In our last quarterly client letter, “Winter (Rate Cuts) Is Coming,” we argued that the labor market and economy had sufficiently cooled, prompting the Federal Reserve to consider cutting interest rates for the first time in more than four years, especially as inflation began to ease. At that time, we maintained a neutral stance on risk allocation due to the potential for an upcoming recession.However, recent developments have led us to upgrade our outlook. In the coming month, we intend to modestly increase our exposure to risk assets, such as stocks and commodities, while reducing our bond holdings. We’ve also raised some cash as we enter October—a typically volatile month, particularly during election years—to strategically reposition our portfolio in sectors we expect to thrive in the current environment. Although the short-term outlook has improved, we remain wary of long-term inflation and the US fiscal situation, which will likely necessitate creative and active portfolio management to effectively navigate future volatility.
And We’re Off!
The Federal Reserve kicked off its easing campaign with a significant 0.50% rate cut, larger than the usual 0.25%. This move allowed other central banks to follow suit without fearing large declines in their currencies relative to the US dollar, which could have worsened inflation in their countries. Within a week of the Fed’s cut, China responded with substantial fiscal and monetary stimulus, leading to a rapid 30% rise in its stock market.The Fed had been signaling its intent to cut rates for months, and this coordinated global easing made September one of the most active months for rate cuts since the turn of the century—comparable to March 2020 and the 2008-2009 Great Financial Crisis. Historically, such periods of global easing have led to strong economic growth and rising corporate profits, trends we expect to continue into 2025, supporting stocks and providing a much-needed economic boost. 
Source
Following the three previous periods of substantial global central bank easing, we saw an acceleration in global growth and corporate profits. We anticipate a similar outcome with the recent round of central bank rate cuts, which should bolster stocks in 2025 and provide a much-needed lift to the economy. Our Global Stimulus Index (depicted in red below) supports this view, indicating that the next peak in manufacturing is unlikely to occur until late 2025 or early 2026, as measured by the ISM Manufacturing PMI (shown as the black line below). 
I’ll Take a “K” Pat
The economy has muddled through the past two years, with unemployment ticking up but only affecting a few key industries. Retail sales, however, remained strong, which was puzzling until recent revisions to Gross Domestic Income (GDI) revealed an $800 billion increase—$600 billion of which was consumer income. This explains the robust retail spending and why businesses haven’t laid off workers despite slower job growth.The “K-shaped” recovery illustrates the contrasting experiences of different income groups. The Michigan Consumer Sentiment survey reveals that 40% of higher-income respondents reported feeling better off, compared to only 14% of lower-income respondents—similar to trends observed during the Great Financial Crisis. Both groups saw improvements after the 2007 recession until the onset of COVID-19. However, since 2022, their experiences have diverged significantly. What changed? 
“Everyone loves an early inflation…everyone benefits, and no one pays.”The last stimulus check to consumers as part of the COVID-19 economic response was issued in March 2021, which was the third round of “free” money given to consumers. That year saw robust economic growth and generally strong consumption by all income cohorts, alongside a roaring stock market. Both consumer and business sentiment improved, and everyone seemed to be in high spirits. This concept is illustrated by Jens O. Parsson (Ronald H. Marcks) in his book, Dying of Money – Lessons of the Great German and American Inflations, where he describes “early inflation” as follows:
“Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays.”
The three rounds of stimulus checks led to a buildup of excess savings in consumers’ bank accounts. However, in 2022, as inflation surged, these savings began to be depleted. Instead of boosting consumption levels, consumers used their savings to cover rising prices, which meant that maintaining their standard of living required drawing down their bank accounts. By early 2024, this excess savings had been entirely exhausted.From late 2021 to early 2022, inflation reached what Parsson describes as “terminal inflation,” significantly impacting low-income earners and reducing their standard of living. Parsson explains terminal inflation as follows:
“In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.”
Although the current annual inflation rate, as measured by the Consumer Price Index (CPI), was 2.4% in September, consumers—especially those in lower-income brackets—are still feeling the impact of the cumulative inflation from the past four years. Food and shelter, which make up a larger portion of low-income spending, are significantly higher than pre-COVID levels. This is a painful reminder that nothing in life is truly free, as reckless government spending has eroded the purchasing power of the US Dollar (USD) and diminished the standard of living for many.From 2000 to 2010 (a period of ten years, most major currencies lost 20-24% of their purchasing power, a trend typical of a 2% annual inflation rate. However, in just the past four years (shown below), we have witnessed a similar degree of currency devaluation and loss in purchasing power that previously took a full decade to occur. In the US, prices are now approximately 20% higher than they were four years ago, with specific categories such as vehicle insurance, shelter, and food increasing by 50% or more since 2020. 
You Can’t Handle The (Real) Truth
We have focused heavily on inflation because it is critical to understanding the broader economic picture. How can the stock market reach record highs while many individual stocks remain stagnant? Why do consumers feel pessimistic about the economy when reports show growth? The answer lies in the difference between the nominal economy (unadjusted for inflation) and the real (inflation-adjusted) economy.For example, while retail sales are up 15% since March 2021, this growth is entirely due to rising prices, not increased sales. Inflation-adjusted retail sales are actually down 1.2% over the past three and a half years. The last time we saw negative real retail sales over a similar period was during the 2007-2009 recession, which explains why the economy doesn’t “feel” strong despite reports of robust retail sales.When you adjust for inflation, the true economic picture becomes clearer. Persistent inflation can have long-term, devastating effects. For instance, during the high inflation of the 1970s, the stock market made little progress from 1968 to 1982. While the Dow Jones Industrial Average only lost 15% over 14 years, when adjusted for inflation, it actually lost nearly 70% of its value (shown in red below). 
Investment Strategy for Inflationary Periods
Navigating inflationary periods requires two key strategies: overweighting commodities and employing active management. In the turbulent period between 1968-1982, the Dow Jones saw four large rallies ranging from 34% to 75%, and four large declines ranging from 23% to 45%. Clearly, a passive buy-and-hold strategy does not work well in a sideways market, highlighting the importance of active management in response to the business cycle. 
Looking ahead, we expect global central bank easing and fiscal stimulus to lead to economic growth reaccelerating in 2025. With that growth will come higher inflation and interest rates. Given this outlook, we plan to reduce our exposure to bonds, as most of their returns have likely been realized, and shift more towards stocks and commodities. We are maintaining higher-than-normal cash reserves in the near term to take advantage of market volatility, especially with upcoming election uncertainties and the November payroll report.Once these short-term uncertainties pass, we expect the market to strengthen into the end of the year, bolstered by record levels of stock buybacks, which typically peak in November and December. While we anticipate an upturn in the economy for 2025, we are mindful that elevated inflation could quickly change the investment landscape.More By This Author:Raw Realities: AI, Data Centers, And The Global Energy Transition
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