Embracing Risk

After operating in an environment where risks were clearly backstopped by the Federal Reserve. For investors, the world we have known for at least the last 13 years was on course for a fundamental change. The message that investors should be hearing loud and clear is that that there are risks that can’t be clearly analyzed, the Fed may not be able to save us this time and we need to re-learn how to live with risk.

The Fed statement on Wednesday was precisely what the consensus expected, but markets were a bit less than impressed and interpreted the statement as more hawkish (i.e., more likely to be aggressive in fighting inflation). Our take is that the Fed is still leaning toward this inflationary episode to be temporary. Chair Powell noted three headwinds for inflation: 1) fiscal policy, which has been additive to growth over the last 2 years, looks to be negative this year; 2) monetary policy is on a path to be less accommodating this year, and 3) inflation, to the extent it is not yet embedded, has a self-limiting function – the initial reaction to inflation is reduced demand. The path outlined by the Fed is consistent with economists that inflation will tend to ease over the course of the year. This is somewhat baked in, to the extranet that the large inflation jumps occurred last spring, which will tend to turn the inflation data down sometime in the second quarter, which may well change the inflation narrative.

On the chart above, we have taken CPI data from the St. Louis Fed (blue line) and assumed that from here forward, we would have inflation of 0.4% per month or roughly a 5% annual rate (red line) through 2022. Even at this fairly high level of assumed inflation, the numbers begin to look better in 2-3 months’ time.

We believe, as Chair Powell states, there are risks to this forecast. There is nothing that assures us that inflation won’t worsen and we suspect the biggest of these risks is energy. Food inflation is important, but if wheat prices are high, it is incentive to plant more wheat in the next cycle, and it is self-limiting to a degree. Energy is different. High prices act as an additional tax on everyone. There is no avoiding it. In addition, because of climate change concerns, investment in energy has been lacking. The simple reality is that we need to move toward renewable energy, but there are technological roadblocks that still must be overcome to get there. We have been systematically underinvesting in traditional energy which is required to get us to the future. Underinvestment leads to shortages and shortages lead to higher prices. (And if sanctions are imposed on Russia, the situation quickly gets worse… See below.)

 

Risk: It’s Not Just the Fed

Something that has been receiving precious little attention until Ukraine entered the news cycle is geopolitical risk. There are more than a few potential flashpoints that could explode without warning. The four obvious ones are:

  • Ukraine – The situation is complicated by the lack of unity among NATO partners. That could embolden Putin to take chance.
  • China – China still has its eyes on Taiwan, and with the numerous distractions impacting the U.S., now may be an opportune time to act.
  • Iran/Yemen – Iran continues to push nuclear enrichment capabilities. We may not be willing not act, but Israel has no such issues. In Yemen, the Iran backed Houthi rebels unsuccessfully attempted to strike a U.S. airbase in the UAE, threatening a wider Middle East escalation.
  • North Korea – Who knows what’s going on in North Korea or what Kim Jong-un’s motivations are. Anything is possible.

Over many years, the Western economies have allowed themselves to become economically entangled with their adversaries and, in many cases, dependent on them. That complicates matters enormously. The Cuban missile crisis was purely a political stand-off. Imagine if our economy had a meaningful level of dependence on Cuba at that time. If Russia moves into Ukraine and sanctions are imposed, who will make up for the lost Russian oil and gas production? If China moves into Taiwan and sanctions are imposed, who will supply all the goods currently coming from China?

The risks of something out of left field are real, but these are risks that are difficult, if not impossible, to calculate. We can’t look historical valuations, or analyze income statements and balance sheets to judge risk. Yet it’s fair to say that if real hostilities break out, we will experience yet another ‘flight to quality’ like we have seen in past market disruptions. The implies that stocks go down, potentially way down, and gold and Treasury bonds become the investments du jour once again. (And it would massively complicate the Fed’s job of taming inflation.)

We are only one bad decision by a field commander or one tactical error by some general away from an escalation. It’s an impossible risk to define or predict. Markets need to embrace the risks it can do nothing about, and that implies very choppy markets, at best.


What We’re Reading

Fed Chair Powell’s Press Conference (1 hour video)

Americans sour on nation’s direction in new NBC News poll

GDP grew at a 6.9% pace to close out 2021

Inside the Daring Mission That Thwarted a Nazi Atomic Bomb

IMF cuts 2022 global growth forecast as U.S., China recovery wanes

Kremlin offers frosty response to Blinken letter as world waits for Putin’s next move

Xi Jinping’s iron grip on power brings new form of corruption

Seniors struggle with a new era of rapidly rising prices

The Surprising Secret of Synchronization

 

Disclosures:
Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forwardlooking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
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By: thinkhouse