Russo/Sino Alliance — Post-Post-Cold War — Erodes Globalization — Russia’s Control of Gas Supplies to Europe — Germany May Ration — German Industrial Production Suffers—Increase Depth of European Recession—European Central Bank Will Face a Dilemma

The global economy faces inflationary pressures from the Euro-Asian alliance formed by China and Russia. During the first Cold War, both Russia — behind the iron curtain – and China – behind the bamboo curtain — represented minor economic powers. In the new post-post-Cold War era, the alliance of China’s powerhouse economy with Russia’s control of important sources of raw materials, energy, and foodstuffs changes global economic equations. The post-post-Cold War era will undo the relatively stable global relationships developed since the fall of the Soviet Union. The less stable relationships will increase inflationary pressures as globalization erodes. The Sino-Russian alliance will, at a minimum, bifurcate the world. In doing so, it will add friction to world trade, prove inflationary, and lead to potential conflicts. Russia’s invasion of Ukraine in order to add strategic depth – a historic Russian effort to protect its landlocked western and southern borders — provides an example of all three. The war caused both energy and hard and soft commodity prices to sharply rise. The resulting inflationary pressures broadly impacted the global economy. The blockage of Ukraine’s black seaports put a severe strain on global trade in wheat and other agricultural products. Russia’s control of natural gas supplies to Europe may force Germany to ration natural gas next winter (see Figure 1). If that occurs, German industrial production will suffer and increase the likely depth of an expected European recession. How the European central bank will respond in light of its current efforts to fight inflation creates significant risks for the Eurozone.

Figure 1

Euro Share of Gas Imports in Prime Energy Consumption-2020

Source: Eurostat and ECB Calculations

Fed 75bps Increase in June and Likely In July Elevates Risk For An Economic Slowing or Pullback

The Cleveland Fed’s median CPI for May increased to over 5.5% annually which reflected a broadening inflationary impact on CPI components (see Figure 2). Broadening and increasing inflation left the Fed little choice at its May meeting but to raise the funds rate by 75bps rather than 50bps to 1-1/2 to 1-3/4%. The 75bps increase in June and likely in July elevates the risk for an economic slowing or pullback. Nine of the Fed’s 12 tightening cycles since 1950 ended with a recession (see Figure 3).

Figure 2

12-Month Inflation Growth Rate – 1/2018-5/2022 — Headline, Core, and Median

Source: Federal Reserve Bank of Cleveland, Bureau of Labor Statistics

Figure 3

Money-Market Interest Rates Changes and Recessions

Source: The Wall Street Journal

CPI Core Inflation Shows Little Change at High Plateau Levels In 2022—Peaking Inflation? — High Food and Energy Inflation Takes an Increasing Share of Consumer Wallets — Demand for Goods and Services Will Likely Slow

Unlike headline CPI inflation, core CPI inflation —which excludes food and energy — shows little change for the first four months of 2022 — albeit at a plateau three times the Fed’s 2% average inflation target (see Figure 4). As a result, food and energy plus shelter costs take an increasing share of consumer wallets at the same time their real incomes decline. These demands on consumer wallets will likely lead to slowing demand for goods and services. With that shift, the economy will likely slow and, over time, moderate core inflation.

Figure 4

CPI Inflation — Headline vs. Core — Past 12 Months — Seasonally Adjusted

Source: Federal Reserve Bank of Cleveland, Bureau of Labor Statistics, Haver Analytics

NBER Study — Current Inflation Much Closer to Past Inflation Peaks — Conclusion — Reaching Fed’s Average 2 Percent Target Will Take Longer

A recent NBER working paper, with Larry Summers as one of the authors, compares current inflation with pre-1983. To make that comparison, the paper restates pre-1983 CPI results using today’s methodology. With that restatement, the paper found: “that current inflation levels are much closer to past inflation peaks than the official series would suggest” (see Figures 5 & 6). As the paper points out, housing represents both an investment and consumption good. Pre-1983, the BLS did not separate these two factors. It measured shelter—homeownership expenses to include house prices, mortgage interest rates, property taxes, and insurance and maintenance costs. This pre-1983 methodology resulted in a volatile shelter series. During a tightening cycle, shelter inflation rapidly increased in sync with mortgage rates. The reverse proved true during a loosening cycle as mortgage rates declined. In 1983, the BLS shifted from home ownership expenses to owner’s equivalent rent (OER). The change eliminated the investment in the house as part of CPI shelter expense. Instead, the BLS determined the OER by using statistical methods to estimate rental prices for similar units. What does this mean for current monetary policies and the likely measured inflation response? Using current CPI calculations, which exclude mortgage rates, disinflation during the Volcker-era turned out to be less than using pre-1983 measurements. As a result, and unlike the past, shelter inflation will not decline as rapidly when the Fed eases its policies. This means it will likely take the Fed longer to reach its 2 percent average inflation target and require the same level of disinflation that Volcker produced.

