Larry Summers, the former Treasury Secretary under Clinton and former member of Obama’s National Economic Council, voiced his fears concerning the overheating of the US economy this past week and weighed the specter of the potential impact that higher than expected inflation could have. He said the US is seeing the “least responsible” macroeconomic policy in 40 years. Summers qualified his remarks and hedged his bets that he is completely wrong by saying there was a one third chance that the economy could overheat and inflation overshoot. This seemed to be an arbitrary probability he picked out of thin air but a summation of what he thinks is below:

1. Best Case Scenario – The Goldilocks scenario for the US economy is that the stimulus takes hold boosting the economy, rates remain low and inflation remains tepid. In this scenario the proposed tax hike by President Biden may be digestible and we may even start to move towards tackling the debt that the pandemic brought on. Summers gives this a 1/3 probability.
2. Inflation and Credible Fed Scenario – This scenario sees inflation ticking up in the next year or two to a level which the Fed is uncomfortable with. The problem is we don’t know exactly what that level is since the Fed has said they will tolerate periods of inflation higher than 2% to bring the long term figure closer to 2%. If inflation ends up jumping to a 3% or 4% level on an annual basis, a credible Fed would likely be forced to raise rates and choke off the recovery plunging the US into another recession. Again, Summers gives this an even 1/3 probability as well.
3. Inflation and Fed Losing Credibility – This is the nightmare scenario in which inflation creeps markedly above 2% for some time, the Fed keeps rates at 0, and does not react in time which will produce the market to change their inflation expectations. The Fed could act this way as it thinks that raising rates would plunge the economy into recession and doing so wouldn’t be politically viable or it may come under under pressure from the White House to not raise rates. Markets would lose confidence in the Fed’s independence as well as its ability and willingness to control inflation. This could send markets plunging both in bonds and stocks leaving investors with little to turn to for a decent return and safety. Summers seems to imply that this scenario also has a 1/3 probability.

Pontificating on the Markets

After the last financial crisis, Congress dragged former fed chair Alan Greenspan in front of Congress and legislators remarked that some market participants were shouting warnings about a bubble in the housing markets and Greenspan reacted saying “people say a lot of things”. He points to a problem that exists in the financial media in that it is dominated by fear and that there are tons of dire predictions that never materialize. This is probably why Summers hedged his bets on his comments by weighing every outcome with a 1/3 probability, it means that whatever outcome happens he could say he predicted it.

That doesn’t work with markets. As regular folks and as investors we have a choice in how we can position ourselves based on what may happen. This is why financial advisors stress diversity of investments, because there are too many things that could go wrong over time with a single stock investment. Yes there are potential big payoffs by gambling all your money on GameStop but there are also big risks. Diversifying away this risk is what many financial advisors focus on.

Yet there are other macro risks which Summers is pointing to which are plausible in the three scenarios he paints. Beneath his comments lies an uncomfortable truth that this generations risks being completely blindsided by: we haven’t experienced sustained high inflation.

What High Inflation Looks Like

When you take a step back you may come to the realization that there are few people in the markets or in positions of power that have a strong memory of how corrosive inflation is to people’s well being. The last time an able investor with capital to put to work was able to anticipate and hedge for higher inflation was over 40 years ago. We have to assume at the younger end of that it would be someone in there let 20’s to early 30’s at the youngest at that time, this hypothetical person was likely highly educated and trained to spot the risks to inflation and was deft enough to act on it. This is clearly a small population of people but I’m sure they existed.

This person who anticipated and invested their capital hedging themselves from much of the effects of inflation is likely around 70 years old at the youngest. They likely have long since retired and if they are still a smart investor, have hedged themselves for a potential uptick in inflation this time around as well, allowing them to lead a quiet life in retirement.

The rest of us however will be having to deal with the potential of higher inflation, which even if not hyper-inflation will cause big problems in a lot of things we take for granted, mainly:

• Real rates are negative now, even if the Fed were to keep short term rates low, inflation expectations moving upwards would mean rising nominal rates across the board for the economy. Mortgages, consumer debt and fiscal debt would all become more expensive. This could produce a soft or even downward trending housing market and make new government spending more politically difficult. Programs could get cut and taxes may have to be raised.
• Pay does not tend to move one to one with inflation for most people. Prices would be rising faster than wages essentially acting as another tax on incomes and quickly making people a little poorer. Standards of living will deteriorate.
• Inflation expectations don’t adjust quickly. Once the markets and especially the public adjust their inflation expectations, the hard work of the Fed adjusting them over years will be destroyed. Winning that trust back would likely require dramatically higher interest rates and a punishing recession to bring them back in line and this could take years.
• People’s perception of inflation is almost nonexistent right now. Most just look at gas prices and that about it. Imagine if food, transportation, housing and services were all climbing at the rate that gas prices go up in the summer. If you think inequality is bad now, just wait until the invisible tax on the poor of higher inflation rears its head.

Should You Protect Yourself and How?

Yesterday I shared on the IG page a chart of M2 money supply growth. It’s a nice chart but I didn’t give it context. The right chart was to show M2 money growth and inflation together in the past 110 years.

We are essentially guinea pigs in the Fed and Treasury’s experiment on stimulus coupled with money growth. What Summers is pointing to is that yes there is a chance this could turn out well, but history has shown that there is a significant chance that this could turn out bad and we don’t seem to be prepared for it.

So first as an investor you need to decide whether you believe this argument on inflation given money growth and the stimulus. Second if you do, you also need to understand there is a good chance you could be wrong and despite all the warnings, inflation remains tame and the economy booms with little side effect. So how do you invest for all of these scenarios?

The first step is to allocate a portion of your portfolio to the few areas that will do well in an inflationary environment: materials and commodities. I do this through the Vanguard Materials ETF (VAW) as well as the PowerShares DB Commodities Index fund (DBC) which tracks 14 commodities through futures contracts. I personally would rather hold gold miners which pay me a dividend as opposed to gold but holding gold or other commodities like silver may also be attractive for you here. Energy is also an area that would likely do well in such an environment. The Vanguard Energy ETF (VDE) can give you exposure to the entire sector there.

The US seems to be going it alone on this experiment too which could hurt the dollar as well. Unhedged foreign bond funds could also prove useful. The PIMCO International Unhedged Foreign Bond Fund (PFUIX) could offer exposure here.

Finally you would also want to have exposure to the US in case of a Goldilocks scenario developing. This can be done through boring old ETF’s such as the Vanguard Total Market ETF (VTI) or small cap ETF’s like VB that track indexes like the Russell 2000. I am bullish on small caps and mid caps in such a Goldilocks scenario as they seem to be catching up to their large cap counterparts as of late on the expectation that the stimulus will boost their profits.

In either situation locking in low fixed rates and not paying down low cost debt would be extremely beneficial which is why refinancing your home as soon as possible and not paying down the mortgage immediately can offer huge advantages. As long as you invest the proceeds of any refinance, if the US economy improves you will benefit and if the US stumbles and foreign markets become more attractive you can also do well, letting inflation eat away at your mortgage costs over time while watching the value of commodity and foreign assets rise. No matter what you do though, only those that put their money to work and make a bet one way or another will be the winners, then maybe you will be the one smiling at 70 letting the world world worry as you sit on the beach.

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