Economy, Inflation, Pandemic, War and the Investment Outlook

It's really different this time.

I will try to use this post to break down what's happening in the economy, where it's heading and the impact on investments. 

Any attempt to summarize and categorize where the economy is headed is fraught with almost impossible challenges.

Let's start with the present situation.   The economy is growing, probably in the 2-3% range.   The job market is tight.  We have historically low unemployment with impressive job gains each month and the ratio of job openings (11 million) to unemployed (6 million) at historic highs.  But we still have 800,000 less workers than pre-pandemic.  At the current rate of job creation, we might see those 800,000 workers added in 2-3 months.  When new jobs are created then overall demand is increased which should lead to continued economic growth, decreases in federal government deficits, and improvements in state budgets.  

We have high inflation.   There are many causes.  Let's start with the demand-supply imbalance.  The pandemic shifted demand from services to goods.  The government stimulus checks whetted demand.  At the same time supply  for goods was constrained by pandemic related shutdowns and supply side bottlenecks (shortage of container/container ships/truck drivers).   

The federal fiscal policies related to the pandemic were clearly inflationary.  The biggest culprit was likely the helicopter money that was doled out to everyone with no pragmatic means testing.  This combined with the Federal Reserve Board (the "Fed") monetary policy of zero interest rates, huge balance sheet increases and intervention into secondary credit markets added fuel to the inflation fire.

The symbol of inflation is the price of oil (or more prosaically the price of gas at the pump).  The 2020 pandemic related shutdowns decimated the demand for oil which led to a decrease in the price of oil.  Many US drilling operations became unprofitable and shutdown.  Global investment in exploration and drilling evaporated.   As the world emerged from the pandemic demand increased, OPEC+ suppressed supply and other sources or supply didn't materialize.  Then we add the Russian invasion of Ukraine.  The world consumes about 100 million barrels of oil a day(!) and Russia produces about 10% of that total.   

Potential future government policy of fossil fuels will continue to constrain investment and therefore supply.  As the world emerges from pandemic shutdowns (especially China) demand will increase and it seems likely that the price of oil will continue to increase.  I've heard estimates of $150/barrel leading to $5-$6 for a gallon of gas.  As consumer spending shifts to paying to drive cars and heat homes spending on other goods and services will be impacted.   

A secondary impact of the Russian invasion is the cost of food.  Russia and Ukraine are huge exporters of wheat.   Wheat, like oil, is a global commodity.   The war will have an impact.   I heard recently (Bloomberg radio) that 70% of the cost of food is related to energy. 

All this inflation has resulted in the Fed's belated switch in monetary policy.    The Fed has moved off of zero interest rates and is now shrinking their balance sheet.  The idea is that these policies will be "transmitted" to the real economy by "tightening market conditions".   What does that mean?  Raising interest rates will make business investments more costly.   The Fed hopes this will lead to a reduction in demand.  The increase in interest rates will directly lead to an increase in new home mortgage rates which should also lead to a reduction in demand.   The point is to reduce demand so that the demand-supply imbalances that currently exist and lead to inflation will abate.  

The secondary impact of Fed monetary policy is on stock prices.   Most stock prices are calculated bases on earnings and valuations.  Valuations are inversely related to interest rates.  The higher the interest rates the lower the valuations.  Lowering valuations, all else being equal, will lead to lower stock prices.  Lower stock prices are linked to consumer spending through what's thought to be a wealth effect.  When investors see the increases in their investments the theory says they become more optimistic and spend more.  The converse should also be true.  The theory is that the Fed policy should restrain demand of market participants.

How high will the Fed raise rates?   Projections range from 2.5% to over 4%.

Will the decrease in demand related to inflation offset the increase in demand related to job creation?

Will unemployment have to increase before inflation subsides?  Or will inflation decrease as pandemic supply side constraints are alleviated?   This would allow the Fed to moderate their policy.

Is stagflation a possibility?  High inflation (oil, food) leading to demand destruction for other consumer goods leading to higher unemployment. 

What asset classes will work best in this changing environment?   Stocks, bonds, cash, real estate, commodities?

Positive conditions for each asset class

Stocks - growing economy, interest rate increases moderate, inflation a key factor
Bonds - lower inflation, interest rate increases moderate,  recession or slow growth

Cash - lower inflation, higher interest rates
Commodities - higher inflation, weak dollar, global economy grows

Real Estate - ??