The Roaring 20/20’s

History Does Not Repeat; It Often Rhymes

Hindsight is 20/20.  Central banks' capitulation as to the nature of pervasively high inflation reveals this adage to be true.  Our current economic plight is not at all unfamiliar, nor is the prognosis and cure. In the multiple economic cycles encountered since the World War era, and the subsequent rise of Keynesian economic policy orthodoxy, history shows that in instances of a negative supply shock, a similar pattern often occurs:  1) government sponsored fiscal stimulus packages, made culpable by large increases in the money supply, are put into effect; followed by 2) an uptick in both economic activity and inflation; and then ultimately resulting in 3) an unwinding. The appropriate prescription involves restoring equilibrium by raising aggregate supply, decreasing aggregate demand, and reducing the money supply.

Overindulgence; Necessary Restraint

To better understand the evolution of this cycle, we must first endeavor to ascertain the impetus.  Stimulus is, well, stimulating. In excess it may unwittingly cause prolonged damage. The prominent contrarian investor Michael Burry, who gained infamy for correctly identifying and profiting from the Great Financial Crisis (GFC) in 2008, recently likened the current episode of excess stimulus to a drug addiction.  Such an analog illustrates how a sustainable recovery may require a period of withdrawal and is often painful.  To be sure, following broad economic slowdown at the onset of the global COVID pandemic, the multi trillion-dollar stimulus packages deployed by the U.S. and many other developed nations effectively super charged consumers’ aggregate demand and kickstarted the domestic and global economy.  In retrospect, no good deed goes unpunished.    

Short-term Gain; Long-term Pain

Several rounds of stimulus checks and extended unemployment benefits fortified consumers’ willingness to spend even while workers remained in short supply. Antithetical to the demand-driven recovery prescription, the global aggregate supply of goods had already fallen dramatically as factories shuttered during the lockdown and workers remained hesitant to return following their reopening.  At present, the extraordinary stimulus has produced a large gap between job openings and workers available to fill them (i.e., the employment gap) with many companies struggling to find and retain employees.

As we have seen, a severe negative supply shock is not easy to reverse as supply chains are impaired and workers are scarce. In the meantime a large increase in the money supply created immediate, benefits for those who received the additional liquidity from stimulus packages.  As a result, this stimulus elevated consumption by increasing the willingness to pay for the relatively fewer available goods and services, causing surplus inventory to be quickly sold.  From there, the economy took off at an unsustainable rate and business profits began to rise alongside prices.    

In the long-term, the benefit of stimulated consumption comes at the expense of higher inflation which impacts all members of the economy.  As the money supply expands, and continues to circulate through the economy, purchasing power is diminished while depleted supply levels leave fewer available goods and services for purchase.  Perpetuating the existing supply chain woes, rising labor wages and input costs have forced output to slow and profit margins will begin to decline.  Left untreated, less efficient producers will be forced out of business, unemployment will rise as the existing employment gap shrinks from fewer job openings, and economic activity will stagnate. At this stage, the optimal prescription requires discipline, and a bit of innovation, to narrow the current aggregate supply/demand imbalance throughout the global economy.

Increase Productivity; Avoid Stagflation  

A slowing economy and rising unemployment may lead us into a recession but are not sufficient to stop rapid inflation.  There is no long-term relationship between unemployment and the rate of inflation. We can look back to the decade of the 1970’s to see this dynamic.  A key distinction between that era and today is the current superior rate of productivity growth.  Productivity measures how effective inputs are at producing outputs.  The economy wants to expand, it just simply cannot keep up with demand due in part to the large employment gap.  To bridge this gap, and necessarily slow the increase of input costs, we must simply better utilize the workers that we do have via productivity enhancement.

Productivity enhancement is the primary tool to address the natural constraints within the economy and adequately raise aggregate supply.  In the long-term, the maximum quantity of production capacity within an economy, known as Potential GDP, is determined by factors of production such as physical and human capital ignited by technology advancements.  Potential GDP advances to new levels within a market-oriented environment that rewards innovation and supports capital investment. However, increasing Potential GDP can only be sustainably achieved through productivity enhancements which may take years to fully realize.  To date, capital investment by business remains robust, signaling support for innovation, and we are optimistic that a severe recession may be avoided as a result.

