Inflation is a heavy topic and one that can be both complex and yet, easy to understand. There are economists on opposite ends of the inflation debate and how it impacts the markets, which can become confusing. Fergus Cullen helps us break this down, highlighting the important aspects to understand for the ramification of inflation in your portfolio and life in the future.
Dynamics of Inflation
When looking at making investments, Fergus immediately highlights that inflation “affects investing decisions but is not the basis for investing decisions.” He refers to his latest investments in energy, which have benefited from and are a by-product of inflation. However, the initial investment was not based on inflation.
Inflation could be a few years away or be in the ‘here and now’. There is no perfect formula for inflation and its creation has eluded the majority of people. To find a good starting point, Fergus likes to use Louis-Vincent Gave’s framework.
"There are three prices that matter more than any other" - Louis-Vincent Gave
- The US Dollar
- The US 10 year Treasury Bond
- The price of the barrel of oil
Understanding the dynamics that drive these, will generally help position your entire portfolio and investment outlook well. This is due to a significant number of global investments which are priced off of these variables. When you look at what is happening in the markets now, with the COVID-19 pandemic, they are having a huge impact. It will impact how you choose to position your portfolio over the long term. This is influenced by having an inflationary or deflationary outlook.
Fergus has a strong view that the price of oil is increasing due to the immense supply destruction and oil consumption continuing higher. What the central banks are doing in the US will undoubtedly have significant impact on not just the US dollar but the Treasury market too.
Understanding the direction of the dollar and Treasury market, places investors in a good position for what may be coming down the pipeline over the years. Therefore, when it comes to understanding where these two elements are heading in the long term, we need to know the context in the US and by default the Fed finds itself in currently. On many occasions, when central banks undertake additional policy to reach their inflation targets, and don’t achieve inflation, it emboldens them to pursue a more extreme policy. This is due to political incentives found within politicians.
Debt and Inflation
When looking at the US debt level, it can very quickly become unmanageable if rates rise. When it comes to dealing with large levels of debt and entitlements, Louis-Vincent Gave, again provides three options:
- Default
- Austerity
- Inflation
Of these three, inflation is the path of least resistance, which becomes the obvious choice for politicians, simply because it is their easiest option. Once this understanding is in place, it shouldn’t be too challenging to figure out the likely path for the politicians and central bankers.
Fergus delves into the cyclicality of inflation by highlighting Rick Rule’s view that “high prices are the cure for high prices, low prices are a cure for low prices.” With debt growing at a rapid rate, we find ourselves with two unpalatable options of the three Vincent describes. This is what makes inflation the ‘go to’ choice for politicians – again, the concept of least resistance.
The size of future entitlement payments is also unmanageable, with Medicare, Medicaid and Social Security payments. To put it simply, the ‘boomers’ and subsequent generations are drawing out more from the system than they put back in. Druckenmiller refers to this as “generational theft”. It is too politically difficult to take a haircut as it would not be passed in government. Therefore, to mitigate this issue, they will undergo the route of inflation. As Fergus puts it “[it’s] an easy way for them to make the balance match”. Inflation acts like a silent tax in this case.
Chain of Logic: Comparing Monetary and Fiscal Policy
Back in the Financial Crisis of 2008/9, monetary policy was the dominant method to alleviate the effects of the crisis. The argument is that there wasn’t any inflation, so why is it any different now? We must understand that monetary and fiscal policy are different based.
Monetary Policy pushes reserves into the banking system but it can’t force banks to lend it out.
Fiscal Policy involves getting money directly into peoples’ hands. This is currently ongoing with stimulus checks and employment payments. It’s just about getting money into people’s hands so they can start spending it to get the economy going again. This is what stokes inflation.
When comparing asset inflation to fiscal, you see a very different economy when you give one billionaire $1bn as opposed to one million people a total of $1bn. The billionaire’s consumption won’t change as much, they may probably just buy a yacht or another property. The one million individuals who benefit from the $1bn stimuli instead are likely to spend it on basic goods and services, which has an inflationary effect. This is a huge difference when comparing the monetary policy impacts through, and out of, 2009.
Won’t the US just end up like Japan?
Over the past year, we have seen a more bottom-up approach conducted by governments. The US saw cash handouts to its citizens, and the UK saw fiscal policy where workers received 80% of their salaries. The more money in the hands of people over corporations, the more likely they will spend it on goods, which is inflationary. The problem with these kinds of handouts is that it is not productive. Fergus draws an analogy to World War II, where goods were used for infrastructure like factories and roads. Now, governments are essentially paying people to stay at home, and companies that may not need the extra capital injection. The amount of debt will just continue to go up. So won’t the US just end up like Japan?
Japan has a debt of 210% of GDP compared with 120% in the US. In essence Japan is ‘further down the road’. Japan has also been printing money and haven’t had any inflation, so why doesn’t the US simply take their lead?
We must understand that the US is diametrically opposite to Japan in the most important ways. The US has the biggest current account deficit in the world, whereas, Japan has one of the largest current account (trade balance) surpluses. With this surplus, Japan has invested internationally, amounting to 50% of their GDP. Therefore, they have the option of selling or getting their money back. As already mentioned, the US has an investment position of net -65% of GDP (was -8% in 2008), which is largely US bonds held overseas. The US has effectively sold off its assets to pay for the recovery of the Financial Crisis. Lastly Japan is financed by its population as they’ve got high savings, whereas the US has financed externally by selling treasury bonds. 60% of its bonds are held by foreigners.
