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    Capital Markets | 5 min read

    Can We Handle Monetary Policy Normalization Without a Recession?

    At Wednesday’s Post-FOMC press conference, Chairman Jerome Powell made the following statement: “As I looked around the table at today’s meeting, I saw a committee that’s acutely aware of the need to return the economy to price stability and determined to use our tools to do exactly that. The American economy is very strong and well-positioned to handle tighter monetary policy.”

    Really?

    The equity markets certainly enjoyed hearing that as the S&P blasted higher by about 2.5%. Stocks enjoy soothing and bullish statements like that, at least at the moment they are hearing them. Ready, Fire, Aim.

    However, when we get passed words, we have to consider that we are experiencing historic supply-side shocks, first from the worldwide pandemic and now the world’s largest commodity provider (industrial metals, energy, and food) essentially being thrown into the global penalty box.

    We also have the continued demand surge coming from the global economy reset from the deepest dark days of COVID-19. I do not believe there’s been a time in modern history that the combination of these two factors did not lead to major recessions, especially when the Fed acted aggressively with restrictive monetary policy to counter it. The FOMC statement and “dot plot” release that showed the Fed Funds rate, now 34 basis points at a consensus of 2.88% by year-end 2023 (the five-year Treasury rate two years forward is only about 2.28%), is quite aggressive.

    Barry Ritholtz was on Bloomberg TV earlier in the week making some very solid points around the old economic axiom, “The cure for higher prices is higher prices.” Ritholtz was using that axiom to make the point that, often, in products like commodities, the boom-bust nature (think crude or natural gas or lumber) of higher prices driving higher production of those commodities to the point that, before long, there is a supply gut, the price level busts, and we end up back at normalized prices.

    I also think the axiom is true for what we are going through now, massive supply shocks. I have heard many people over the last few months tell me they are delaying purchases on both big and small items to wait out an inflationary cycle that many believe is relatively short-lived. When consumers decide to delay purchases for a later date as opposed to buying now because whatever they are buying will be more expensive in the future, that sounds more deflationary than inflationary to me.

    I wrote the following about two months ago in a memo to myself. I think it still holds very true and I think that the Fed may be underestimating how sensitive to upward short-term rate moves the millions of small to medium size businesses actually are.

    Back in April of 2020, as the global economy locked down, I was afraid of a lot of things. One thing that was down on the list but still in the important column was the status of two lifelong friends' businesses.

    One friend owns a large commercial roofing company in the Ohio Valley area and the other runs the production for a large residential fence manufacturer in the Northeast. If I recall correctly, I kept discussions absent of any shop talk for the first few months because I just assumed things were not going well, perhaps even terminally not well.

    Finally, in the early Fall of 2020, I asked both, “So…how’s business?” I figured it was somewhat safe to ask at this point because if their businesses had collapsed, I would have known by now. The answer I got from both was, “Business has never been better, by a long shot.”

    My fence friend stated at the time that demand for residential fencing was soaring. In fact, demand was so great that they had run out of capacity at their major plant and were negotiating with manufacturers in the Southeast to share facilities or perhaps even entertain the thought of an acquisition. I realized that in my walks around my neighborhood that everyone seemed to be sprucing up their homes. Not major projects like additions but lots of, wait for it, fencing. Forced savings was burning a hole in homeowners’ pockets and now that the home was also a primary place of work, school, and entertainment, the home was where the savings were going.

    Meanwhile, my roofing buddy also reported that he was bidding on more contracts than ever, which was really something considering that 2018 and 2019 were record years for him, driven mostly by the stimulus of the Trump corporate tax cuts. His biggest problem, one that is now familiar to us, was keeping employees and constant material shortages.

    I found the hot commercial roofing demand fascinating. When the economy shut down in the early Spring, cash became king, as it always does in a credit crisis. The shocks we saw even to normally highly liquid assets and credit-worthy borrowers were unprecedented. The hoarding cash and the raising of cash (for those that could access the capital markets) for American business were done at a manic pace. Now seemingly on a dime, cash was being put to work in the form of investments in operating capital.

    After my initial fact-finding mission, I cursed myself for not speaking to both friends earlier in the Spring of 2020 as their business color screamed of recovery trade for stocks! Therefore, I am now pestering them every couple of months, and I am happy to report that things just keep getting better. In fact, my fencing friend’s company was purchased by a middle-market private equity firm in late 2019. Now they are being sold to another private equity firm for a heck of a lot more than where they were purchased for in 2019. While I fear a lot of that increase is due to the tremendous inflow of funds into private equity resulting in too much money chasing too few deals, the valuation increase is still very impressive.

    My main questions to both friends centered around input costs and how much they are able to pass on to end buyers. The answer to the latter question is that they have been successful in passing through most of the material inflation. For fencing, resin costs, a major input, have skyrocketed. Supply is tight enough that over-ordering and storing have become new ways of running the business. You over-order because, if you under-order, you’re out of luck as you can’t get any more than what you ordered.

    Likewise, my roofing buddy has taken to pre-ordering millions of dollars of material before finalizing contracts for jobs as opposed to the just-in-time inventory model that he used pre-pandemic.

    What this tells me is that the old way of running a manufacturing business (before the age of just-in-time inventory and the fabled global supply chain) is returning and probably will stay in some form for a while. My friends’ companies represent the profile of thousands of companies across the country who need short-term financing more than they did pre-pandemic.

    Therefore, I have to wonder what the Federal Reserve raising short-term interest rates in 2022 will do to these representative companies. Higher short-term rates won’t improve the global supply chain problem. However, it will definitely add on costs to manufacturers' financing large material inventories which will either spur higher prices for the consumers of their products or a slow down in production of those products.

    I think this illustrates just how narrow the head of the needle the Fed must thread is. The economic recovery has been very uneven and relatively fragile given the continuation of the global pandemic and, now, a major land war in Europe. If the Fed does get it right, then perhaps they can slow the economy down enough to reduce pricing pressures without sending it into recession.

    Hopefully, they can stick the landing. Unfortunately, I doubt it.

    Join our investment experts as they discuss Fed policy, Municipal bond market performance, and 2022 predictions.

    Investing involves certain risks, including possible loss of principal. You should understand and carefully consider a strategy’s objectives, risks, fees, expenses and other information before investing. The views expressed in this commentary are subject to change and are not intended to be a recommendation or investment advice. Such views do not take into account the individual financial circumstances or objectives of any investor that receives them. All indices are unmanaged and are not available for direct investment. Indices do not incur costs including the payment of transaction costs, fees and other expenses. This information should not be considered a solicitation or an offer to provide any service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Past performance is no guarantee of future results.

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    John Tuohy

    John Tuohy is CEO of SWBC Investment Services, LLC, a Broker/Dealer and SWBC Investment Company, an SEC Registered Investment Advisor (RIA). In his role, John is responsible for identifying, developing, and executing the division's strategic plan and all business development, sales, and marketing activities.

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