Bedtime For Bonzo
<June 3, 2022>
Like many 10-year old’s, my son doesn’t like going to bed early. Around bedtime he’ll often tuck himself into the corner of the sofa, hoping he’ll go unnoticed. While this occasionally works, I usually know where to find him and send him to bed on time. To improve his success rate, he recently implemented a new strategy of searching for sporting events on television with only a few minutes remaining.
“Time to go to bed,” I say.
“But dad, there’s only five minutes left. It’s the NBA playoffs. Can I watch the end?” He asks.
“Ok, but after that you’re going straight to bed,” I respond.
The game ends and what do you know, he finds another game. This time it’s a baseball game.
“Dad, it’s the ninth inning with runners on. Can I watch the end?” he asks again.
“Ok, but after that you’re going straight to bed,” I say again.
I’ll give him credit. It was a clever scheme that worked too many times until one night I realized I was being duped and yelled, “That’s it, bedtime for Bonzo!” and chased him into his room.
My son’s attempt to avoid being sent to bed reminds me of the Federal Reserve's fight against inflation. Considering all the Fed’s talk and limited action, it’s clear the Federal Reserve is playing the delay game. Just one more month and we’ll do it. Just one more data point and we’ll do it. Just one more press conference talking about why we’re going to do it, and we’ll do it. Meanwhile, we’ve had over a year of red-hot inflation with a tremendous amount of purchasing power lost, likely never to return. It’s just one big game of avoiding what the Fed is dreading—raising interest rates and shrinking its balance sheet.
While we disagree with the Federal Reserve, we understand its apprehension. Over the past few months, we’ve seen what life in the financial markets can be like without the Fed’s artificial bid and effortless money creation. Without the Federal Reserve’s heavy hand, free markets and price discovery have returned, with investors being left on their own to determine the price of stocks and bonds. Since QE has ended, many stocks have declined, and bond yields of all stripes have risen.
Considering how dependent the U.S. economy has become on asset prices, it shouldn’t be surprising that the Federal Reserve doesn’t want to fight inflation. The markets are having difficulty functioning without QE, let alone with QT and a fed funds rate approaching the rate of inflation. In our opinion, the Fed’s delay game has nothing to do with being patient or diligent. Instead, we believe it’s an attempt by the Federal Reserve to make it to a period of easier year-over-year inflation comparisons.
Over the next several months, year-over-year inflation comparisons will become much easier, increasing the probability that upcoming inflation reports will show a moderating trend. We expect the Fed will use any slowdown in year-over-year inflation as proof their policies are working, providing cover to delay their plans to tighten monetary policy and protect asset prices.
Of course, the delay game is not risk-free and to date has come with significant cost. While the damage to financial markets has been mostly orderly and contained, inflation has taken a devastating bite out of the average American’s purchasing power. Forget about keeping up with the Jones’s, today most Americans just want to keep up with the rising cost of a tank of gas, groceries, and rent!
The Federal Reserve’s delay game has also destroyed savings and for many, the dream of owning a home. And while the Fed may soon tout the decline in year-over-year inflation, the delay game does nothing to compensate consumers and savers for the significant amount of inflationary damage they’ve already incurred. As such, don’t expect a “my bad” inflation refund check signed by Chairman Powell anytime soon!
As the Fed sits on its hands waiting for easier inflation comparisons, businesses have been left on their own to adapt and fight rising costs. Unlike the Fed, companies do not have the luxury to play the delay game. Given their responsibility to shareholders, they are under continuous pressure to maintain profit margins and pass on additional price increases. As we wrap up our Q1 earnings review, one thing is clear: inflation remains the most challenging issue for most companies. Executives are managing their businesses as if the Federal Reserve will continue to do very little to address an inflationary environment few executives have ever experienced in their careers.
The consumer is also not waiting for the Fed’s help. They’re adapting, and in many cases, pulling back on spending. As we wrote in last month’s post, The Great Inventory Build, we believed there was a growing risk to consumer discretionary results from rising inflation, lack of stimulus, difficult comparisons, negative real wages, and declining stock and bond prices. Based on recent earnings results, our hunch turned out to be correct, with several companies reporting consumers are in fact altering their spending habits.
Most notably, Target Corporation (TGT) discussed shifting spending trends in their latest conference call, blaming a “rapidly shifting macro backdrop” and “changing consumer behavior” on disappointing quarterly results. Management also stated they experienced a “rapid slowdown” beginning in March, which contributed to excess inventory and lower than expected gross margins.
In our opinion, the underlying goal of the Fed’s delay game is to prolong an economic cycle built on inflated asset prices. However, by shirking its inflation fighting responsibility, we believe the delay game has backfired. Instead of keeping demand elevated by promoting asset inflation, the economy is rolling over as consumers are squeezed and discretionary spending declines. In addition to reduced consumer discretionary spending, we’ve also documented instances of demand destruction in the form of lower capital expenditures due to rising costs and elevated uncertainty surrounding long-term investments.
As businesses and consumers adapt, we too are acting and preparing for the consequences of the Fed’s inflationary neglect. In our opinion, there will be tremendous opportunities once investors realize inflation will not easily go back into the 2% bottle. In effect, we believe investors will eventually realize that they too are being left on their own to protect themselves. It will be this inflationary realization moment that we expect will take away the Federal Reserve’s ability to print unlimited amounts of money, squash the “Fed put,” and end the current market cycle.
With the equity markets declining for most of 2022, it appeared investors were catching on to the consequences of unchecked inflation. However, equities have recently rallied as investors position for the seemingly inevitable “Fed pivot” or pause in policy tightening. For example, on May 26th, stocks were up 2%-3% depending on the benchmark. However, few commentators noted oil was also up $4 per barrel as gasoline prices reached another record high.
In our opinion, further increases in asset prices will have negative consequences for real world inflation. After years of persistent asset bubbles, extraordinary fiscal deficits, and the tightest labor market in decades, inflation is no longer being contained in asset prices. It appears to us that the days of asset inflation without consequences to real world inflation are ending.
The clock is ticking on the Fed’s delay game. They have waited and waited, as inflation has destroyed the standard of living of millions of Americans they promised to protect. And while moderating year-over-year inflation data may show statistical progress, it does nothing to reverse the inflation that has occurred or compensate those that have been harmed. Further, while the rate of year-over-year inflation may continue to decline as it did in April’s CPI report, we believe inflation will remain well above the Fed’s target and well above what the average family can withstand without significantly altering their spending and voting decisions.
We believe the Federal Reserve is trapped. We recognize its delay game, we do not believe it will work, and we are positioned for it to fail. The inflation delay game has gone on for far too long and has done far too much damage—it’s time to put it to rest. It’s bedtime for Bonzo.
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S&P 500: The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
BofA BB High Yield Index: Bank of America BB High Yield Index tracks the performance of US dollar denominated below investment grade rated corporate debt (rated BB) publicly issued in the US domestic market.
Consumer Price Index (CPI): An index of the cost of all goods and services to a typical consumer, calculated and published by the United States Bureau of Labor Statistics.
Quantitative Easing (QE): A form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.
Quantitative Tightening (QT): A form of unconventional monetary policy in which a central bank sells or allows to mature longer-term securities in order to decrease the money supply and reduce the size of the Fed’s balance sheet.
The Fed Put: The Fed put refers to the price level in the financial markets in which the U.S. Federal Reserve will take accommodative actions that would boost financial markets.
The Fed Pivot: Often used to describe abrupt shifts in monetary policy.