LEVATUS Investments | Inflation + Disruptive Change = the Combination to Watch in 2023
The interplay between inflation and disruptive change creates strong cross currents and interesting opportunities.
Photo by Fabio Santaniello Bruun
We are happy to share the below excerpt from our January 2023 letter to clients, ‘Growth and Where to Find It’. We expect the coming year will be a time to embrace new opportunities, while requiring some maneuvering around last year’s residual baggage.
A New Year is always a time to ponder new opportunities and 2023 is no exception. As has been a constant theme of LEVATUS since its inception, advances in the application of technology will once again demonstrate the wonders of human creativity and ingenuity. Moreover, innovation continues to inspire us, as it does each year when we write about what’s on the horizon in our annual Seven Percent Report. The opportunity set is discussed in more depth a bit later in the report. Below is an assessment of the influence the ‘residual baggage’ is likely to have on the arc of the market in coming quarters.
Inflation
The problem of inflation, which haunted us in 2022, continues into 2023 and is joined by the prospect of economic recession. Although the likelihood of stagflation (which historically has been a catalyst for outsized bear equity markets) is receding, the battle against traditional inflation is not yet won. Many Federal Reserve officials believe that it could take several years for inflation to return to the central bank’s two-percent target.
Despite the monetarist adage that “inflation is always and everywhere a monetary phenomenon,” this time the contributors to inflation have been many and varied. Pressure in labor markets continues to fuel wage gains, although some cracks are beginning to appear with reductions in temporary employment. Globalization is no longer supplying the tailwinds to the importation of cheap goods from China and elsewhere. There is no guarantee that downward pressure on commodities will continue. Much will depend on how long the global economy flirts with the doldrums, particularly in the case of China which is trying to extract itself from the grip of Covid.
Adding recession to the mix
While inflation was viewed largely as a supply issue at the start of 2022, the Federal Reserve has now become more fixated on inflation as a demand side problem. Using monetary policy in an aggressive way has increased the likelihood of recession, despite Federal Reserve officials believing they can engineer a soft landing of the economy.
By the measure of the “official recession scorekeeper,” the National Bureau of Economic Research (NBER), the United States is not yet in a recession. The traditional indicators of recession used by the NBER, including real personal income minus government transfers, employment, various forms of real consumer spending, and industrial production have not crossed the threshold signaling a significant decline in economic activity.
However, there are other indicators used by economists that warn of the possibility of recession. One of the most popular is the inversion of the U.S. Treasury yield curve. An inverted yield curve is when yields on shorter maturity instruments are higher than those of longer maturity bonds. The yield curve has been inverted since the spring of 2022. In general, recessions have often started anywhere from 6 to 15 months after a yield curve inversion.
Besides yield curve inversion, business confidence has been eroding as inflation puts pressure on the profitability of firms as sales volumes slow. From the consumer perspective, excess savings accumulated during the pandemic is dwindling as families struggle to maintain their standard of living. In its recently released Global Risks Report, the World Economic Forum highlighted that a cost-of-living crisis could have an adverse impact on global economic activity for years to come.
Are we poised for a soft landing?
Some economists and many in the financial press have been touting a soft-landing scenario for the United States. However, hope and a good narrative do not raise the probability of a soft landing for the economy. Our view is that the United States and many other countries will experience a recession before the end of 2023. We don’t foresee a steep recession, but this is predicated on government and central bank officials avoiding policy mistakes, particularly when it comes to managing inflation.
Those pushing the alternative of no recession, or what is termed a soft landing, constantly reference the idea that the Federal Reserve is about to pivot, meaning shift from raising interest rates to cutting interest rates. This notion of pivot comes from the belief that the central bank has overtightened monetary policy and will have to relax its policy in order to avoid the possibility of a steep recession accompanied by unwanted deflation. So far as history is concerned, it has not been kind to those who believe that a monetary policy pivot will bring a pronounced retrenchment of inflation with any sort of staying power.
Because the Federal Reserve has constantly expressed reservations about pivoting in 2023, we can see only an extremely narrow path to a soft landing for the U.S. economy.
Bottom Line
Patient investing is the power of not being forced to chase the latest short-term trend but relying on the strength of a proven investment process. Our client’s greatest advantage is long term capital, and 2022 was an excellent example of the power of patience. A focus on absolute risk, not relative, has left client portfolios in a position to capitalize on unfolding opportunities. Value has been created in the market as prices have declined over the past 14 months. Once inflation stabilizes, even in the context of a normal economic slowdown, there are well priced, well positioned investments for the decade ahead.
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ABOUT THE AUTHOR
Keith Savard has more than 40 years of economic/finance research and investment experience in the United States and overseas. He has worked as a staff member at the Board of Governors of the Federal Reserve System and as an international economist at the U.S. Department of State. A solid background in macroeconomic analysis and financial regulatory and monetary policy issues, combined with sovereign and credit risk skills, has enabled Keith to offer investors actionable top-down investment strategies and expertise facilitating a broad-range of asset allocation decisions. His deep knowledge and understanding of emerging markets, gained through extensive travel and meetings with cabinet-level officials, company CEOs and local investors, affords opportunities to invest confidently beyond the United States.
