is the author CEO and Chief Investment Officer of Richard Bernstein Advisors
The Maytag Repairman was a fictional washing machine mechanic who was lonely because no one ever needed to repair a trusty Maytag machine. Instead of tools, he brought a book of crossword puzzles and solitaire cards to combat his boredom.
For years, the US Federal Reserve played the role of Maytag’s fixer with respect to inflation. With the spread of globalization and the resulting decline in secular inflation, there was not much to do to fight inflation. Instead, it can ease monetary policy more generously during periods of financial market volatility without much concern that its efforts to rescue investors might fuel inflation.
Repeated attempts to reduce financial market volatility led to the use of the term Federal Reserve. Investors viewed the Fed’s behavior as if the central bank were constantly writing a protective call option to limit investors’ downside risk.
With guaranteed downside support, investors rationally took on too much risk, as the Federal Reserve repeatedly reduced financial market volatility by significantly reducing interest rates. Risk taking was often extreme. There have been three notable financial bubbles in the last 25 years – the dot-com boom, the housing market, and the rise of tech companies / growth stocks / digital currencies before the recent sharp correction.
Before the pandemic, some investors wondered why the Fed was concerned about global warming and climate change. Its dual mission is to focus on unemployment and inflation, yet it has begun to delve into climate change policy.
A false argument might be that those at the Fed are fed up. Just like the Maytag repairman who had nothing to do playing the solitaire game, they were looking for something to do during a long period of secular inflation. When secular inflation made its job relatively boring, the Fed’s attention easily wandered to issues like climate change.
However, the Fed’s phone has been ringing lately. Inflation is back and there has been a lot of work to do. Perhaps reflecting a renewed sense of urgency, Federal Reserve Chairman Jay Powell a few weeks ago specifically stated that climate change is not the central bank’s responsibility.
Unfortunately, some financial watchdogs and Fed officials don’t seem to understand the need for focus. Some support stopping the rate hikes or even lowering them. Such actions seem premature when the real Fed funds rate has just turned positive and inflation is well above any reasonable target.
Investors act as if the central bank is ready, willing and able to provide easy security for money by the Fed. The growing perception that inflation has peaked and the central bank will soon “pivot” to lower interest rates has so far increased in the riskiest and most speculative assets in 2023. Meme shares are up more than 25 percent, Bitcoin is up more than 40 percent, and innovation fund Ark, which invests in the speculative technology landscape, is up more than 30 percent. The best-performing US sectors year-to-date are communications, consumer discretionary and technology.
If the Fed’s contraction is a thing of the past, history shows that traditional defensive sectors outperform when there is a similar combination of today’s tighter monetary policy and declining corporate profits. Needs outnumber wants, and sectors such as consumer staples, healthcare and utilities tend to lead the way.
Long-term investors should ignore what we’ve derisively called “funny dogs in a crazy world” to focus on the US’s underinvestment in real productive assets. The potential returns from long-term opportunities in public and private sector infrastructure and manufacturing capacity look attractive. Few investors seem to be aware that bottom-up analyst forecasts suggest that energy sector earnings could grow more than twice as fast as technology over the next five years.
It is certainly understandable that financial market watchers would want the Fed to reverse course and write another put option. Much of the business in the financial sector is built on generous, cheap money.
However, the entire credibility of the central bank is at stake and the Fed must end. No one wants a recession, but allowing inflation to return could damage the US economy for a decade or more and, in the current volatile political climate, could even destabilize US and other governments.