2021 Third Quarter Newsletter & Outlook

Camp Transitory vs. Camp Persistent vs. Camp “Surely, you can’t be that sure”

The debate about inflation and its implications for investors has been heating up for months. This newsletter discusses the ‘Camps’, or schools of thought, that experts have aligned themselves with to explain the data and its implications for stock and bonds. The recent uptick in inflation (see Figure 1) has fueled the debate, and highlights why I have positioned client portfolios to protect against a possible rapid loss in value.

MCS Third Quarter Performance Review

Through September 30, 2021 (if MCS clients’ investments were treated as one large portfolio including their cash), on average clients gained 1.7%, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P 500) gained 15.9%, and the Bloomberg Barclays Aggregate Bond Index lost 1.6%. The range of MCS individual client returns was from a gain of 6.5% to a loss of 0.4%1
The client with the lowest return took a 60% cash distribution, and an underperforming asset negatively
impacted her returns. The next lowest returns were for newer clients who have less equity exposure. Clients with the highest returns had higher US equity exposure or exposure to a legacy stock position that outperformed. MCS client returns were protected from the bond market underperformance by the focus on short term bonds, which did not decline in price.

Camp Transitory

Most financial advisors are in Camp Transitory, meaning the inflation spike will be temporary. Northern Trust Asset Managementi , a global investment manager, articulates this position as follows:

How long, exactly, is transitory? This recent inflation spike has lasted longer than many first expected (emphasis added). But we don’t define transitory by length of time. Instead, transitory is defined by whether the underlying supply/demand conditions can be “fixed” on their own or will take outside forces (such as central banks raising rates to temper demand). By this definition we remain firmly in Camp Transitory. Prices of these transit-oriented goods have increased due to a combination of surging pandemic recovery demand and insufficient supply, which should dissipate as production resumes and ports clear. Semiconductor shortages have acutely plagued automobile production (as well as other goods). It will likely take well into 2022 before that problem is fully resolved, but many goods markets have already started to correct. Indeed, used car prices have come down a bit in the last few months. Meanwhile, higher demand elasticity (change in demand per change in price) allows consumers to delay purchases if prices are too high. Also, if price increases aren’t repeatable, by definition inflation will be transitory (if gas prices stay at today’s same “high” prices over the next year, gasoline inflation will be 0%). Because we believe these supply/demand mismatches can fix themselves, we remain in the transitory camp — even if transitory proves longer than preconceived time-based definitions.

Restating the highlighted section, if prices go up 25% in 1 year, and remain flat for the next 3 years, it’s transitory inflation (no worries); but if prices go up 5.75% per year for the next 4 years, again ending in a 25% increase, then it’s persistent inflation (that’s bad).

What the Hell!? While both outcomes stink, clearly the scenario of a 25% increase in year one is more
burdensome for a consumer than a 5.75% per year increase for 4 years.

For the transitory story to work out, the labor market and global supply chains must fix themselves, and quickly. Yet these very complex global systems, now out of whack, may be more difficult to fix than a broken domestic financial system. Diane Coyle, writing for Project Syndicateii, stated: “the splitting of global production chains into ever more specialized links over several decades has led to unexpectedly close correlations between supply shocks in different industries, as with fertilizer and food or semiconductors and cars.”

Translation: a significant part of the global economy is brittle and thus not easily or quickly put back together once broken. It’s not clear how quickly it can normalize itself and reverse inflationary pressures.

Camp Persistent

On October 6, Bill Dudley, who served as president of the Federal Reserve Bank of New York from 2009 to 2018, as vice chair of the Federal Open Market Committee, and as chief U.S. economist at Goldman Sachs, wrote an article for Bloomberg titled, “The Fed Is Fighting the Wrong Inflation Wariii”.

Dudley observed that the Fed, chastened by failing to react forcefully enough to mitigate the impact of Great Recession (the Fed famously didn’t see it coming, although yours truly did), is now making sure it doesn’t make that mistake again. The obvious problem is the Fed is trying to do the right thing now, under completely different circumstances.

