Dear clients and friends,
I recently had an opportunity to proofread my daughter Madelyn’s essay for an undergraduate course in Supply Chain Management, which is the focus of her collegiate studies. In the paper, she discussed her real-world experience in the retail clothing industry and how difficult it has been, in the post-covid environment, to effectively manage store inventory. From the sourcing of fabrics to distribution logistics to obtaining microchips for RFID tags to hiring customer-friendly staff for the stores, every once-routine aspect of the retailing process has been upended in the past few years, with higher consumer and producer prices the direct outcome.
As you may guess, the underlying problem – impacting not only the haberdashers of the world but manufacturers and sellers of just about everything in the global economy – is a mismatch between supply and demand. But that by itself doesn’t answer key questions: supply of what? demand for what? As the famed economist, Irving Fisher wrote in the preamble to one of his textbooks, “A critic of the science said, ‘If you want to make a first-class economist, catch a parrot and teach him to say ‘supply and demand’ in response to every question you ask him. What determines wages? Supply and demand. What determines interest? Supply and demand. What determines the distribution of wealth? Supply and demand.’ In every instance the answer is right, but it explains nothing.” [1]
As students of finance and economics, we’ve graphed supply and demand curves ad nauseam. We are thus aware of a general assumption that all else the same, supply will rise to meet increased demand. But in the short run, if demand surges and supply can’t catch up, inflation happens. Indeed, one definition of inflation is simply, “too much money chasing too few goods.”
In theory, the converse should also hold true: if demand wanes, prices should fall until excess supply is absorbed. That notion seems to capture current Federal Reserve policy in a nutshell: raise interest rates enough to make the cost of money prohibitively expensive (think mortgages, auto loans, corporate debt) thereby quelling demand for the things money will buy and, in so doing, slaying the inflationary dragon.
There’s a possible short-sightedness in the Fed’s approach: it is aimed almost solely on curtailing demand, and, in our opinion, largely ignores the supply constraints endemic in today’s global economy. Microchip shortages are made worse by China’s zero-Covid lockdown policy. Soaring food prices in Europe and Africa result from grain shortages caused by Russia’s vile assault on Ukraine. Global energy prices are higher because of the Ukraine war, climate policies and other geopolitical factors.
While prior years’ fiscal and monetary stimuli certainly provided fuel for current inflationary fires, the Fed’s efforts to rein in those stimuli – to combat inflation by attacking demand – may prove self-defeating if instead they inflict further damage on already impaired global supply capabilities. As former Fed nominee Judy Shelton points out, “At a time when we are trying to increase supply to soak up demand, the Fed’s strategy is to slow down economic growth. And at a time when we are coaxing people to come back to work, the Fed’s strategy is to increase unemployment.” [2] One possible outcome is that the Fed will continue to raise rates beyond current expectations, even if doing so tips the U.S. economy into recession and proves somewhat ineffective in the fight against inflation.
How do global inflation and the Fed’s policies impact your investments? As noted in prior communications, we have managed interest rate risk in the fixed-income portion of client portfolios by emphasizing high-quality short-term bonds, including funds that hold short-term U.S. government securities. As such, our bond holdings this year have been less volatile than widely used longer-term bond benchmarks, some of which have fallen almost as much as equities. As the Fed continues to push rates higher in the coming months, we believe our short-term fixed-income holdings will better withstand bond market volatility and allow you to benefit more quickly from higher bond yields.
Similarly, while our stock portfolios have remained underweight in international and emerging market equities, we have further reduced non-U.S. stock exposure as we believe the outlook for global economies is more uncertain, and inflationary pressures stronger, than in the U.S. On a positive note, we want to remind investors of a potential silver lining to recent volatility: as stocks decline and companies adjust to new economic realities, the stage may be set for healthier returns in the years to come. Though the past is never indicative of the future, we are cautiously optimistic that better days may be ahead. As always, we encourage you to reach out at any time to discuss your portfolio to ensure your mix of assets is appropriate and aligned with your financial goals.
With warm regards,
Mitch Schlesinger, Investment Strategist
[1] 1910, Introduction to Economic Science by Irving Fisher, Quote Page 133, Macmillan Company, New York. (Google Books full view)
[2] CNBC interview with Judy Shelton, 2022-09-27
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