BFS Insights Highlighted in HBJ Economic Forecast issue

This article by BFS director of research and a portfolio manager Rosa Y. C. Chen originally appeared in the Hartford Business Journal on January 13, 2025.

The short-term outlook for the economy is strong with a near-term recession less likely.

Inflation is decelerating, unemployment is low, and corporate earnings are solid. This constructive economy is backed by a supportive Fed that is cutting rates.

Rising debt levels have repeatedly been passed on to the next administration, yet we may be nearing a crossroad. As the necessity to resolve this debt load becomes more urgent, investors that position themselves for this eventuality are likely to see greater returns.

Historically, there are four options to resolve a government debt problem. Two options are austerity or default, neither of which are likely to happen given the current geopolitical willpower.

The third is a productivity miracle. Even with AI at the cornerstone of any potential needle-moving breakthroughs, we don’t believe this will be enough to fix the entire problem.

What is necessary is the tried-and-true technique used by countries all over the world that have found themselves in a similar situation — pay back the debt with less-valuable dollars.

By having nominal GDP grow faster than the debt, the government can generate more tax revenues than the debt grows. The easiest way to do this is to generate lots of inflation.

Over time, this inflation eats away at the debt, lowering your debt/GDP ratio.

This is why we believe inflation may be higher going forward than most people are predicting. The government, including the Federal Reserve, won’t openly support higher inflation; yet by their actions, they will most likely choose the inflationary path to continue to fund the government.

We’ve become used to extremely low inflation over the past 10 to 15 years, and the implications of investing during periods of higher inflation are important to understand. Investors now need to be focused not just on growing their capital, but also emphasizing maintaining purchasing power, especially over very long periods of time.

Targeting best-of-breed companies is always advisable, but in times of inflation, it’s prudent to narrow in on best-of-breed companies that either have growth prospects or wield significant pricing power.

If a company is thriving and growing, its earnings growth can outpace inflation. Some companies may have strong pricing power due to inelasticity of demand, while still others may have business models that inherently benefit from a rise in prices.

The past few years have differentiated those companies that were challenged in pushing through much higher inflation than we’ve been used to, and those that maintain sales volume and margins in an inflationary world.

The idea is to emphasize the latter and not the former.

It’s impossible to pinpoint when this strong economy may dovetail with the need to generate inflation. That’s why it’s crucial to properly position investment portfolios ahead of time.

That requires a focus on the best-of-breed companies that have strong competitive advantages, pricing power and resiliency over the long term.

There are two other pillars to provide inflationary support. The first includes companies with opportunistic growth potential due to secular tailwinds and innovation, such as those with AI prospects and market share gains.

The second group are tangible, asset-driven companies that are exposed to commodities, such as agriculture or gold.

Gold serves as an inherent inflation hedge, has been steadily purchased by foreign central banks, and offers a 5,000-year history of being the currency of last resort.