In our most recent Thoughts on the Current Outlook, we enumerated the reasons why we believe inflation will stay sticky for longer than many expected: high energy prices, continuing COVID shutdowns in China, an historically tight labor market and strong real estate demand.

Most concerning to us is the energy price situation. In the past, very high energy prices have often preceded recessions as pain at the pump typically acts as a tax on consumers, who react by reducing other purchases. While the Biden administration wants to blame Putin for the spike in oil prices, the reality is that oil prices were rising long before the invasion because the new administration abandoned US energy self-sufficiency. From the low 50s in January, 2021, crude climbed to the low 80s in October, 2021 and then to the low 90s in early February, 2022, a few weeks before the invasion. While hindsight is 20/20, one could certainly make the argument that the US had the power to bring down energy prices in 2021 by producing more oil (in 2020, we were net exporters of oil) and our failure to do so indirectly funded Putin’s war on Ukraine.

Unfortunately, it does not appear that we have learned anything from this experience and so have no credible policy to bring down energy prices. We are likely left only with the natural market remedy, which is demand destruction resulting from a weaker economy. Until this materializes, energy prices will be a strong driver of inflation.

Enter the Federal Reserve which now realizes it is well behind the curve in raising rates to cool the economy and bring down inflation with it. With 75 bps of increases already behind them, they expect to raise rates at least another 100 bps – 50bps at each of the next two meetings. We believe these steps alone would cool the economy somewhat. But a further contributor is that the enormous COVID stimulus programs of the last two years have now expired. The combination of these two factors could easily put us into recession.

Even if we avoid a recession, growth will definitely slow even while inflation stays high. Those of us who experienced it for a good chunk of the 1970s understand that stagflation – high inflation and slow growth at the same time -- isn’t good for any financial assets. Holding cash is a guaranteed loss of purchasing power to inflation. Bonds are the same, at least until yields are high enough to compensate for inflation, which we are a long way from right now. And stocks suffer as investors aren’t willing to pay much for future earnings which must be discounted at a high rate (inflation plus a risk premium).

So what could go right and help us out? First, China could get past its COVID restrictions and, perhaps more importantly, relax the Communist Party’s recent grip on the free markets that have driven its growth for the last 30 years. We are more optimistic about the former than the latter. But the reality of much slower growth may cause Xi Jinping to moderate his future policies toward the private sector. Relaxation of US tariffs on Chinese exports would also help (one positive policy the Biden administration has said it is considering).

Second, the US consumer may continue to bail out our economy. After two years of lockdowns, we are all anxious to do things we haven’t been able to do much of: travel, shop in stores, eat in restaurants and gather with family and friends. There is an enormous amount of pent-up demand that will likely continue to drive growth for some time yet.

Third, markets will adjust to the new environment and create new opportunities. We are likely only part of the way through this process but we won’t fully know it is done until we are well on the other side of those adjustments. In the meantime, markets are likely to be quite volatile.

Our approach is a combination of preserving capital where possible while also looking to invest in good long-term opportunities as they become available at attractive prices.