Three Key Thoughts:

1. We Didn’t Start the Fire

2. Inflation: What Sticks?

3. China: Rapid Change

We Didn’t Start the Fire

In 1989, Billy Joel wrote the song “We Didn’t Start the Fire” to show a young Julian Lennon that life was just as challenging for Billy growing up in the 50s and 60s as it was for a 21 year old Lennon in 1989. If you aren’t familiar with the song, it is a stream of consciousness recitation of some of the main events that took place from 1949 to 1989. The song ends with a reference to Tiananmen Square, which was just a few months before the fall of the Berlin Wall. Billy Joel might be challenged to reduce each year since then to one line.

My reason for bringing it up is I was struck by hearing the song’s lyric “It was always burning since the world’s been turning” juxtaposed against President Biden’s recent mild complaint about the number of issues he has had to deal with at once. Well, unfortunately for the President, it has always been so and isn’t likely to change anytime soon. One of the best things he could do is not create problems where they didn’t exist before.

The current fire in Washington is about “infrastructure” in its various potential forms. A bipartisan physical infrastructure bill passed the Senate but not the House, as some members don’t want to move that bill forward without the second “human infrastructure” bill being done at the same time. That stand-off has led to efforts to try to slim down the size of the second bill. Our concern revolves around the various and sundry tax proposals that have been floated to pay for the second bill. It is impossible to predict where all of this debate will come out. For now, the markets prefer inaction.

Besides this fire, there are many others burning, including: rising prices for food, fuel and housing, an increasingly aggressive China, the immigration crisis at our southern border, fallout from the Afghan pullout and North Korea military testing, to name a few. Oh, and there’s an historic pandemic that we could get better under control if we could figure out how to get more people vaccinated.

Inflation: What Sticks?

Yesterday, the Social Security Administration announced that recipients will receive a 5.9% increase in their benefits in 2022. This is the biggest increase in 40 years and a good reflection of how quickly inflation expectations could get embedded in consumers’ thinking. The big question facing the Federal Reserve as it tries to decide how much stimulus the economy still needs is whether the inflation we are now seeing is “transitory” or “sticky.” Home price increases and wage pressures will be sticky for a while as we can’t “produce” more homes or workers quickly. On the other hand, we think price increases induced by supply chain problems are likely to be temporary as we work through the backlogs at ports, shipping companies and raw materials producers.

We wouldn’t be surprised to see prices for oil and natural gas stay high, or even go higher, in the near term as it appears that we have abandoned the energy independence we achieved a few years ago, in favor of more environmentally friendly policies. While that is a great long-term goal, the short-term impact will be greater dependence on imported energy, the price of which is outside of our control. Indeed, those foreign producers know that traditional fossil fuel consumption will likely decline over the very long term, giving them an incentive to maximize profits during periods of strong demand.

Speaking of strong demand, the proliferation of “We’re Hiring” signs throughout the country is staggering. On a recent driving trip through Montana, we encountered several fast food restaurants that could not open their dining rooms for lack of employees. When high demand meets low supply, prices rise and that is what we are seeing in wages. But we also have had a longstanding labor supply problem because our birth rate is not replacing the working population and we have dramatically reduced the amount of legal immigration over the last decade. What we wouldn’t give for a rational set of immigration policies – we aren’t getting our hopes up!

China: Rapid Change

The Xi regime has laid out three guiding principles for policymaking: security, stability and common prosperity. From these basic building blocks have come a flurry of regulatory actions over the last year. Starting with the quashing of the IPO of Ant Financial and progressing through actions damaging businesses in the social media, private education, gambling and gaming sectors, the Xi regime has created a great deal of uncertainty surrounding their relationship with private enterprise.

Perhaps more importantly, their efforts to rein in the red-hot residential housing market have run headlong into the financial distress of the country largest property developer, Evergrande. It is not at all clear how policymakers are going to (1) resolve Evergrande’s liquidity crisis; (2) maintain confidence in the housing market; and (3) cool price increases. This problem is particularly acute because of the great importance of home equity to the net worth of Chinese citizens, particularly the hundreds of millions of city dwellers.

Meanwhile, China has stepped up both its rhetoric and its military maneuvers aimed at Taiwan. While all of these activities could be viewed as consistent with positive social goals, as well as being consistent with the three guiding principles, they also come directly ahead of the expected re-election of President Xi to an unprecedented third term next year. To us, this smacks more of power consolidation than social welfare.

Bottom line, many investors are being cautious about the implications of these rapid changes for future economic growth in China and the continued evolution of their markets.

Investment Implications

We remain optimistic that the reopening of the US economy will continue, perhaps at a more measured pace. Inflation and the Fed’s reaction to it will be front and center over the coming months, which could introduce more market volatility for both stocks and bonds. Right now, Washington is doing what is does best – nothing. We are hopeful that continues. We are keeping asset allocations close to long term targets, with sufficient cash available to take advantage of short-term setbacks.