Iron Capital Insights

  • Iron Capital Insights
  • April 19, 2021
  • Chuck Osborne

Great Expectations

Great expectations often lead to disappointment. No, I’m not talking about the Dickens novel, Pip would never disappoint. I’m talking about real life. How many times do we go into a situation, from a movie to a vacation destination, with really high expectations, only to end up disappointed?

It happens all the time and it begs the question, are the Disney “Star Wars” movies really that bad? This may be blasphemy, but I don’t think they are as horrible as most Star Wars fans seem to believe. The issue is when it says, “Star Wars,” our expectations go, well…to the stars. The original faced no such obstacle. No one had any expectations as nothing like it had every really been done.

Back in our universe and in present day, we are in the midst of an economic recovery from the reaction to COVID-19, and expectations are getting great. The Fed has said it foresees 6 percent economic growth. When most people hear that they probably celebrate, but when I hear that I immediately think: We could grow at 5.5 percent and Wall Street will be disappointed.

During the pandemic the U.S. economy continued to do much better than expected. Commerce, which was already moving online, accelerated that trend. The professional class simply worked from home and barely missed a beat. In the meantime, hospitality workers and school children took the brunt of our draconian reaction – which will be looked back upon as a human tragedy, but they don’t move the economic needle. Beating expectations leads to bullish markets.

In fact, the market is far less interested in absolute growth than it is in growth relative to expectations. We are setting up for potential disappointment, while the Fed has kept the gas pedal to the floor, saying it no longer cares about short-term inflation but will keep the money loose until people get back to work.

At the same time, the administration and Congress are passing relief packages seemingly designed to stop people from going back to work. As I write, the CEO of Red Lobster is on TV saying they can’t find workers. This is a theme. People will not go back to work because they do not want to give up their enhanced unemployment benefits. In the words of Ronald Reagan, the safety net needs to be a hand up, not a handout. It was Bill Clinton who signed the reform to end the harmful policies left over from the Great Society to encourage people back to work.

Those reforms have now been completely undermined. That is a political issue, but it spills over because the Fed now says it won’t fight inflation until unemployment is where they want it. So these sets of policies have the potential to lead to permanent higher unemployment and easy money, which could lead to inflation. The Producer Price Index, which tracks wholesale prices, is up more than 4 percent over the last year, and the recent reading for the Consumer Price Index was 2.6 percent – more than half a percent higher than the Fed’s long-term target.

For years economists have believed that inflation was a monetary policy issue; loose policy (i.e. low interest rates) caused inflation. However, when we actually fought inflation in the 1970s, we had a combination of loose monetary policy and runaway government spending from the Johnson, Nixon/Ford, and Carter administrations. Paul Volcker, Fed Chair at the time, famously raised rates to stop inflation, but Ronald Reagan also slowed the growth of government spending.

Reagan was right, and one does not have to be an economist to understand that. His re-election strategy was simple: Are you better off? He won 49 of the 50 states, narrowly losing in his opponent’s home state. Eight years later, Bill Clinton won largely by admitting that Reagan was right, explaining that being socially liberal shouldn’t have to mean being anti-economic freedom.

For 20 years government spending was largely kept under control, and despite easy monetary policy which led to the dot-com and later the housing bubble, inflation as a whole has been kept at bay. Starting in 2000 and accelerating until this past year of explosive fiscal spending, those controls were loosened to point where they are now completely off.

Is inflation a solely monetary issue, or is it the combination of loose monetary policy plus big government spending? I don’t know the answer to that question, but I do know that too few policy makers are asking it.

Our great expectations could lead to disappointment coupled with inflation. That will not be fun. It might not; it might all work out, but this is the risk we face today. Be cautious when others are greedy – that is investment wisdom to live by and something to keep in mind. It is time for caution.

Warm regards,

Chuck Osborne, CFA
Managing Director