Recession or higher structural inflation? This is in essence the dilemma facing the Federal reserve. Most banks & analysts have been predicting the worst; 1.5-3% increase of fed fund rates and even a reduction of the balance sheet. Such a scenario would ravage asset prices and curtail economic growth, leading an already slowing economy into recession. History, context and political game theory suggest the tightening may eventually be far less than the current consensus. To start with, the largest borrower in the world, the US government, can’t afford for rates to go too high too fast. As politics continue to be driven by fiscal largesse, government debt will continue to expand and, should rates get too high, the greenback may start to decline and, in the face of a gaping trade deficit, accelerate inflation ever more. A more modest Fed tightening may be able to partially curb inflation before standing aside, a pattern that we have already seen twice in 2013 and 2018 (see chart). That would lead to higher structural inflation and a floor to asset prices. Yet the current tightening cycle is different from the last 30 years and the possibility of a policy mistake is very high. For more than a decade the US central bank had the latitude to loose financial conditions basically as they saw fit and by doing so contributed to inflating asset prices at the current levels. The highest inflation trend in 40 years has changed that. We have entered a decade of elevated risk and cognizant investors should make sure their portfolios are built for resilience. 60/40, passive indexing and other models that worked over the past two decades are unlikely to provide much protection and may, on the contrary, magnify exposure to systemic risk. A full rethinking of portfolios around secular macro themes such as inflation, sovereign risk and technology disruption is probably best. It’s time to Swerve.

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