundant, non-intermittent power generation. Germany decided to outsource this function to Russia. Germany willfully painted itself in a corner using Russian, oil-based paint. For now, Russian energy exports are exempt from war-time sanctions, giving Germany some time to address its energy vulnerabilities. A more permanent solution, especially for Germany, relies on investments that have not been made yet, infrastructure that has not yet been built and technological breakthroughs that do not yet exist.
From a geopolitical standpoint, the Ukrainian War (and the pandemic, to some degree) exposed the fragility of the global network of alliances and the fragility of many trading networks and supply chains. For example, when the U.S. asked India to denounce Russian aggression and
boycott Russian energy exports, the nation politely demurred. When American diplomats hinted at the possibility of secondary sanctions on Russian trading partners, India’s response was more forceful. A senior minister suggested that India’s Russian oil imports in a month were less than Europe’s in an afternoon, and that western diplomats should address that before coming after India. India is a populous and fast-growing nation that is dependent on energy imports, especially coking coal. It is not in its current or future interests to preemptively alienate energy exporters. In fact, it is in their best interest to build the most diversified and secure network of potential energy trading partners that it can. America: “You will be on the wrong side of history!” India: “Sorry Cowboy, we’ve got bills to pay.” Many commodity-exporting countries were alarmed when the U.S. froze Russian Central Bank reserves. This will cause most exporters to rethink their outsized dollar-based reserve positions, and to diversify their currency reserve holdings. The implications for the U.S. dollar as the world’s reserve currency could be immense. More troubling was how ineffective and temporary the decline in the Russian ruble turned out to be after the Russian Central Bank instituted counter-measures. ‘Big move, little effect’ means bad diplomacy. As alliances are frayed by new economic realities, we expect a decline in globalization, and perhaps a new cold war bifurcation. Trade will be slower and more expensive. It’s too early to anticipate who joins what team.
The U.S. recovery is slowing down, but consumers are in good shape. Both JPMorgan Chase Chief Executive Officer Jamie Dimon and Bank of America Corp. CEO Brian Moynihan referenced healthy consumer spending and solid consumer balance sheets in recent comments. Checkable deposits for households and nonprofits rose to $4.06 trillion in December from $1.16 trillion at the end of 2019. The previous high for this metric before the pandemic was $1.41 trillion. That is a lot of liquidity. In his annual letter, CEO Dimon noted that between 2020 and 2021, enormous fiscal and monetary stimulus flooded the money supply. On the fiscal side, the government added approximately $5.0 trillion (or 21% of 2021 GDP) into the economy. On the monetary side, the Federal Reserve engineered $4.4 trillion (or 18% of 2021 GDP) of quantitative easing (QE). These efforts added more than $2.5 trillion to the accounts of consumers and almost $1 trillion into state and local governments. That money is being spent. Consumer spending is now 12% above pre-pandemic levels. Dimon writes, “During 2020 and 2021, many aberrant things also happened: 2 million people retired early; the supply of immigrant workers dropped by 1 million due to immigration policies; available jobs skyrocketed to 11 million (again unprecedented); and job seekers dropped to 5 million. Wage growth accelerated dramatically, particularly in low-income jobs.” He also notes surging home and asset prices. Our policy-makers, both in the government and at the Fed, created more money to chase the same amount (or in some cases, lesser amounts) of products. This has resulted in the highest levels of inflation seen in this country in 40 years. The most recent Consumer Price Index print was 8.5% year-over-year, the largest increase since December 1981. The latest reading for the Producer Price Index was even worse. The PPI represents wholesale prices, or prices of inputs that consumers will buy in the future. The March PPI was up 11.2% year-over-year. Details in the sub-categories of the report were even more alarming. Processed goods for intermediate demand were up 21.7% year-over-year, and have been reading above 20% for the last 11 months. Unprocessed goods for intermediate demand were up 40.8% year-over-year, and have been above 30% for the last 13 months. Those are input costs that will end up in consumer goods within twelve months. Inflation does not look transitory to us.
Inflation is pernicious, and stamping it out is a painful process. It is well-established what needs to be done, because inflation is as old as fiat money. It is rare to find the political will and moral authority to get it done. Let us leave you with a long quote by a vaunted economic thinker observing a period of inflation and geo-political turbulence from over a century ago. Following the Great War, John Maynard Keynes wrote an essay titled “The Economic Consequences of the Peace”.
“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become "profiteers," who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of Society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Keynes goes on:
“In the latter stages of the war all the belligerent Governments practised (sic), from necessity or incompetence, what a Bolshevist might have done from design. Even now, when the war is over, most of them continue out of weakness the same malpractices…By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract and of the established equilibrium of wealth which is the inevitable result of inflation, these Governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century. But they have no plan for replacing it.”
Following the pandemic, many countries are in an over-leveraged economic position similar to what Keynes was observing in 1919. If the Federal Reserve can act decisively and independently, it should be able to break the inflationary spiral, with the trade-off of a few years of stagflation and a probable recession in the next year or so. If the Fed cannot act independently or will not act decisively, the likely result is a decade lost to inflation, similar to the 1969-1982 period in the U.S. Those were not happy years for investors. One of John Maynard Keynes contemporaries also thought a lot about inflation, but was not quite as wordy. Calvin Coolidge said, “Inflation is repudiation.” Markets do not like repudiation.
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