Another great piece from Frontier's Geremy van Arkel.
There’s a topic that has been dominating the airwaves post-pandemic. And that’s inflation. Turn on, tune in, and you will likely hear pontification on the subject. Most of us in the U.S. are feeling the impact of inflation in our lives as well. Whether it’s the groceries we buy, energy bills we pay, used cars we get, or travel we (finally!) get to do, prices seem higher than they have been in a very long time. Domestically, the latest official measurements of inflation put the CPI-U (Consumer Price Index for All Urban Consumers) at about 5% for the past 12 months, which is a print far beyond the inflation levels of the pre-COVID environment, as well as beyond the Fed target of 2%. More importantly, this 5% level is higher than yields on almost all bonds, implying something’s got to give.
The big question is, will this inflation be persistent or is it merely transient? The Fed, and many economists, appear to believe that inflation is transient. On the other end of the spectrum are traders, several of whom believe that inflation is here to stay. As with any other subject where there are two parties, both proclaiming their opposing answers to be the correct one, I try to skirt my way out of the debate with my “the truth is somewhere in the middle” quip. But now I feel like I have held off from expressing my belief for long enough and am compelled to enter the fray. That being said – spoiler alert – I honestly do think that the truth is somewhere in the middle.
How Did We Get Here?
Before delving into the current state of U.S. inflation, it’s worthwhile looking at what we did to get to where we are now. I believe that the current era for the capital markets’ environment began after the 2008 financial crisis—an event that marked a hard reset for the global economy. The era between 2009-2019 was one of the slowest economic recoveries on record, despite constant global central government stimulus, near-full employment, and ever-increasing debt levels. I call this era “Slow and Low”—slow growth, low inflation, and low interest rates.
While the decade following 2008 was a low inflation era, the big question is why? How in the world didn't the continued, staggering levels of stimulus, government debt and persistent monetary policy, move the needle towards growth or inflation? In fact, interest rates in some countries drifted into negative territory! Well, the answer, by most measures and to the contrary of popular opinion at the time, the post-2008 environment has been dominated by a few powerful deflationary forces.
Changing Demographics – All across the first world, populations are aging, and family formations are falling. Older people tend to save more – worried they’ll outlive their retirement savings – while younger people tend to be minimalists. Many rent apartments in cities vs. buying homes or take public transportation vs. buying cars. These demographic trends imply slow growth in consumption which is deflationary.
High Debt Levels – Most First-world countries, businesses, and consumers carry more debt today than ever before. Once high debt levels are reached, new debt has diminishing returns, and old debt needs to be paid off. This often results in less spending and an oversupply of goods.
Shareholder Primacy – For decades, average wages have not kept up with earnings growth nor inflation. This has been great for business ownership, but disadvantageous for the average worker’s wallet.
Technology – If the 1990’s and 2000’s represented the buildout of the technology infrastructure, then the 2010’s and 2020’s represent the use of technology to create scale. Some technology is inherently destructive for prices.
Globalization – Globalization has likely never been a stronger force of deflation than it is now: competitors, supply chains, and movement of capital have become more and more interlinked.
But the question is: Are these deflationary forces persistent or transient?
The Breakdown
During the “Slow and Low” era, there seemed to be no meaningful way to stimulate growth or inflation of prices in the real economy. Yet there was inflation. It was in asset prices.
A decade of global stimulus had become “trapped” in capital markets. What do I mean by trapped? There is an economic theorem that suggests if the government increases the money supply—by either printing more money or through government debt—GDP (Gross Domestic Product) growth occurs through the concept of money velocity, or how money is re-spent. That formula is: Money Supply x Money Velocity = Change in GDP. But what if money velocity falls while money supply increases? Would that mean the stimulus is being saved, not spent? Well, looking at what has happened post-2008, investors have saved money—and that has been saved by investing in assets or the stock market. So, one could presume that, under these circumstances, increasing the money supply only served to increase asset prices.
As a result of—or aided and abetted by—constant government stimulus and debt creation, asset prices of stocks, bonds and real estate have simultaneously drifted to near their highest prices on record. For consumers and particularly investors, slow and low combined with high asset prices provided a predictable backdrop for wealth creation.
Under these conditions, it appeared that the role of central governments was to keep interest rates low and thus keep asset prices high. Since so much wealth is now stored in assets, changes in asset prices are now more significant to the state of economy than, say, variations in the job market or in wages. If this is true, asset prices have become the economy. Want to improve the economy? Raise asset prices. Conversely, it would seem nearly impossible to have a strong economy and falling asset prices.
