Inflation and Recession. These are the two buzz words all over the market right now. The sentiment is broadly pessimistic. But is there still an upside? I believe there is.
As a trader myself, I’m pretty much on the front line. Inflation increases the cost of my goods. Rising fuel costs have made shipping them several times more expensive. And I’ve had to raise prices, with the worry of causing a decline in sales constantly at the back of my mind. But I’m still quietly optimistic, and I’ll attempt to explain why using some basic economic diagrams.
This is your basic Supply and Demand chart. Before COVID19, the economy was more or less at equilibrium. The economy was near capacity, prices were stable.
COVID 19 shifted the Demand Curve dramatically to the left from D1 to D2 when almost all countries went into lockdown. The economy was producing way below capacity, many businesses had to close (some permanently), and unemployment was high. Prices came down from P1 to P2, and production reduced from Q1 to Q2. This was a deflationary recession.
After countries gradually lifted their lockdowns, demand bounced back relatively fast. However, economic capacity had reduced, due to supply chain snarls. Factories simply couldn’t churn out products fast enough, and the supply chain had a lot of bottlenecks exacerbating the supply problem.
The Demand curve shifted right from D2 to D3 as lockdowns were gradually lifted. Also, the Capacity line had shifted left from C1 to C2. Prices went up from P2 to P3, while there was economic growth (real GDP went up from Q2 to Q3). This was the time of inflationary growth. However, it did not last long.
As demand continues to grow and normalize (e.g the travel industry is opening up again), the demand curve continues its march to the right, shifting ever closer from D3 to D1. However, the Capacity line did not shift. In fact, it had shifted even further left, due to the Ukraine war in Feb 2022 and China’s COVID lockdowns in Shanghai in Apr 2022.
To simplify the discussion, let’s just assume the capacity line did not move and remained at C2 (in reality, it shifted further left). Any movement of the Demand curve to the right will only result in price moving vertically up the C2 line (from P3 to P4), while GDP remains stuck at Q3, constrained by the capacity limit. This is inflation with no economic growth. We are entering into the era of stagflation, which is what a lot of economists are predicting.
So what are the Fed and other central banks trying to achieve with tighter monetary policy? By increasing interest rates, it is trying to reduce consumption. People can’t borrow as much to buy houses, cars and/or other goods and services on credit. Businesses won’t borrow as much either as borrowing costs are higher. The Fed is trying to shift the demand curve from D1 back to D3. This will reduce prices from P4 to P3, without causing a reduction in real GDP.
However, if they over-correct and push the demand curve too far to the left, GDP will be forced to go below Q3, the capacity of the economy. They will inadvertently cause a recession, which is a bigger problem than inflation. It’s a choice between everybody having a job but having a higher cost of living, or many people out of a job and unable to make any living at all.
Furthermore, the Demand Curve, Supply Curve and Capacity lines are shifting all the time! It is a moving target and it’s impossible to get it exactly right. This is why the Fed takes an incremental approach towards its tightening, gradually increasing interest rates by 50 basis points at a time instead of 75 points. They know they need to correct the situation, but they are also very worried about over-correcting.
There are 3 main factors holding the Capacity line back:
(a) Ukraine War
(b) Supply Chain imbalances
(c) Covid19 Lockdowns in China.
It is hard to predict when the Ukraine war will end (or at least subside), but the supply chain snarls will eventually reduce as the operators take steps to reduce congestion. China, one way or another, will also exit from its unsustainable state of constant lockdowns, either by way of abandoning its zero-COVID strategy or by way of increasing its vaccination rate from 88% to the high 90s (especially among the elderly).
Beijing cannot afford to keep its economy suppressed for too long. Therefore, the Capacity line will eventually shift right when the supply chain de-congests and China opens up its economy further. It may not shift all the way from C2 to C1, unless the Ukraine war ends as well, but it will move right nonetheless. This results in two possible scenarios.
The first is if the Fed fails to push demand back BEFORE the capacity shifts, and the Demand curve remains at D1. A shifting of the Capacity line right from C2 to C1 will result in prices dropping from P4 to P5, and real GDP increasing from Q3 to Q1. This is economic nirvana; increased GDP at reduced prices. What more can you wish for?
The second is if the shift in the Capacity line happens AFTER the Fed has successfully pushed the Demand curve from D1 back to D3, pushing prices from P4 to P3. A subsequent increase of Capacity from C2 to C1 will result in prices going up from P3 to P5. Real GDP also grows from Q3 to Q1. It’s not exactly nirvana, but not too bad either, because there is economic growth AND inflation is still lower than before.
Since both expected scenarios result in (a) economic growth, and (b) lower or negative inflation, how do you think the stock market will react?
Let me put this in real terms using my own situation. As COVID restrictions ease, I can feel that the demand for my products is red hot. However, most of my best-selling products are made in Shanghai. I started running out of products to sell.
For one of my top-selling products, I was expecting stocks to last only 4 weeks, so I increased my price by almost 15%, hoping to stretch it to 8 weeks. However, demand didn’t seem to abate, despite the increased price. At the same time, my shipment of goods was delayed as the factory had to be closed for several weeks.
The red-hot demand I was feeling is a sign of the Demand curve moving right from D3 towards D1. But I didn’t manage to sell more units despite the increased demand because I was constrained by supply, which is currently stuck at the C2 line. Thus, my real GDP as measured by the number of units sold remains unchanged at Q3, despite my customers having to pay an increased price (from P3 to P4).
Once the COVID situation in Shanghai improves, my supply will resume. I will thus have more units to sell, and I can bring my prices back down to where it was previously. Everybody is now happy because I am selling more units, while my customers are enjoying lower prices!
So the strategy for me now is really to continue preparing my businesses for the expected growth, containing costs the best I can while improving efficiency whenever there’s a chance.
On the investment front, I’m mainly looking at the shares of good companies that are likely to benefit from such inflationary growth.