Low Inflation, High Inflation, and a bit of Recession

In 1979, Paul Volcker was named Fed chairman by President Jimmy Carter. Following his appointment, the Fed raised rates to over 20% in order to stem inflation. It led to a lot of disgruntlement at the time. But there are clear parallels with the problems that the U.S. economy is facing today.

Last year Charlie Munger, Vice Chairman of Berkshire Hathaway and right-hand man to Warren Buffett, spoke at the 2022 Daily Journal Annual Meeting. He raised several important points that affected investors throughout the following twelve months. And may still affect their investment strategies into the future.

Charlie raised the prospect of a horrible recession that threatens the U.S. economy for much longer than expected. He explained how, in the 1970s and 1980s, the recession was thwarted by raising interest rates above 20% - something that he doesn’t believe that modern day politicians would ever allow. And, as a result, he believes that “the new troubles are likely to be different from the old troubles.”

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Monetary and fiscal stimulus in response to the pandemic in countries like the U.S., Japan, the EU, and the UK has come at a terrible price. A price that only Japan has been able to (partly) meet. But even Japan isn’t an ideal example, according to Charlie. He sees the U.S. and Japanese challenges as being somewhat different.

What lessons can be learnt from Japan

Japan is currently struggling to keep inflation at 2%. In February this year Japan’s core inflation hit a 41 year high. But whereas most of the world are worried about inflation spiraling into the double digits, Japan have managed to maintain it at just 4.2%.

Japan has avoided a recession so far, even following years of quantitative easing, incidentally a strategy invented by the Japanese. Some argue that Japan’s inflation levels are due to several reasons, the biggest one being how the country only returned to its pre-pandemic size during quarter two of last year – much later than the U.S. or Europe. The other being related to the specifics of an ageing population coupled with a slowdown in wage increases.

There is a prediction that wage increases may be sought by businesses in Japan during the spring of 2023, which will bring new fiscal policies by the Bank of Japan. Hopefully the recession will be averted once again.

Is the heyday of stock returns over?

Buying power has been dramatically reduced for most people due to the way that inflation has increased. Even with returns of 5% or more, investment strategies are struggling to keep up with the rate of inflation. Something that current investors are not used to seeing.

Charlie believes that “no other generations in the history of the world ever got returns like that” – returns of 10% plus, or even 5%. He doesn’t think that the future will be easier, and in fact he believes it will be harder.

During the last few days of February Warren Buffett wrote a letter to the shareholders of Berkshire Hathaway.

One of the most important points that Warren makes in his letter is how: “Despite our (U.S.) citizens’ penchant – almost enthusiasm – for self-criticism and self-doubt, I have yet to see a time when it made sense to make a long-term bet against America.”

The comments by two of the most experienced investors in the history of the U.S. highlight two things. The first is that the markets have changed, possibly forever. The other is that the future of investing will be dictated by the U.S. Countries like Japan may hold clues to the future. But the answer rests in how the Federal Reserve manages the challenges in the short term.

What investment strategies are popular when high inflation prevails

As of January, the inflation rate in the U.S. had slowed to 6.2%, dropping from 6.5% in December. At the same time, the Federal Reserve has set interest rates at 4.75%. 2023 may be the year that inflation and interest rates meet. A moment that may see the start of the return to some sort of normality.

But it won’t happen overnight. And inflation probably won’t drop to 2% that quickly either. There is one little positive difference from the 80s. Today there are huge swathes of the population who don’t remember the recessions of the late 70s and early 80s. Those same people are less inclined to expect prices to continue to grow. That sentiment can only help with the recovery.

All of these challenges are giving investors and allocators a big headache. Especially as many of them are used to low interest rate, low inflation investment strategies. Just like the majority of society.

The question is whether traditional inflation-protected assets are the right way forward? Questions surrounding real estate prices, fluctuation in the price of highly sought after stocks like Apple, high-yield bank loans, or gold have shown during 2022 that they are not necessarily the answer.

To get a flavour of the Quant Strats full program download the agenda here.

Where to look for a yield curve in 2023

In a recent story, a leading commentator has shown that a negative 2-year / 10-year Treasury spread has been ongoing for almost six months. Whilst alone this isn’t worrying, economists have concluded that a downward-sloping U.S. Treasury yield curve is an important indicator of future recessions.

There is a better argument for holding long-term bonds, but anything under 3 years will probably give a negative return. Trading in the $23 trillion U.S. government bond market is a good early warning system about dangers that forecasters can’t normally spot. When coupled with a drop in market sentiment the dangers of a recession can be real.

Looking at the job data in the U.S. is a good gauge to see how bad the future might be. And, for now, job data is looking better than it has for many years. Except that there is confusion about the data available in the market. Employers have stated how they added 2.7 million jobs in the U.S. in the last six months of 2022. At the same time households put the number at only 12,000.

This means that the future is anything but clear. 2023 may be the year that job growth will be real and a recession will be avoided. It could also be the year that the signs of a recession coming were seen, but not enough was done to avoid it.

Come to Quant Strats in New York this March to find out more about inflation and how to hedge against a recession from some of the leading figures in quantitative finance. Register here now!