Cost of Capital. The Past, Present and Future? | Part 7

2022 Financial Predictions

As 2022 begins, I think a clearer picture of our financial challenges is coming into view – despite the noise emanating from the pandemic.  Among the myriad of relevant data points, I note the following:

  • Consumer Price Index inflation is now in the 6% zone. Estimates for 2022 vary widely from the inflation hawks and doves.
  • By many measures, real US bond yields are now in negative territory – which generally makes sense only if the inflation doves are right that inflation will subside quickly.
  • So far, the anecdotal evidence (strikes, lack of workers) indicates that we are beginning to see the effects of a wage-driven inflationary spiral. See the last installment of the Cost of Capital Series, PART 6 | Are We Looking at Wage Inflation?
  • Driven in large part by rock-bottom interest rates, the stock market is experiencing new highs.

This set of realities may be incongruous, and probably only works in a Goldilocks environment where CPI and wage inflation, worker shortages and other concerns recede quickly.

But in the real world we live in, can a Goldilocks scenario prevail?  Certainly the Fed and adherents of Modern Monetary Theory would have you believe that it will.  And they point out that a big chunk of the current spike in inflation relates to energy prices, which they think will abate.  But even if they are right about energy (personally, I think they are wrong), overall inflation does not appear to be “transitory”.

How Inflation Affects Financial Markets

I believe that the late Milton Friedman, dean of the monetarist economics movement, got it right.  According to Professor Friedman, inflation is and always will be a monetary phenomenon.  Print more money and prices rise.  We certainly have seen that in financial markets, and there is clear evidence that the loose monetary policies of the last 10-plus years are culpable.  And now we are seeing it on store shelves.

And of course, there is the push to decouple from the Chinese supply chain.  It is unclear how much of this will actually happen, but any change will likely be accompanied by higher prices to US consumers.


Dollar Hegemony Concerns

But there may be another, even more unsettling factor at work.  The question of the continuation of dollar hegemony has been a concern for quite a while now.  Recent geopolitical events (Taiwan, Ukraine) have chipped away at US dominance and the Pax Americana.  Like it or not, there is a risk that we may experience a serious erosion of the dollar’s status as a reserve currency.  Probably not replaced, but “augmented” with other instruments.  If that happens, geopolitical events may no longer result in a flight to the dollar.  Instead, the dollar could sink.

And that means we would be importing more inflation.  Not to mention higher risk spreads if Pax America unravels.

A number of well-respected economic observers have suggested that the right US response to the data is to get ahead of the problem and increase interest rates aggressively.  I agree with that.  But the same observers seem to believe that there is no way the Fed or the Biden Administration will pursue this alternative as vigorously as needed.  Instead, we will see the Fed constantly raising rates in response to reported inflation (but never enough to snuff out inflation as Paul Volcker did).  I agree with that too.


Capital Markets Predictions

Given the foregoing, I think that a status quo scenario for capital markets is increasingly looking to be a bad bet.  Virtually all of the probabilities are to the downside.  How long can this limbo last?  It’s difficult to say, but I would be watching for the following in the weeks ahead:

  • Monthly CPI figures. If reported inflation does not subside soon, putting the genie back in the bottle will not be easy.
  • Labor force participation. Unless we see a big increase in numbers of people working, the labor market will remain tight.
  • Wage rates. If higher CPI numbers are followed by large wage increases, inflation will be reinforced.
  • Fed rate increases. The Fed can counterbalance these forces through actions such as rate increases and reducing the money supply.  The challenge is that real rates need to be positive for this strategy to work.  Unless the CPI inflation subsides quickly (a recurring theme), the Fed will have to increase rates to the point where recession risks are significant.  Instead, I believe that the Fed will only take small (but much ballyhooed) steps.

I think the near-term table is set for somewhat higher interest rates, continued high inflation and a rocky stock market.  I also believe that this happens with or without the pandemic.  Longer-term, there is a good chance we will see a long-overdue recession and/or a large tax increase.

Time to take my 70s wardrobe out of the closet.


Want to Discuss This Further?

This post and the accompanying exhibits were produced in-house by members of the Gordian team. Clients, potential clients and members of the media can book a call or meeting to learn more by contacting Leslie Glassman directly.

Commentary by Gordian Group CEO Henry Owsley