Dudley goes on:

This dovishness [dovishness refers to the Fed’s policy of letting inflation run] increases the risk of a major policy error. If the economic outlook evolves in unexpected ways, Fed officials will almost certainly be slow to respond – because they’ll need time to update their views, because their new framework demands patience, and because they think the negative consequences of delay are very modest. Hence, if inflation proves more persistent than anticipated and even accelerates as the economy pushes beyond full employment, they’ll have to tighten much more aggressively than they expect. The result could more resemble what happened from 2004 to 2006 — when the Fed raised its short-term interest-rate target by 4.25 percentage points, to 5.25% from 1%, with quarter-percentage-point increases in 17 consecutive policy-making meetings — than what they currently have penciled in.

A faster pace of tightening would come as a shock for financial markets and could risk tipping the economy back into recession. That’s the danger of fighting the wrong war.

On October 8, Harvard professor and Former US Treasury Secretary Lawrence Summers reiterated his view “that markets are not fully pricing in the risks of a tail event2, where the (interest) rate goes up pretty fast…” In September, he wrote about the very serious danger of repeating past mistakes, referring to the high-inflation era of the 1970s, and that being comfortable with faster inflation is a riskiv. He identified the following parallels to that era:

  • A White House trying to deliver progressive social and economic policies
  • Military withdrawals from long-term conflicts (Afghanistan in 2021 and Vietnam in the 1970s)
  • The increase of social protests
  • A Federal Reserve increasingly talking of social objectives

Other recent headlines and expert comments on inflation from Bloomberg:

Inflation Scares Goldman’s Waldron More Than Any Other Risk
2021-10-13 Bloomberg

Goldman Sachs Group Inc. President John Waldron says inflation is the number one risk that he worries about right now. “It’s not transitory,” Waldron said Wednesday at a conference. “I’ve never seen a greater divergence between what’s defined as transitory and what’s being seen day in and day out.v

History Tells Us to Worry About Inflation: Ferdinando Giuglianovi
2021-02-09 Bloomberg

“Just like clothes and food, macroeconomics has its fashions. The latest is for public debt.” However, this latest macroeconomic fad is based on one crucial assumption: that inflation will stay subdued, letting central bankers continue with low rates and big asset purchases. That’s a pretty big thing to rely on.”

Camp “Surely, You Can’t Be That Sure”

It is statements from current Fed Chair Jerome Powell and former Fed Chair (and current US Treasury Secretary) Janet Yellen, that sent me to this camp:

“I’ve never seen these kind of supply-chain issues, never seen an economy that combines drastic labor shortages with lots of unemployed people and a lot of slack in the labor market,” Powell told a virtual Fed Listens panel on Friday, September 24.

Or this, from a Bloomberg article on September 29: when asked if U.S. policy makers overdid it in dealing with the economic crisis wrought by Covid-19, Powell argued instead that they had finally managed to avoid the perennial trap of a lackluster response.

“I think the historical record is thick with examples of underdoing it, and pretty much in every cycle, we just tend to underestimate the damage and underestimate the need for a response,” Powell said. “I think we’ve avoided that this time.”

Yikes, I can’t help but feel that, looking back, this statement will be seen as oozing irony.

Another example that puts me in this camp are Yellen’s October 24, 2021 comments about inflation and interest rates when compared to her 2017 comments. In 2017, she was defending the Fed’s policy of continuing to raise rates after inflation ‘mysteriously’ plunged. “Ms. Yellen told a National Association for Business Economics conference in Cleveland. “It would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.”vii (Emphasis added).

Now, with inflation running at 3.62% for PCE3, she says, “I don’t think we’re about to lose control of inflation,” pushing back on criticism by former Treasury Secretary Lawrence Summers this month. “Americans haven’t seen inflation like we have experienced recently in a long time. But as we get back to normal, expect that to end.”viii

To recap, in 2017, Janet Yellen / the Fed were defending their policy to raise rates when inflation was below 2%, saying it would have been imprudent to wait until inflation was back to 2%. Now they are defending their policy to not raise rates, saying despite current inflation of 3.62%, it will not be a problem (transitory) and therefore they don’t need to do anything at this time!

In fairness, I recognize this is not easy for the Fed. Even experts have a limited understanding of how the world works. I am also mindful that current events, such as the Pandemic, Afghanistan, and the US Republican Party, all defied experts’ expectations and, in doing so, radically shifted the course of world events toward destabilization.

