The May inflation report did little to ease concerns of a coming recession. Overall inflation was up 8.6% year over year, even more than the 8.3% in April. The most volatile segments of the inflation report, food and energy, were up 10% and 35%, respectively. These segments are particularly affected by the Ukrainian War. Investors are concerned that the Federal Reserve’s (Fed) interest rate increases in response to this inflation will slow the economy too much. That is, higher rates and a tighter money supply will slow demand for goods and services causing an economic contraction and, instead of the hoped-for soft landing, the economy will enter a recession. However, these events could lead to some positive long-term developments.
The Fed’s rate increases represent the first time that the Fed has been forced to act boldly in the “hawkish” direction in the last 30 to 40 years. Prior to the current inflation, the Fed kept the money supply loose to prevent deflation after the Financial Crisis and the pandemic. While this strategy has primarily worked, there have been negative consequences that may now be correcting.
Investors have not been able to receive a competitive return from bonds for the last 15 years. After accounting for inflation, bond yields have provided investors with negative returns during much of this period. If interest rates continue to rise and inflation starts to come down, investors will then be able to invest in stable investments that produce positive real – after inflation is accounted for – returns. Significantly, this will allow investors to take less risk as many have been forced to invest a greater percentage of their assets in riskier assets than if there had been a safer alternative available. In aggregate, this development should also reduce volatility across all markets since those investors that decide to remain holding risky assets, such as stocks and private equity investments, will be better able to handle the risks involved.
Low interest rates have also enticed consumers and businesses to borrow more money. Homeowners have added mortgage debt to buy more house since the carrying costs were low. Businesses have added debt and bought back their own shares. While these moves are rational, buying back shares to juice earnings per share growth is not the same as growing earnings through investment. Higher rates will probably lead to lower levels of debt, less risk throughout the system and possibly better capital allocation.
Since the end of the Cold War, international trade has increased dramatically. The developed economies have shifted manufacturing to Asia to benefit from lower factory wages. Similarly, Europe outsourced its Energy production to Russia. The pandemic and Russia’s invasion of Ukraine have highlighted the fragility of these interdependencies.
Russia used its energy sales to Western Europe to build its military. European governments promoted this relationship in part because they believed that trade would lead to shared democratic values. This miscalculation has enabled Russia’s aggression, yet the war may lead to a stronger more independent Europe.
Europe has boycotted Russian coal and is in the process of ending its purchases of Russian oil. While much of Europe is still dependent on Russian natural gas, every country is working hard to end this relationship. There are still buyers for Russian energy; however, transporting these products to China and India is much more difficult than supplying Europe. Therefore, the current war may lead to a stronger and more unified Western Europe, and a weakened Russia that is unable to cause as much misery as now.
Covid has caused supply chain disruptions since the inception of the pandemic. These disruptions still plague the economy as China has enforced strict lockdowns that stall manufacturing. The impacts of these shutdowns have been felt in lower-end industries and crucial areas such as computer chips.
These shortages have led to efforts by corporations and governments to onshore more manufacturing. For example, Intel is investing a staggering $20 billion to build a 1,000-acre Mega factory for semiconductor chips in Ohio. The company plans to break ground this year and start production by 2025. The state of Ohio is contributing about $2 billion in development and tax incentives for the project. The federal government is also likely to pass a $52 billion semiconductor funding act this year to further boost onshore chip manufacturing. Battery technology is another area of strategic importance as the US transitions to electric vehicles. According to the US Department of Energy’s loan program, the US only has 5% of the battery capacity to meet 2030 goals. Given this shortage, the Department of Energy is lending aggressively to promote US battery development.
Increased domestic manufacturing will probably cause higher prices; however, the change may have a few positive effects. Higher salaries associated with greater domestic manufacturing could create a positive feedback loop as these better wages stimulate more economic demand. Another benefit is that the system will be much less prone to future disruption since operating conditions are far more stable in the US than abroad. Finally, there may be global climate benefits since US factories are more efficient than those in the developing world where pollution controls are lacking.
The arguments laid out above are not meant to be Pollyannaish. Current events have produced hardship for many and untold suffering for the Ukrainians. However, humans and markets are adaptable and the responses to the current crises could produce concrete benefits in the future.