Joel Bowman and Dan Denning on Allocation Strategy

“[T]here are serious problems with our money system. You can either solve them in the way governments have solved them in the past, which is inflating away the debt, which is a huge quality of life issue for people right now on fixed incomes whose costs have gone up, whose rent has gone up, whose fuel has gone up, whose energy costs, whose food. That's happening now.” ~ Dan Denning, Publisher, Bonner Private Research TRANSCRIPT Joel Bowman:I'm Joel Bowman for the Fatal Conceits podcast, a show about money, markets, manias, and mobs, and I'm joined by Mr. Dan Denning, who we haven't heard from for a little while, who's been hanging out up in the high plains of Laramie, Wyoming. Welcome to the show, Dan.Dan Denning:Hi, Joel. Yeah, winter's nearly over. So, I've come out from my hibernation. And I didn't see my shadow, so it's safe to come out.Joel Bowman:Right. Mate, I thought we would start just at the top here with the other subject that everybody's talking about and I don't mean Will Smith's inability to take a joke, but the 8% official, let's say, inflation rate. It's the highest that at least has been witnessed in America in the 40 years of my lifetime. But the official rate is probably, or the unofficial rate rather, is probably a bit higher, maybe considerably higher than what most people are being told. What's your read on the ground when you go to the pump and the grocery store and order your frozen steaks?Dan Denning:Yeah. Well, anecdotally prices are definitely up. I don't drive, although I recently bought a used car from one of my uncles. So, I timed that probably poorly as a contrarian, where I'm buying-Joel Bowman:Mate's rates, I hope.Dan Denning:Yeah. So, anecdotally he said the market there is still incredibly tight and it's partly because dealer inventories are low. And I don't know if that's a supply chain issue. But also part of it is that prior to the supply chain issues, if you looked at the financing in the car market for new cars, the company-owned financiers, in addition to the dealers, were offering extremely generous terms with no money down and financing for 48 months or 72 months. And we see that before in all sorts of credit booms, where it brings forward demand. And I think in the car market, it brought forward demand so that there just wasn't a lot of...Once that hit the supply chain issue, then you saw a real shortage of both used and new cars. So, prices are up. But I just talked to a friend of mine who lives in Spain, in Barcelona. And he said energy prices are through the roof over there, and food prices are up. So, I think the big picture for investors is that the Fed was poorly, poorly mistaken in all of its policy guidance about inflation. So, when it said 2% was the target, and then it was willing to let inflation overshoot until that showed up in the data, and then it did show up in the data and they ignored the data, they missed it. They missed the boat.And now the problem is, how do you get ahead of rising prices? And we can get into that later if you want, but it's not what the market thinks it is. So, nine rate rises between now and the end of the year is not going to be enough to get in front of inflation. So, the inflation will probably go higher, and it will take a higher policy rate to bring it under control, if the Fed has the stomach for that. Which they don't have the brain for it, and I don't think they have the stomach for it either.Joel Bowman:So, as part of the narrative that the Fed either willingly or unwillingly sold to the American public... I asked Bill this question up in Salta just last week and I'm wondering on your take. Were you surprised at the switch in narrative from Chairman Powell's frustration with not having been able to achieve inflation, to watching it tick over the targeted 2%, calling it transitory, then actually it's good for you, and now bizarrely in somewhat of a non sequitur, I think, to many people. Having 8% or generation high inflation positioned as the price we pay for standing shoulder to shoulder with our Ukrainian brethren? I mean, that seems a bit of a stretch, but are people buying into that or is that, do you think, a coverall for them getting away with the kind of shenanigans they wanted to get away with in the beginning?Dan Denning:I think part of it is an insular bubble mentality with policy-makers, especially at the monetary level, that they didn't see that quantitative easing itself was inflationary because they saw that it was contained to, really, a kind of antiquated back corner of the financial system about in what form reserves were held. Were they held as cash with banks or were they held as treasury bonds and were they held at the Fed or somewhere else? So, when the Fed expanded its balance sheet prior to 2020 and it was about 4.3 trillion, they said, "Well, that was fine. That didn't cause consumer price inflation. The only inflation that it caused was asset price inflation." And that seemed to be okay for one reason, because the Fed has this theory that the wealth effect, when people have more financial paper net worth, they tend to spend more money. And that actually helps get them to that 2% inflation target. They thought, "Well, that's okay. Rising stock prices produce the wealth effect, which produces 2% consumer price inflation. That's the policy." Also, it turns out that some of those Fed governors may have been front-running their own policy decisions.Joel Bowman:No, no, no.Dan Denning:So, rising stock prices were great. But then something did appear to change in 2020 when the Fed doubles its balance sheet, roughly, from 4.3 to whatever it is, 8.9 trillion now, in two years. That was inflationary because a lot of the bonds that the Fed bought was money that the government spent on the fiscal side that went directly into consumer pockets. So, this was the Paycheck Protection Program, which turned out to be riddled with fraud. This was the stimulus that was sent to people's pockets. And of course, now you're talking about the government handing out even more money to offset another policy blunder the energy market. But that did clearly turn out to be consumer price inflation, the stimulus and all of the money spent during the pandemic.And I think the mistake from an academic point of view, which is what the mentality that the Fed governors are locked in, is that they're saying, "Well, that shouldn't produce inflation. It should be fine. It's transitory," which is why they said that. Or, "It's related to interruptions in the supply chain." It didn't occur to them that inflation is a cyclical process and that once it gets underway, also as a psychological process, then something has to break the cycle, and that something is not magically lower gas prices. It's interest rates that are much higher than the rate of inflation. So, we have nominal interest rates that are barely positive right now, but in real terms are still negative. So, if inflation's at 8% and real interest rates are negative 2% and to combat inflation, real interest rates have to be three to 5% higher than the inflation rate, you're looking at real interest rates or nominal interest rates of around 12 to 14% to break the cycle of inflation.And that is clearly so unfathomable to investors and to policy-makers that they don't know what to do with it. But that's the Fed's own Taylor rule, which says where interest rates need to be to have inflation at 2%, stable prices, and full employment. And if you use that model, depending on the rate of inflation, current interest rates would have to be at least 12% and as high as 21%, depending on what you use as the rate of inflation, to break the cycle of higher prices. And so that's something we're working on right now, Tom and I, to figure out, well, is that possible? If the market were in control of interest rates, where would they be? And then obviously, what do you do with your money in that environment?You don't want to have your money i… This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.bonnerprivateresearch.com/subscribe