The markets have it wrong
There is ample skepticism around the US Fed’s ability to pull a ‘soft landing’ in its attempt to get inflation off the boils by raising rates. Monetary policy is a blunt implement and the conundrum about whether the target ‘neutral’ rate is indeed neutral has sent markets into a selling frenzy. The current national debt and inflation levels besetting the American economy make the pursuit of a balanced policy outcome ambitious, to say the least, prompting fear that aggressive hikes may snowball the economy into a recession.
There is an inherent fallacy in this argument as the inflation that we see today is not purely a result of overspending by the Fed. While QE may have proven to overheat the US economy, there isn’t a perfect correlation between money supply and inflation. One doesn’t need to be an economist to understand that changes in price levels would also be impacted by changes in people’s willingness to spend (read: velocity of money in economese) and growth of supply in the economy. Inflation has resulted from a multivariate equation of factors — some of them more transient and some manifesting from a changing world order. Fragile and interconnected global supply chains have been clobbered by the reinstatement of pandemic restrictions in China and the humanitarian crisis brought by Russia’s invasion of Ukraine.
While raising rates is disinflationary to an extent, it is not a complete toolkit. It would not resolve supply-side dislocations — shipping ports remain congested and the American trucking industry continues to be paralyzed by a shortage of drivers. Journeys that shipments make from source to their destination are in disarray as traditional transportation routes (many of them using trains passing Russia) are being reconsidered to comply with Western sanctions. It appears glim but as these black swan events pass and other things remain the same, current blockages will become oversupply of the future, cooling the price levels down. We have seen a similar pattern on the demand side, plunging during the pandemic and positively rebounding on the opening of economies.
In that sense, financial markets have it wrong. Growth, technology, and green stocks are getting obliterated in the last few months when in fact investment in innovation, technology and de-carbonization would be the strongest disinflationary forces in the long run for the global economy. The indiscriminate and broad-based tech sell-off as a response to rising rates is disproportionate to the size of the impact that changing discount rates should have on valuations. The greatest alpha is in the most useful innovations; certainly, those that build resilient supply chains but also across sectors and industries — from autonomous technologies and robotics to fintech and genomics. What financial markets reflect today is an upside-down thesis.
More globalization (not less) and measured de-regulation (at least in the short to medium term) will be vital to boosting domestic and international supply and managing inflation as a consequence. To some extent, we may see more regionalization and diversification of production centers as companies try to build more resilience but to completely move away from long supply chains is fanciful. Even a more politically fractious world will continue to stay interconnected for trade and economic arbitrage. It is better technology and a shift from fossils that will reign in the reoriented global supply chains. De-carbonization can be inflationary in the short term as green infrastructure is ramped up — new transmission lines, solar panels, sustainable terminal logistics networks — all have a setup cost and bear an upward pressure on prices. In order to be harnessed as a disinflationary force, scale must be achieved which needs effective government action in the form of supportive legislation. We are already seeing this in the case of Electric Vehicle (EV) engines, which are projected by the European Federation for Transport and Environment (T&E) to become cheaper than Internal Combustion Engines (ICEs) by 2027.
“No one rings a bell at the top”, said someone. As markets lose their animal spirits and start muting away from bubble territory, bear market rallies and declines are being triggered by any inch of hope or despair. Observant investors will pick on indicators when sentiment-driven broad sell-offs sediment the winners and err in their fundamental valuations — sticking with strategy will be their best inflation hedge.