Figure 5

Official and Corrected Headline CPI

Source: Bureau of Labor Statistics, Authors’ Calculations NBER Working Paper No. 30116, Authors Bolhuis, Cramer, and Summers

Figure 6

Official and Corrected Core CPI

Source: Bureau of Labor Statistics, Authors’ Calculations NBER Working Paper No. 30116, Authors Bolhuis, Cramer, and Summers

Supply Factors Contributed to More Than Half of PCE Inflation – Opening Supply Chains Will Prove Important to Moderating Inflation

To bring down inflation, the Fed’s current strategy aggressively uses both raising its funds rate and reducing its balance sheet (QT). By doing so, it seeks to slow demand for goods and services. At the same time, the Fed cannot directly affect supply-driven inflation. In light of that, a recent study by the Federal reserve bank of San Francisco concluded: “….supply factors are responsible for more than half of the current elevated level of 12-month PCE inflation” (see Figures 7 and 8). Based on that bank’s analysis, outside of the Fed’s direct influence, supply chain loosening will prove important to bringing down inflationary pressures. The weekly Goldman Sachs research group’s bottleneck index shows reduced supply chain pressures (see Figure 9). Among other factors, the index readings reflect a smaller container ship backlog at west coast ports and lower container rates. Over the next two months, opening Shanghai, after the recent zero-COVID lockdowns, will prove an important test for improving supply chain flow through.

Figure 7

Contribution to Annualized Monthly Changes in PCE Index Inflation

Source: Federal Reserve Bank of San Francisco

Figure 8

Bottlenecks Disrupted Supply Chains

Source: Bank for International Settlements

Figure 9

GS Weekly Bottleneck Index

Source: Goldman Sachs Research Group

Rising Unemployment Rate Above Fed’s Expectations Could Provide a Signal for Fed Easing

Labor contributes a second important supply constraint to the economy. The April FOMC statement included the following sentence: “the committee expects inflation to return to its 2 percent objective and the labor market to remain strong.” Then in the following month — May, the FOMC struck that sentence from its post-meeting statement. Without stating it, the Fed, in effect, publicly admitted that bringing down inflation will require weakening a very strong, tight job market. Over the last three months, employment growth averaged over 400,000 new jobs monthly, with the unemployment rate falling to 3.6%. The underlying strength of the job market will force the Fed to raise the less restrictive negative real funds rate closer to zero or higher. At its May meeting, the FOMC projected that 2024 unemployment most likely would rise to 4.1% (see Figure 10). According to many economists, to moderate inflation, will require a higher unemployment rate than current Fed projections. However, the Fed’s board of governors remains dovish at its core, particularly with the addition of its two new board members. Therefore, the rising unemployment rate will likely provide a key signal when the Fed will likely reconsider its monetary policies.

Figure 10

Distributions of Federal Reserve Members and Federal Reserve Bank Presidents’ Projections for 2024 Unemployment Rate

Source: Federal Reserve Board

Investment Conclusions

Quantitative Tightening May Cap Multiples — Greater Focus on Real Earnings Growth – Leads to Greater Investment Selectivity — As the Fed draws down its balance sheet, the resulting reduced financial market liquidity will likely pressure stock multiples. As a result, longer-term equity multiples will not likely achieve similar overall valuation levels that both historic low interest rates and explosive Federal reserve balance sheet growth underwrote over the last decade. In the absence of multiple inflation, investors, more than ever, will need to focus on real corporate earnings growth. This possible change could then lead away from broad stock indices, popular over the prior decade, to greater investment selectivity. With ten stocks comprising roughly thirty percent of the S&P 500 stock index, this change would also increase the importance of diversity in managing portfolios.

Defensive Stocks with Long-Term Growth – With the current higher than normal economic uncertainties, investors should continue to hold defensive stocks in such sectors as health care, utilities, and consumer non-durables. Health care will prove not only defensive in this current investment environment but also benefit, longer-term, from the growing healthcare needs of aging baby boomers. In the case of utilities, while near-term defensive, electric vehicle growth should also spark long-term growth for electric utilities.

Looking Through Investment Downturn — Investors should also begin looking through this uncertain economic period and investment downturn to take advantage of attractive stock valuations of quality companies that can show both consistent earnings growth and long-term dividend increases that exceed the rate of inflation.

Energy — The “Putin Shock” will lead to a rethinking of energy security and electric generating systems reliability. This will require updating “green” planning to determine realistic timing required to reach economic scale. Those changes could result in expanded investments in the energy industries, including fossil fuel, “green,” and nuclear. Businesses producing and servicing those industries should benefit.

Security — The growing security “alliance” between the two great Eurasian powers — China and Russia — will likely prove beneficial to companies supplying defense equipment and services. The Ukraine war will prove a testing laboratory, similar to the Spanish Civil War, for the development of new military strategies, tactics, and advanced weapons. This shift will likely force countries to make major reassessments of what weaponry they will acquire and substantially increase their defense spending. Both domestic and non-U.S. defense companies will likely benefit from a long-term period of greater emphasis on defense.

Displacement and Replacement — The “Putin Shock” will also lead to a broad list of displacements and replacements. For example, uncertain grain and oilseeds production from Russia and Ukraine should benefit companies broadly providing increased productivity using precision farming technology systems and equipment. The same will also prove true for developing new sources of key hard commodities. In the latter case, new sources of key hard commodities will also prove critical in meeting demands from alternative energy and electric vehicle industries (see Figure 11).

Figure 11

Russia and Ukraine Large Commodity Suppliers

Source: Bank for International Settlements

Fixed Income and Alternatives — Our prior commentaries suggested long-duration fixed-income investments would prove unattractive during a period of high inflation and historically low interest rates. Now, with aggressive actions by the Fed to bring down inflation, economic slowing will likely follow. A slowing economy will, over time, increase the attractiveness of fixed-income securities. Shorter-duration treasury notes should prove effective to offset higher equity market uncertainties. As recommended in previous commentaries, a select group of alternative investments also fits that portion of the portfolio historically committed to fixed income.