Bob Prince is a Co-Chief Investment Officer at Bridgewater. He recently wrote an update on the U.S. economy and where he sees it progressing, which I summarized below.
Bob Prince believes that the odds are in favor of our economy being in a period of stagflation that could last for years.
The Fed faces a tough decision in trying to (1.) avoid a deep economic contraction and (2.) manage high inflation. Bob Prince believes that the Fed will have to go back and forth on which of these to avoid, and this will result in a long period of too-high inflation and too-low growth, also known as stagflation.
The difficult part for the Fed is:
If interest rates rise to a high level and the Fed does more quantitative tightening (QT), this will defeat high inflation, but it will also increase the risk of the economy going into a deep economic contraction.
The opposite is true also.
If the Fed decreases the Fed Funds rate which has an effect on lowering interest rates, and they do less QT (or if they do QE) then this will help prevent the economy from going into a deep economic contraction, but it raises the probability of high inflation.
Therefore, the Fed is in a difficult position because one solution worsens the other.
This is part of the reason why Bridgewater’s indicators are pointing toward the U.S. economy heading toward a long period of high inflation and a weakening of real growth.
The reason the Fed is in this predicament was because of the policy mistake they made over the last couple years. Their mistake was pumping too much money and credit into the economy and keeping interest rates near zero for too long.
“The policy mistake was continuing to pump money and credit into the economy and keeping interest rates near zero as this transition occurred, rather than leaning into the wind at that time. Now the monetary inflation is entrenched via the inertia of the income-spending flywheel.”
- Bob Prince
The policy response in dealing with high inflation is likely to cause financial markets to perform worse than the economy.
Historically, stocks have been the worst-performing asset in periods of stagflation. If the economy is stimulated by the Fed’s policies during the stagflation period, then stocks perform better during this phase.
This could be the reason why stocks have currently been performing better. Inflation, based on the consumer price index (CPI), is still at a high level of 8.5%, but this index came in below expectations. The market could see this as a sign that the Fed will tighten less going forward and possibly even loosen monetary policy.
Bob Prince sees the Fed pausing or reversing course at some point, but he then sees the Fed having to do a second tightening cycle. The second tightening cycle isn’t discounted in the markets right now so this poses a risk to a decline in markets and wealth.
“More likely, we see good odds that they pause or reverse course at some point, causing stagflation to be sustained for longer, requiring at least a second tightening cycle to achieve the desired level of inflation. A second tightening cycle is not discounted at all and presents the greatest risk of massive wealth destruction.”
- Bob Prince
During periods of stagflation, nominal GDP grows at a high rate. During the 1970’s stagflation, nominal GDP grew by over 5%. This is high compared to what our economy has seen over the last decade.
The problem is that nominal GDP is based on how much money is spent and not what consumers get for that money. So spending is higher because of higher prices, therefore, nominal GDP is higher, but after factoring in the higher prices (inflation), real GDP actually contracts.
On the labor side, Bridgewater still sees labor rates remaining high because the labor markets are tight. Unemployment is low, high inflation is giving employees bargaining power for wages, and there are lots of job offers in the market.