It did appear as though no government agency was going to stand by and let asset prices fall under their watch. In 2013, the Fed embarked on its first attempt to undo monetary stimulus. The “Taper Tantrum,” as it became known, was Fed’s tapering of bond purchases. However, this path to reducing quantitative easing came to an abrupt halt the minute that the bond market started to lose money, due to rising interest rates. “Whoops, sorry! We will keep buying assets!” Again, in 2018, the Fed sought to “normalize” interest rates – a reversal of zero percent interest rate policy – by raising the Fed Funds Rate to a target rate of 2.25-2.5%. By fall of 2018, the Fed had reached its target, but what happened? The stock market (S&P 500) abruptly fell 15% and the Fed caved, quickly reducing the Fed Funds Rate back to its comfy resting place of zero percent. The Fed’s game was 0-2, with two failed attempts to unravel stimulus.
Simultaneously, but in an uncoordinated fashion, the central government was accelerating its stimulus through borrowing, spending, and tax cuts.
The signaling was in: investors now know that the government has their back. No one is going to sit by and let asset prices fall. Mind you, none of this was inflationary in the traditional sense. What’s the lesson here?
Go forth and invest.
Fast forward one pandemic later—and the world feels entirely different.
Much of what I have explained above is still applicable, perhaps more so than ever on almost all accounts: more stimulus, more debt, ever higher asset prices. Yet there remains one aspect of this virtuous balance that is becoming disruptive: inflation.
Traditional economists would be quick to note that of course there is inflation, because there is more stimulus than ever. But I wonder if this simple explanation is enough.
Over the last 20 years or so, government spending and monetary policy has not resulted in inflation in the U.S., nor in other countries. After all, Japan has embarked on more than 20 stimulus campaigns, yet their inflation and interest rates remain near the default zero level.
If stimulus doesn't explain inflation, what other factors are in play?
First off, there is a problem with measuring inflation year-over-year. One year ago, the world was in the throes of a pandemic, and most businesses and services were entirely shut down. Thus, any price increase from a year ago represents a starting point that is greatly depressed. This is especially true for areas such as travel, used cars’ sales, and energy. And think of oil prices, which were negative at one point last year. This concept is known as the base effect, and over the last 12 months, it has likely accounted for a lot of the current change in inflation.
To further clarify: for inflation to be 5% next year, prices would have to rise 5% from today’s level, which is different from prices rising 5% over the past year and then just staying at today’s level. This makes sustained inflation year-after-year a tall order.
Secondly, the inflation that we are witnessing is concentrated in a few areas of the marketplace. It has been widely noted that the components of CPI driving the inflation numbers higher are construction inputs, travel, used cars, and the more volatile components of food and energy. Further, the all-important indicator of persistent inflation is wage growth, which—by most measures—is still under control and unemployment is still elevated. Given the lumpiness of the current readings, it does not appear that inflation is universal...yet.
The third important aspect of the current inflation levels may be attributable to what appears to be the COVID-related supply shortage. Across the world, businesses and factories have been dealing with stops and starts due to COVID-shutdowns. There's a different kind of COVID-related shortage, too. We are seeing large numbers of workers opt to not return to work, which has led to worker shortages in some industries. Finally, most businesses had not expected COVID to cause a boom in spending and in demand. Many of them had spent the last decade or so reinvesting their borrowings and profits into share buybacks, as opposed to supply expansion, and were now caught a little flat-footed in terms of output capacity. Increasing production seems to continue to be challenging for some.
These factors influence the ability of many industries to bring finished goods to the market, and the fix will, unfortunately, take time and require that COVID is managed appropriately.
Persistent or transient?
My favorite simplification for inflation is, “too much money chasing too few goods”. That is exactly what is happening this year. There is still a foundation of the ever-present deflationary forces, but supply chains have been disrupted and there has been a demand explosion from consumers and businesses. Consumers and businesses having too much money and supply being disrupted due to COVID-shutdowns and stops and starts has led to an imbalance.
However, it does appear that the factors contributing to inflation are variable, while the factors that are deflationary appear more persistent.
Inflation can be contagious. Temporary inflation in one part of the economy can spill over into another, and transient inflation can quickly become more persistent. Some factors can also be more important than others. For example, I have italicized Wars and Currency Devaluation, as these factors are not present today, but can be very powerful influencers of inflation. To simplify, below are some of the most pertinent factors influencing inflation today:
1. Asset Prices – If asset prices remain high, consumers are expected to remain spendy. If not, all bets are off.
2. Supply Shortages – If supply chains continue to be disrupted, and businesses continue to remain behind the curve of capital expenditures, then goods and services may continue to be under supplied.
