Last month, I examined the culprits that are causing global inflation, such as rising interest rates, persistent supply chain problems (China is blocking cities), and rising energy prices. and fertilizers.
This leads to stagnation. If the increase in costs (inflation) were predictable, wages would equal that increase and the impact on the consumption of goods would be benign. This has been anything but the case lately. Although wages have risen by 3% to 4%, they are significantly behind on official inflation figures and are left in the dust by real inflation. This is before the high interest rates and high prices of fertilizers caused by the Ukrainian war affect food production, food prices and consumer portfolios.
As inflation outpaces wage growth, consumers become poorer and therefore their ability to buy discretionary goods decreases. This is how inflation becomes a headwind for economic growth, and is called inflation.
The impact of inflation on the economy will depend on the differential between the inflation rate and wage growth. The greater the difference between these two numbers, the more inflation slows down the economy, causing inflation.
There is no recession in sight
We are not worried about a recession in the United States.
Recessions are natural cleansing mechanisms for the economy. In the course of economic expansions, companies are starting to drip fat. Their processes are slowing down, hiring too many people, accumulating too much inventory. Recessions are nature’s diet plan for businesses that need to lose some weight. Recessions are not fun (especially for those who lose their jobs), but they have historically been short-term disruptions between economic expansions.
To see how the U.S. economy and actions will react in the face of this high inflation environment, look at the late 1970s and early 1980s. Or you can just look at the last 20 years and invest them.
Over the last 20 years we have had falling interest rates and low inflation, which in turn has led to an endless appreciation (with short-term interruptions only) of house prices. This put extra money in the pockets of consumers and increased the prices of all assets (especially stocks), which in turn increased consumer confidence as people became richer and more comfortable with your expense.
“ The tailwinds of the past become the headwinds of the future. ”
Credit flowed freely; the multiples of the stock market expanded. Although government debt is tripling, interest payments on U.S. debt as a percentage of the federal budget are close to an all-time low. Low interest rates and public spending are stimulating. Now, invest all this and you will get long-term anemic economic growth and a contraction of multiple stock markets. The tailwinds of the past become the headwinds of the future.
For more than 20 years, every time the U.S. economy collapsed, Uncle Fed rescued it, lowering interest rates and injecting liquidity into the market. Both the economy and the market returned to racing. However, the pain we were spared did not go away; it was bottled in the jar of pain. This jar is now almost full and leaking. Today, to keep inflation from turning into hyperinflation, the Fed will have to do the opposite of what it is used to doing in the 21st century: raise rates.
Of course, the economy is a complex and self-adjusting mechanism, and so the gloomy picture I have drawn here may or may not. Human ingenuity should never be underestimated.
Reads: The antidote to stagnation is to increase supplies by investing in economies and people around the world.
However, as investors we must prepare for the worst and expect the best. Because hope is not a strategy, we are focused on preparation. The current dot-com 2.0 bubble still has a lot of room to deflate (we scoured the wreckage and found nothing we liked). Given this expectation, coupled with high global stock market valuations and a bleak global economic outlook, it is clear why our company’s portfolio is positioned more conservatively.
We have intentionally targeted the portfolio for a low-growth environment. Most of the companies we invest in do not go for a predictable economic drummer. Its profitability should not change much if the economy goes through a prolonged contraction or low (real) growth. Yes, the US market is expensive and the economy is full of uncertainty; but we are not market owners, we are owners of carefully selected high quality and undervalued companies.
These include defense companies, which should work well in an inflationary environment, as their contracts are linked to inflation and their customers (US and EU governments) can and are willing to buy, whatever happens. I have written extensively about defense companies here.
Gas pipelines (for oil, natural gas and refined chemicals) should also benefit from inflation, as their costs are mostly fixed and major capital expenditures are behind them. In addition, they are mostly monopolies and therefore have pricing power. As the defense sector, these companies will benefit from Russia’s war with Ukraine, as the US will produce and export more oil and natural gas. Read our thesis on gas pipeline companies here.
Vitaliy Katsenelson is CEO and Investment Manager of Investment Management Associates. He is the author of Active Value Investing: Making Money in Range-Bound Markets and The Little Book of Sideways Markets..
Here are links to more of Katsenelson’s views on the inflation picture (read, listen) and how to invest in inflationary times (read, listen). For more information on Katsenelson’s investment, go to ContrarianEdge.com or listen to his podcast on Investor.FM.
Month: Inflation will be higher for longer, and you won’t like what comes next
Month: Oil prices could be “parabolic”, putting the world economy in a “critical situation”, says the head of Trafigura