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Inflation, Happy Talk and Captain Sensible

Updated: Mar 10, 2022

Our thoughts, prayers and support are with the Ukrainian people as Putin wantonly destroys Ukraine and places a dagger at the heart of the civil society.

Putin must be stopped while avoiding a wider war and potential nuclear conflagration.

Even in the heat of battle, no matter how unseemly, asset managers need to think several moves ahead to protect the assets they are entrusted with, be it their own assets, or as fiduciaries. Indeed, asset managers are in their own battle 24/7, especially in times like now, just that nobody dies. But losing one's life savings can be the next worst thing.

Therefore, even at this delicate moment, the responsible manager must ask, what is the longer-term outlook for inflation, which is at historic highs by some metrics, after the Russian invasion of Ukraine?

Expect more "Happy Talk" from the likes of Chairman Powell and others that everything is under control. Really?

Happy Talkers blamed Covid for the increase in inflation. Supply chain issues, you know? Sold it as a "temporary spike." Had nothing to do with massive government deficit spending and zero percent interest rates. Or, government control of the bond market artificially suppressing mortgage rates to the lowest level in history as housing inflation exploded to almost 20%. Now they say they were wrong about the temporary part, need a bit more time. Yes, inflation may come down, but I doubt it will get anywhere near their 2% target without aggressive Fed action as Covid and related supply chain issues recede. The supply chains in some cases will never return the way they were. It is a new world.

It is the Fed's job to look forward, not back.

Sorry. Prior to the invasion my macro-economic chart package painted the worst inflation outlook I can remember in 40 years as an institutional investor. Inflation at levels comparable to those of 1981/82 when Fed Funds hit 20% to quell the inflation monster. By contrast, Fed Funds are now effectively at zero. The Fed hasn't even started its job.

The invasion did not improve things.

Large new military spending looks likely no matter what the outcome between Russia and Ukraine. That will hot up inflation even more.

The coming inflation was not priced into markets prior to the invasion much less even higher inflation due to more spending.

The forty-year tailwind of the Fed dropping rates from 20% to zero is now over. The invasion just made the headwinds for markets stronger (meaning rates will ultimately have to be raised higher).

A few sanitary overly announced 25 basis point rate hikes will not magically make inflation to go away. What the Happy Talkers don't seem to understand is that once inflationary psychology gets embedded as it is now, the Fed will have to act that much more aggressively later to solve the problem as Volcker had to.

What to do? Prepare for the coming storm.

Pare risk. Stay liquid. Look for short-term, low-risk, uncorrelated investments. Then transport yourself back to 1982, the year rates last peaked. Enjoy the hit song from that year, Happy Talk, by none other than Captain Sensible himself.

Then, follow Captain Sensible down to the South Seas and take a long market vacation.

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