3. Stimulus – If stimulus continues, then capital markets will probably continue to be backstopped.
Which gets me to my pontification of the question of the year: “Is the current inflation that we are experiencing persistent or transient”? Drumroll, please, for here is the answer:
If 1, 2, and 3 above continue, we will likely continue to see elevated levels of inflation. (Or, in other words, the truth is somewhere in the middle.)
Feel free to roast me for a) taking the bait, and b) for a sufficiently vague answer. But this isn’t my first rodeo. My first rodeo was in Sheridan, WY a couple of years ago. I don’t believe this business is about predictions, for essentially no one is serially right at binary predictions. I think it is far more important to know how to position strategies with a goal that investors are not significantly impaired by a surprise negative outcome.
The first and most direct way to hedge inflation is to buy commodities. Commodities represent the input prices of goods and services and are often the most direct link to investing in a general rise in prices of goods. However, commodity prices are historically quite volatile. For example, during the “Slow and Low” era, commodity prices fell more than 50%! Secondly, commodity prices already appear elevated in this current reflation trend. Finally, it does appear that while commodities continue to be over-supplied, it is the finished goods that are experiencing supply shortages. It’s not the number of trees that is impacting lumber prices, but the amount of finished wood product. Thus, investing in the input may or may not represent a hedge against a supply bottleneck.
The second policy change investors could consider would be to reduce their exposure to duration-sensitive fixed income. Inflation generally causes interest rates to rise, and duration-sensitive bonds tend to lose money during periods of unexpected inflation. Currently, pretty much the entire fixed income spectrum of bonds offers yields below inflation—even most junk bonds. The 10-year treasury bond, as depicted on the chart below, offers yields close to 1.2%, which is far below the current inflation rate of 5%.
But interest rates continue to confound the experts. Over the last quarter, interest rates have been falling in the face of inflation, as if to laugh once again at the experts. For my entire career, almost every interest rate prognosticator has been wrong. So, what of all those dire predictions of inflation and rising interest rates? Can any of them be held accountable? Maybe their time has come. Maybe not.
When interest rates rise, recessions tend to occur.
Well, again, investing is easy and it is hard at the same time. With bond yields below inflation, bond investors clearly must believe that the current rate of inflation is unsustainable, or transient, and will likely be much lower in the future than it is today? It’s not enough to know what inflation is today, to make policy changes, one must know what inflation and interest rates will be tomorrow. And, there’s the rub.
More importantly, as noted previously, when the money supply increases, typically so does the demand for storage of that money into assets. This demand for asset storage has pushed interest rates around the world to what seem like impossibly low levels, seemingly unabated.
Maybe investors don’t feel the need to invest all their assets in stocks? A close review of the history of interest rates reveals that when interest rates rise, this often leads to recessions. Following those recessions, interest rates then found new lower lows. Maybe fixed income investors are considering that inflation could cause economic disruptions, thus they are demanding safe storage of their assets today. Which completes the circle. Stocks represent exposure to economic growth, which can be cyclical. To potentially offset against future disruptions of those equities, investors often also own high-quality bonds.
Either selling high-quality bonds, and/or increasing exposure to commodities could hedge against an uncertain inflation environment today, but it would also increase portfolio risk for the future. Given that inflation has already happened, and commodities have already risen, inflation would have to spiral upward from here to make that policy change payoff. With asset prices near all-time highs, I am not sure if now is the time to be increasing risk in portfolios.
At Frontier, we manage strategies that seek to maximize expected return for specific target levels of possible downside risk. In doing this, we try to consider multiple outcomes for asset prices, the economy, interest rates, and inflation. Frontier strategies not only reflect our estimates for current and long-term allocation conditions, but also most other possible outcomes. Therefore, we account for both higher inflation and lower inflation in our strategy construction process. For our inflation inputs, we consider longer-term inflation, which we believe is a far more stable methodology than trying to guess inflation serially, year after year. However, it doesn’t mean that we are not aware of the current inflation situation, we just believe that our process has already accounted for multiple differing possibilities of inflation.
For Frontier investors, we feel there is no need to do anything drastic in the face of changes in current inflation. As Warren Buffett has said, the level of activity in your investment portfolio should resemble the level of activity of a sloth. That statement might be most relevant when investors feel the greatest pull to change something, because it is at those points that they may be most likely to make a poor decision. Acting on the recent past is almost never a good idea. Particularly making decisions based on last year, a year that is highly improbable to repeat. Maybe, the appropriate portfolio to hold for the long-term future is exactly the portfolio that you hold today
