Three Key Thoughts:

1. Fighting Inflation First

2. Begging for Oil

3. China is Not Russia

Fighting Inflation First

In 1974, new President Gerald R. Ford inherited a major inflation problem, brought on by spending on the Vietnam War and then exacerbated by the oil embargo in 1973. To garner public support for inflation fighting measures, Ford’s team dreamed up a “Whip Inflation Now” campaign, encouraging citizens to do their small part to reduce inflation’s bite. One corny aspect of the plan was the now-infamous “WIN” button, which was broadly distributed to the public. The program was largely viewed as a failure and inflation remained an enormous problem for the remainder of Ford’s term and throughout the Carter years.

We don’t expect the Federal Reserve to start distributing WIN buttons any time soon, but they have certainly taken up the mantra. Chair Jerome Powell has said on several occasions that fighting inflation is the Fed’s first priority, even if it risks bringing on recession. Their preference would be to slow the economy just enough to bring inflation down, but this will be a very difficult challenge. The Fed’s tools are very blunt instruments – interest rates and bond buying/selling – while inflation is coming from several sources.

Inflation from housing costs and labor shortages are likely to remain sticky for a while as we are chronically in short supply of housing (relative to the demographic need) and labor (as our population growth hasn’t been sufficient to keep up with the demand for labor). Throw in high energy prices driven by our abandonment of energy independence and the war in Ukraine, and you have a very difficult set of inflation drivers for the Fed to address. We aren’t surprised to see them acting aggressively now in hopes of reducing demand for housing, labor and energy. Consumers are already feeling the pinch, psychologically anyway. The University of Michigan’s Index of Consumer Sentiment stands at 50, an all-time low for that index, mostly based on concerns about inflation. What’s rare is that this reading comes when unemployment is close to all-time lows.

Begging for Oil

Moving away from fossil fuels for the good of our planet is a goal easily embraced. However, having spent more than 100 years building a power grid and transportation infrastructure based on fossil fuels, the transition to new energy sources will be long and complicated. We believe using the high current price of oil to try to force consumers to transition to alternative fuel sources is destined to be a failure because we are missing two critical pre-cursors to a sustained move away from fossil fuels: technology and infrastructure.

On the technology side, we need major advancements in battery technology and power storage. Advancements in technology to improve battery life, speed charging time and reduce weight are being driven by market forces and progress continues. Absent major breakthroughs that improve functionality and reduce costs, a major shift to electric vehicles (EVs) isn’t likely until at least the next decade. With respect to power storage and transportation, solar and wind power are notoriously unreliable as Texas is experiencing at this writing. These are exceptionally difficult problems that will take time to solve.

The real laggard, however, is our current power grid. It is riddled with regional inconsistencies and inefficiencies and simply cannot handle even minor disruptions in supply or surges in demand. Burdening the current system with even more demands from EVs and other forms of electrification won’t work. We believe fixing this problem with require national leadership and effort.

For now, we are left to beg for oil from anyone and everyone in a vain attempt to moderate prices. Not surprisingly, our entreaties have fallen on deaf ears. Producers are happy to sell their current production at high prices, recognizing that they too will need to transition away from fossil fuels in the future. They also expect that investments to expand capacity now are unlikely to pay off over the long term. Further, they know that the US has the ability, but not the current will, to solve its own energy supply problem. We expect energy prices to stay high until demand is reduced by a slower economy, which the Fed is working on!

China is Not Russia

We have written in the past about our concerns regarding the direction that President Xi has taken China. Certainly, he has used the pandemic as an excuse to impose draconian limits on personal freedoms that the Chinese people were just getting used to having. At least as important though are the changes he has brought about economically. Imposing far reaching restrictions and fines on certain large businesses (real estate and education, for example) has dented investors’ confidence in the future viability of businesses that are not closely tied to the government priorities. And the Chinese markets have suffered as a result.

As these changes filtered through to the real economy, growth has slowed to a crawl and the government is beginning to put in place stimulus plans to try to re-ignite growth. While it remains to be seen how successful these stimulus plans will be, they highlight a major difference between China and Russia. In China, political loyalty is to the Chinese Communist Party (CCP), which has its own unique organizational structure and approach to governance. Despite the special “historical figure” status that Xi has achieved, he is ultimately accountable to the CCP. Assuming they can get past their COVID lockdowns, we expect Xi to return to a focus on the party’s long-term priorities of stability and manageable economic growth.

There is no similar accountability structure in Russia. Putin is accountable to no one, least of all the average citizen, for whom he has no regard. This is the biggest problem with the harsh sanctions that were imposed by western countries after the Ukraine invasion – they hurt the average Russian citizen but have no impact on Putin. So long as the US does relatively little to help our European allies with their energy needs, Putin remains in a reasonably strong position, able to prosecute a war of attrition funded by high energy prices. And, having controlled the messages they receive, he has no pressure from his domestic population to bring an end to his “special military operation.” Indeed, he can inflict deep economic pain on the west through higher energy prices and supply disruptions, even while fighting to expand his territory and influence.

Investment Implications

The Federal Reserve’s policies will slow down our economy, even as inflation stays high in the short term. How much slowing? How much inflation? These are key unknowns. As the markets sort this out, we expect more volatility. We are staying patient, keeping asset allocations stable and watching for new opportunities.