Client Letter - On Energy Prices, Gov Debt, & Inflation
Written by Larry Eppolito, MBA,CFP®
First of all, as I write this, markets are broadly down about 6% year-to-date. As I’ve said many times, “that’s not down.” Down is what happens when we endure a recession. During recessions stocks fall an average of 35% off the peak. It could be more; it could be less.
A recession can happen at any time. We may see one soon, or we may not see one for 10 years or more. By definition, they arrive as a surprise.
Pre-Planning
That’s why we plan for recessions in advance. Our stock-to-bond allocation is designed so that we can withstand the full cycle – not just the good years, but the difficult ones as well.
Confirmation Bias
Keep in mind, no matter what happens, we’ll think we knew it was going to happen the way it did. Everyone has an element of this bias. I know I do, but I recognize it. We become better investors once we recognize its existence.
In talking with people, I believe many economic concepts are put forth incorrectly. So, let me try to clear a few of them up.
Outstanding Government Debt – Big Number, Better Context
You’ll often hear that U.S. government debt is about $39T – and that’s true. But that’s the headline number. A more relevant number is debt held by the public – roughly $31T – since that excludes money the government effectively owes to itself. Our Gross Domestic Product (GDP) is about $31T. So, our outstanding debt is about 100% of economic output. This means something.
Percentages Give Perspective
At this level, that’s elevated – but not unprecedented, and not an immediate problem. What matters more is the direction of travel. The current annual budget deficit is running around 6% of GDP. As a rule of thumb, if the economy is growing at, say, 4% (before adjusting for inflation), then a 4% deficit keeps things roughly in balance. At 6%, we’re running a bit hot.
Most economists believe this is not sustainable forever – but manageable for now. So, this is a long-term discipline issue, not a near-term breaking point.
Inflation – It’s a Money Issue, Not a Debt Issue
There’s a common belief that high government debt causes inflation. I hear this a lot. Why? The media has been repeating this narrative since the early 1970s. But it’s not that simple – and is not necessarily true.
Inflation comes from “too much money chasing too few goods” – not from the existence of debt itself.
Debt Is a Tailwind – Until It Isn’t
Think of a household. If the family borrows money and spends above their cash flow, it will accumulate debt. Because it can borrow, it consumes more than its income alone would allow. So, in this phase, borrowing acts as a tailwind – consumption rises, and economic activity gets a boost.
But once the debt becomes burdensome, the dynamic flips. The household must pull back. Future spending is constrained.
The same principle that applies to households applies to companies, and governments. As debt builds, it may eventually act as a brake on future demand.
That’s why, over time, excessive debt is more often disinflationary than inflationary.
Energy Prices – More Complicated Than “Higher = Inflation”
Higher energy prices are often assumed to be inflationary. That’s true in the short term – but it’s not the full story.
A lot of this thinking traces back to the 1970s when oil shocks coincided with a period of high inflation. The conclusion many drew was that rising energy prices caused the inflation.
But rising energy prices can actually be a disinflationary force. How so? They act more like a tax on consumption. When households spend more on energy, they typically spend less elsewhere – so demand shifts rather than simply accelerates.
Larry, that’s not what Walter Cronkite told us!
LFE: Yes, I remember. I was misled too (but I was in junior high school, so I had no shot at the Fed Chairmanship anyway).
Larry, so why did we get such horrible inflation?
LFE: The Federal Reserve Bank largely caused it. How so?
It Was the Money Supply!
Energy price spikes can push inflation higher in the short term. But unless the Federal Reserve overreacts by adding too much liquidity – pouring too much money into the economy (“fuel for the economic fire”) – those price increases tend to work their way through the system rather than compound into sustained inflation.
In the 1970s, energy shocks were the spark – but it was monetary policy that turned it into a conflagration. Two successive Fed Chairmen poured way too much money into the system, and inflation became embedded.
So, it wasn’t energy alone – it was the policy response that allowed inflation to take hold—and then it spiraled, as rising prices led to higher wages, which led to higher costs, and then still higher prices.
A Brief Word on Iran – A True Wildcard
The situation with Iran is obviously a bit of a wildcard. And it’s one of those areas where smart, well-informed people can disagree. For instance:
- Some geopolitical experts would like to see things wind down sooner rather than later – the thinking being that key leadership elements have already been disrupted, and at some point you take the win and move on.
- Others believe leaving too soon would be a mistake – that Iran would rebuild its ballistic missile capability, restart its nuclear program, and we’d be right back where we started… with the added risk of a regime that can periodically pressure the global economy through a choke point like the Strait of Hormuz.
Keep in mind, energy prices are set globally, so when there’s disruption, prices rise everywhere – including here. But the U.S. has an important advantage: we are largely energy self-sufficient. That doesn’t shield us from price increases, but it does reduce the risk of true shortages that can destabilize other economies.
In Summary:
- These are real issues – energy prices, government debt, and inflation – but they are not new, and they are not unmanageable.
- Energy prices can move markets in the short term, but they don’t dictate long-term inflation.
- Debt is elevated, but it becomes a problem over time – not overnight. We have time to address it, but it should be a major focus.
- And inflation, as we’ve discussed, is ultimately driven by money and policy – not debt, and less so by high energy prices.
- As always, markets are a barometer – they move ahead of the news, not in response to it. The challenge is separating what feels urgent from what is truly important.
- There is a reasonable chance the conflict resolves over the coming months – which could leave the world in a more stable place.
- The markets relative resilience suggests it views this as a months – not years – issue.
People Often Mistake the Temporary for the Permanent
Over the years, I’ve noticed that people tend to believe that whatever is happening now will continue indefinitely. But history tells a different story. Even during the most difficult times, “long” has never meant “forever.”
“For myself I am an optimist – it does not seem to be much use to be anything else.” (Winston Churchill)
Our job is to stay disciplined, stay focused on the long term, and not get pulled off course by narratives that come and go.
Best wishes,
Larry
Main Sources:
- The Wall Street Journal
- The New York Times
Other Sources:
- Raymond James Washington Policy Weekly Wrap, Ed Mills et al.
- Raymond James Weekly Daily Investment Strategy, Up and Adam, Larry Adam, CIO
- Raymond James Weekly Institutional Equity Strategy
- Raymond James Weekly Economic Release
- Raymond James Daily Morning Brew
- CNBC Professional
- Bloomberg News
- Financial Advisor Magazine
- The Boston Globe
Any opinions are those of Larry Eppolito and Michael Carbone not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change. This information is not intended as a solicitation or recommendation of any kind. Investments mentioned may not be suitable for all investors. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Diversification and asset allocation do not ensure a profit or protect against a loss.
Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.
Stocks offer long-term growth potential but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations and the potential loss of principal.
Investing in fixed income securities (bonds) involves certain risks such as market risk, if sold prior to maturity, and credit risk, especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity. Bond prices fluctuate inversely to changes in interest rates. In other words, if interest rates rise, after your purchase, you may receive less than your purchase price should you liquidate early. Bonds provide a fixed rate of return if held to maturity.
Investing in oil or the energy sector involves special risks, including the potential adverse effects of state and federal regulation and may not be suitable for all investors.