MCS Investment Strategy: What I’m Waiting For, and Why

Against the backdrop of climbing inflation are extremely high valuations for stocks and bonds which, research shows, lead to poor future results. John Hussman’s October 2021 newsletter article “The Wealth Is In The Denominatorix” does an excellent job of estimating future stock returns based on starting valuations. He states:

“The upshot of this is that the likelihood of stocks outperforming Treasury bills is strongly affected by the level of starting valuations. With valuations at the most extreme level in history, investors should seriously consider the possibility that the total return of the S&P 500 could very well lag the return on lowly Treasury bills for something on the order of 20 years.” (Note: Current Treasury bill rates are .06%, or effectively zero.)

He cites previous periods in which the investor returns were very poor for well over a decade:

…the total return of the U.S. stock market lagged both Treasury bills and CPI inflation for 13 years following the 1905 market peak, 16 years following the 1929 peak, 18 years following the 1965 peak (actually more 20 years if one measures from Feb 1962 to Aug 1982), and 13 years following the 2000 peak. These very long, interesting trips to nowhere comprise at least 60 years within just over a century of data and can be identified by one defining feature: extreme starting valuations.

I would add that what he calls ‘interesting trips to nowhere’ is a euthamism for ‘quite unpleasant experiences’ for investors.

Figure 2, below, is yet another example of how today’s investors are following hype rather than profitable companies. It feels so very “DotCom-ish.”

Figure 2
Making Money on Companies That Make No Money
% of Russell 3000 Growth Stocks with Negative Earnings

I am waiting for interest rates to increase due to persistently higher than expected inflation. Unlike the Great Recession, there has been little to no damage to most consumers; retired and working. There has however been significant damage to the availability of stuff to spend money on. Too much money, chasing a limited supply of good and services, usually spells: Inflation.

This will negatively impact long term bonds and interest rate sensitive stocks first. I expect those committed to stock investing will favor rotation to companies that can pass inflation through to their customers. The ability to pass through inflation, of course, reinforces its persistence. Though stock enthusiasts will trot out the ‘stocks beat inflation’ argument for staying the course, that argument is not always true (see Hussman’s comments about valuation, page 5). For example, stocks did not beat inflation from 1966 to 1982. This was an extremely volatile period for stock (and bond) investors.

How the Fed responds matters. The point is that I do not know how this story plays out and there is no shortage of potential landmines. Current inflation and high valuations tell a prudent investor to be very cautious.

As I write this, an inflation thunderstorm is developing over the yield parched landscape, and there’s plenty of deadwood in and around Camp Transitory. Lightning is unpredictable. Did I mention that it’s a narrow one lane road out of Camp Transitory?

1 MCS Family Wealth Advisors (MCS) consolidated client returns are dollar-weighted, net of investment
management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary Income/Growth accounts under management for at least one full month in 2021. These accounts represent 94% of MCS’s discretionary assets under management as of 09/30/2021 and were invested primarily in US stocks and bonds (11% of client assets on 09/30/2021 were invested in tax-exempt municipal bonds). The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Bloomberg Barclays US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.

2 A ‘tail event’ refers to a bell-shaped distribution of outcomes with the ‘tail’ being the being the far left more extreme negative outcome. ‘Not fully pricing in the risks’ means the market is underestimating the likelihood and severity of such outcomes. In other words, the investors are ignoring chances of their portfolios getting severely whacked.

3 PCE: Personal Consumption Expenditure is the Fed’s favored inflation measure vs better known CPI,
Consumer Price Index, currently 5.4%.

i Sturkenboom, Wouter, “Camp Transitory”, Northern Trust Asset Management, 09/30/2021
ii Coyle, Diane; “The Great Supply Chain Massacre”; Project Syndicate 10/15/2021
iii Dudley, Bill, “The Federal Reserve Is Fighting the Wrong Inflation War”, Bloomberg, 10/06/2021
iv Kennedy, Simon, “Summers Sees Dangerous Policy Parallels With High-Inflation Era”, Bloomberg 09/10/2021
v Song, Zijia; “Inflation Scares Goldman’s Waldron More Than Any Other Risk”, Bloomberg, 10/13/2021
vi Giugliano, Fernando, “History Tells US to Worry About Inflation”, Bloomberg, 02/09/2021
vii Harrison, David; “Yellen Defends Fed Rate-Rise Plan Despite ‘Mystery’ of Low Inflation”, Wall Street Journal,
viii CNN “State of the Union”, October 24, 2021
ix Hussman, John P.; “The Wealth Is In The Denominator”, Hussman Funds, 10/15/2021