Crypto News: Inflation will make a third year of large equity gains difficult

Last week, I told you investing in 2025 will be won or lost on inflation. This week I'm going to tell you why I lean toward 'lost' over 'won'.

Ironically, inflation fears reached a bit of a peak a couple weeks ago. We had seen some elevated inflation numbers embedded in economic data from a survey of purchasing managers and the University of Michigan's consumer survey. And we also had data telling us the job market was doing just fine — from job openings, to unemployment claims, to the monthly jobs numbers. That combination got the yield on the longest maturity US government bond briefly over 5%, something we've seen for mere days in the last decade and a half.

Then all of a sudden, yields collapsed. I'm only talking about 20 basis points here, of course. But still, the inability of yields to sustain a move over 5% tells you that the market sees government bonds as good value at these levels. It will take more than just an inflation scare to get us higher.

Unfortunately a lot of things are conspiring to actually get us that inflation -- and that's even before we think of the impact of President Donald Trump's (still not fully fleshed out) policies. That means were likely to again see yields north of 5% if the economy holds up strongly, with the resulting negative implications for equities. That's my base case. Here's why:

Inflation is already sticky everywhere in the developed world except China
Trump's stated policies would only add to inflation, not diminish it
Demographics and de-globalization may be the key to why there will be no reprieve
Central banks are in a no-win situation, especially the Fed. Nothing they do will curb inflation short of causing a recession
The conclusion: This is bad news for investors. I'll explain why

The US is not alone on inflation

I know those are bold statements said in a fully declarative tone as if they will happen. The truth is there is considerable uncertainty. And, as always, when I have a downbeat outlook, I'm hoping I'm wrong. Right now the market thinks I'm wrong, too. Just look at the rally in stocks over the past week as the inflation bogey man receded from view, with the S&P 500 back at a record high Wednesday afternoon.

I think the market is getting ahead of itself. Globally, inflation is a problem, even in advanced economies where growth has been poor or deflation had previously reined supreme. Take Europe, for example. Apollo Global's Chief Economist Torsten Slok noted earlier this week that Euro area services inflation is 4%. And it's sticky, meaning it has remained at this level for a long time after the post-pandemic inflationary shock.

The latest figures through November for Japan, which had been beset by deflation for decades, show inflation now at 2.9%. Inflation has been over 2% in Japan continuously since April 2022, the longest period in over three decades.

So, it's not like last week's 2.9% consumer price inflation in the US was an anomaly. One would expect price pressures to be even higher given the enviable jobs and growth picture in America relative to the rest of the developed world.

Trump will add to this

I know the American President promised to bring down inflation, which was a defining issue for the election. The reality, though, is that his policies are all pro-inflationary. He wants to cut taxes, which adds demand to an economy growing near 3%. That's inflation. He wants to deport millions of people who are in the US illegally. That will add to a shortage of workers, especially in agriculture, housing and hospitality. That's inflation, too. And Trump wants to impose tariffs on the country's three biggest trading partners, Canada, Mexico and China. That's inflation three.

It's not a question of whether Trump's stated policies will cause inflation to rise. It's a question of whether he's 'bluffing' and if not, by how much inflation will rise. Look no further than drug prices. Potentially, we're looking at 3% inflation for years to come. That's something already expected by consumers, by the way, given the last University of Michigan Poll showed inflation expectations for the next 5 to 10 years at 3.3%.

By the numbers

3.2%

- The core consumer price inflation rate through December, excluding food and energy (which had been keeping inflation down)

In some ways, we're just normalizing the economy

3% inflation isn't the end of the world. The best recent period of growth in the US, the 1990s, saw inflation consistently over 2% except during the Asian Financial Crisis and the LTCM collapse. Sustained inflation below 2% was an artifact of the balance sheet repair and low growth period after the Great Financial Crisis — something we don't want to re-visit.

Perhaps then, we should just think of this post-pandemic new normal as a return to the pre-crisis norm of 2 ½% inflation and decent growth.

The big difference is demographics

If I had to pick one thing that's different this time, it's the demographic component. In the 1990s, the world was welcoming in the post-Soviet bloc and Communist China labor supply into global trade, which helped lower consumer prices around the world. The US was also moving toward freer trade with places like Mexico, which both helped de-industrialize the States and reduce prices. Birth rates and anti-immigrant fervor had yet to shut down population growth in the industrialized west too.

You take away these three components and what was 2 ½% inflation becomes 3% inflation pretty quickly.

What will the Fed do?

This puts the Fed in a bind. On the one hand, lowering interest rates to zero percent during the pandemic allowed the majority of high-income households and big businesses to lock in favorable fixed-rate debt terms that will last for years to come. That means high rates simply don't have as big of a punch as they usually do — and lowering rates may ironically actually lower growth if it has more of a negative impact on interest income than it does on relieving financial distress.

On the other hand, the Fed simply hasn't created anywhere near the kind of financial distress that would slow the economy though monetary policy. And so, if Trump's pro-inflationary policies start kicking in, the next move by the Fed could very well be to hike rates, not lower them. And given how high rates have less impact because of the 'rate lock' situation, the central bank might even need to raise rates enough to cause a recession in order to get monetary policy to have any anti-inflationary impact at all.

You can hear some Fed officials saying just the opposite. People like Chicago Fed President Goolsbee, New York Fed President Williams and Fed Governor Waller have all suggested rate cuts are still on the table as soon as March. The market is priced as if July is the next rate cut. Realistically, I don't expect even that.

Here's why this is bad news

Normalization of macro variables back to the pre-GFC era also means normalization of asset price ratios too. When Jamie Dimon, the last remaining big bank CEO who served before the GFC, says "asset prices are kind of inflated", he's hearkening back to that pre-GFC time when bond yields were higher and price/earnings ratios were lower.

If we normalize back the numbers that prevailed just 20 years ago, we're talking about a S&P 500 P/E ratio around 20 times instead of today's 25 to 30 times earnings. And when growth was good and inflation at 2.5% during the 1990s, the 10-year bond was at its nadir during a crisis at 4.15% — a level that helped fuel a bubble. Before the Asian Crisis, it was rarely below 6%.

In a world of re-shoring, tariffs, and slower industrialized nation population growth, the bigger risk is higher inflation, higher yields and therefore lower P/E ratios. That's bad news for stock and bonds alike, though good news for savers.

My expectation for 2025 is sustained inflation and, therefore, 10-year bond yields above above 4.50%, with any level above 4.75% having a negative impact on long duration assets like equities. Sustained yields above 5% are a decently-sized tail risk. So, for equities, while we are about to hit new record highs, I just think these levels won't last for the entire year.