Respect the Fiscal Cliff; Engage Quantitative Tightening  

But raising aggregate supply is slow and is only half of the equation.  To break inflation’s fever, we must also address aggregate demand.  President Biden has recently remarked as to the extraordinary reduction in the Federal deficit under his brief tenure, adding, “[we] reduce federal borrowing, and we help combat inflation.” However, a further evaluation reveals that the primary contributor to the deficit reduction is the mere curtailment of emergency COVID spending. Notwithstanding, President Biden’s comments illustrates a tacit understanding of at least one of the drivers of inflation – excess government spending. Indeed, a necessary condition to bring aggregate demand in line with supply is to simply stop adding fuel to the fire.  As straightforward as this may seem, it is indirect conflict with many proposed solutions to easing the pain of inflation.  

For example, California, reeling from the highest gasoline prices in the nation, is poised to issue payments of up to $1,050 to 23 million residents as part of a $17 billion inflation relief package. While the added stimulus from this rebate plan will have little to no effect on prevailing global market prices, it serves as an effective anecdote as to just how difficult fiscal discipline may be to achieve. However, fiscal austerity will only go so far. Recently, President Biden made fighting inflation a top economic priority, noting his commitment to address inflation more directly while still leaving the bulk of execution to the Federal Reserve (Fed) who control the money supply.  

Reducing the money supply in circulation is a critical and final component of contending with inflation.  The Fed uses two primary tools to implement its policy: setting short-term interest rates and conducting open market debt transactions. The Fed’s primary tool, raising short term interest rates, has already been put to work multiple times this year, with more rate hikes expected this summer.  This can help reduce aggregate demand by increasing the cost to borrow cash and increase the opportunity of spending cash.

As part of the COVID stimulus package, the Fed purchased many trillion dollars’ worth of government bonds in the open market (i.e., Quantitative Easing) effectively increasing the money supply in circulation.   Just two years removed from the start of the extraordinary Quantitative Easing, we have now entered the unwinding phase - Quantitative Tightening. As part of the new Quantitative Tightening program the Fed intends to reverse course by actively selling bonds in the open market.  Theoretically, this will enable the Fed to be more precise with where and how much money is in circulation, but this tightening program is untested in practice.

Restrictive Financial Conditions; Elevated Required Return

Tightening actions by the Fed effectively raise the cost of economic activity.  As a pseudo measure of this cost, the Financial Conditions Index (FCI) has steadily increased.  While the increased costs weights down economic activity in the short-term, it makes way for interesting investment opportunities over the long-term.  

To illustrate this point, we define the intrinsic value on an investment as the cumulative free-cash flows to be received in the future, discounted back to the present at an appropriate required rate of return (i.e., the discount rate).  Importantly, the discount rate reflects the compensation demanded by investors for assuming the riskiness of the future free-cash flows. Given the increasing probability of near-term recession, the relative certainty of future free-cash flows is decreasing and required rates of return will be adjusted upward accordingly.  

Additionally, as interest rates rise, so does the discount rate. Given that the intrinsic value of an investment moves inversely with discount rates, rising interest rates are directly contributing to the declination of nearly all asset classes this year. Fire Capital has remained nimble and focused on long-term capital preservation with upside opportunities across all asset classes. To be clear, while financial conditions and interest rates will likely continue to adjust to the Fed’s tightening policy, we are beginning to observe fair, if not attractive prices across various asset classes, for the expected conditions moving forward.

Economic Equilibrium; Sustainable Real Growth

Although the pattern is clear, we have not faced an unwinding phase of this magnitude in at least four decades.  Prolonged inflation is taxation without representation and often leads to political unrest.  While our future has yet to be determined, we have the benefit of the relatively recent past to illuminate the correct path forward and avoid potential pitfalls along the way.  We must maintain the discipline and fortitude to rid the economy of its ailment. At the same time, we should remain wary of proposed solutions, such as cost controls and collective bargaining, that hamper productivity gains and impede the expansion of aggregate supply.  Once the economy is brought back into equilibrium, it will serve as the foundation for sustainable real growth and a prosperous future.  Most of all, we must remember that healing is often not without setbacks and that some additional pain may be felt along the road to recovery. Lastly, we may take solace in that, if we learn from history, we may not be doomed to repeat it - hindsight is always 20/20.    

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