For more than a year, we've been ringing the alarm bell on inflation. While the Federal Reserve's decisive rate cuts in 2020 almost certainly helped prevent an economic collapse, by the spring of 2021 we began making the case that the Fed needed to start raising interest rates to offset the inflationary pressures that were bound to emerge as the lockdowns associated with the COVID-19 pandemic receded.
Through monetary policy, fiscal policy and reduced consumer spending, bank balance sheets swelled by nearly $5 trillion, from $13.3 trillion in January 2020 to $18 trillion by December 2021. This unprecedented increase in the money supply drove interest rates to near-zero and created asset bubbles in real estate, equities, cryptocurrencies and nonfungible tokens. After all, with so much new cash to deploy and a cost of funds approaching zero, this money had to go somewhere.
Financial advisors struggled to keep clients from chasing the latest mania in search of outsize returns — returns that were driven by nothing more than momentum and a huge imbalance between supply (of investable assets) and demand (driven by excess liquidity).
Pent-Up Demand
In early 2021, the Fed was resolute that it wouldn't need to raise interest rates until 2024 at earliest. By the summer, signs of inflation were deemed "transitory" and even in the autumn of 2021, few Wall Street analysts expected any significant movement in interest rates.
We disagreed. Our view — informed by countless conversations with banks and our own experience living through multiple market cycles — suggested that the surplus in deposits could quickly swing the other way as consumer spending resumed and pent-up demand for travel and entertainment would mean that far too many people would simultaneously be seeking far too few airline seats and hotel rooms.
According to Wayne Best, chief economist at Visa, high-net-worth households are sitting on $250 billion of pent-up spending demand — that's a lot of people booking European vacations with minimal price sensitivity.
In the first few months of 2022, depositors burned through a few hundred billion of cash, and as inflation takes its toll on the households least equipped to withstand it, more of this surplus liquidity will evaporate. In the past four weeks, the banks with which we speak regularly have flipped from worrying about excess liquidity to worrying about how they will fund a big uptick in loan growth.
As the cycle continues, we'll begin to worry about asset quality, as inflation is bound to drive an increase in defaults. The rapid growth in buy-now-pay-later (BNPL) schemes remind us of the dangers inherent in this new form of "layaway" financing. As the credit cycle advances, consumers will also feel the impact of an increase in rates on variable rate mortgages and revolving credit lines, coupled with the job losses that are likely to emerge as the economic growth slows.
The Fed's 0.75% rate increase in June didn't come as a surprise to us; we've long held the view that the Fed will need to raise rates more aggressively to curtail aggregate demand and rein in inflationary pressures. But with continued upward revisions in expectations around the federal funds rate, there is seemingly no end in sight. What's clear is that the Fed is significantly concerned about inflation rising higher and lasting longer than they had anticipated even a few months ago, and we expect interest rates to follow suit.
The Inflation Playbook
So, what does this all mean for financial advisors and their clients? Which asset classes perform well in periods of high inflation? Which asset classes will suffer? How can advisors best keep clients on the right path? It's time to dust off the inflation playbook.