Fergus highlights this is really important to understand, as what this means for the US is that they start to debase the currency. Similar to Quantitative Easing (QE), Governments are highly unlikely to cease fiscal stimulus anytime soon. With each new stimulus announced, it is adding to the broad money supply, allowing the Fed’s balance sheet to grow alongside it. This debases the currency. The foreigners who hold US Treasury bonds won’t be happy about being debased and will sell them down, like China and Russia, who already have. This then puts upwards pressure on the rates and on the bonds, which is not good for the US as they have such a large debt burden. Rates begin to rise on Treasuries which the Fed can’t allow past a certain point. This is because the debt servicing cost will make up too large a proportion of tax revenue. The Fed is then forced to step in to buy all of the bonds at a certain level to prevent interest rates rising. This is known as a yield curve control. The US dollar will devalue as US asset holders realise they are being debased and seek to rebalance out of US assets. Therefore, international equities and commodities stand to be the main beneficiaries.
There is too much debt, which is deflationary?
Yield control may sound a little far-fetched. However, this isn’t the first time yield control has been a method for servicing debt. (Fergus reiterates he is putting together the insights from Louis-Vincent Gave, Luke Gromen, and Lynn Odom. They have many resources which he recommends readers to watch to form their own opinion.)
In the 1940s, post-war, the government couldn’t service the debt, so the Fed capped the 10 year Treasury at 2.5%, which is a yield curve control. As a result, debt to GDP went from 110% to 30% by 1951. High inflation can be very effective for solving the debt problem, but it can also ‘wipe you out’. People often forget that long-term government bonds acts as the Treasury’s real drawdown, simply because most of us haven’t seen this in our lifetime. Further, this doesn’t backtest well for those who run algorithms as the historical data doesn’t exist, due to the lack of technology (i.e computers) of the period.
On the topic of government debt, there is a contrasting argument from economists which is “there’s too much debt, which is inflationary”. Russel Napier, a staunch deflationist for the past two decades has recently changed his tune on his perspective of inflation. When asked about the debt load’s deflationary effect, he hits the nail on the head with “too much debt, not enough money”. Essentially, we solve the problem of debt if we simply create enough money.
This is best explained by modern monetary theory. It is the idea that monetary sovereign countries, like the US, UK, Japan etc are not operationally constrained by revenues when it comes to federal government spending. However, the main issue with this theory is that it largely ignores all inflationary risks. The assumption that money will be used efficiently, so there should be a higher amount of spending, does not work in practice. Fergus notes that “public spending is not very efficient in comparison to private spending”. This inevitably leads to the scenario where this money can’t be efficiently allocated, and so you get an “overflow”, which is inflation. This again, draws upon the idea that these stimulus packages we’re seeing today aren’t being used in productive ways.
However, the economy bounces back. This is why Fergus “[doesn't] think the debt is that much of a problem when there's this much stimulus going into the system.”
Inflation is “Transitory”
Lynn Odom refers to inflation as being “transitory”. Although we need to know the difference between:
- Transitory inflation in absolute terms
- Transitory inflation in rate of change terms
Odom is essentially saying that we’re going to see bursts of inflation, prices become higher, but every time they do, the rate at which they change drops off. However, we will stay on a new plateau. Fergus draws upon the example of Coca Cola. When inflation occurs, Coke may put their prices up from $1 to $1.50, however, they will not move back to $1. The rate of change is transitory but the not absolute price sticks. This in essence makes “transitory” a misleading term, as it implies we will ‘go back to normal’ which isn’t the case.
This has always happened, so why is this a new thing?
It’s perceived as ‘new’ as the Fed are trying to keep bond holders calm, by implying prices will ‘return to normal’ in order to keep confidence in the bond market. In essence this may be seen as lying, however Fergus highlights “they've got no choice though because they can't say the truth and say that they're going to be exploited.”
Investing: Being Inflation Aware
Understanding the direction we are headed in will help determine where to position yourself in your portfolio. We dive into food and energy prices. Increases in either is a result of inflation.
At the moment, energy isn’t largely reflecting the rate of inflation yet, but Fergus still believes it’s going to occur. Currently, this is easy to see across the agricultural space. When necessities like corn, soya beans and rice prices rise consumers cannot hide from the increases in cost. Substitution (such as swapping beef for chicken) no longer works as you can’t really substitute necessities like rice, bread and vegetable oil. Energy is similar in this sense that it is involved in the cost of everything: running a factory, powering your home and so forth.
Once the cost of it rises, input costs will also rise with it.
Globalisation to Deglobalisation
Globalisation has had a huge deflationary effect as production has been offshored to countries that offer cheap manufacturing. For example, making a TV in the US for $1,000 and then offshoring production so you can make the same TV in China for $300 is hugely deflationary. The issue here is that with this sourcing of cheap production, there has been no regard to security of supply chains. Paul Singer puts this into perspective well: “Supply chains will move from just in time to just in case.”
Fergus draws on the example of Ford. They can’t make F-150s as they no longer have access to semiconductors. As a result, they will probably choose to manufacture them domestically, in the US, moving forwards, or somewhere where they can guarantee security. This will drive up cost of production, making F-150s more expensive. That in itself is inherently inflationary.
Demographics effect on Inflation
The effect of ageing on inflation is largely misunderstood. Vincent Deluard’s work helps us better understand the demographic impacts. A larger workforce and less dependents has a deflationary effect, as there a more means of production and less consumption.
Fergus highlight’s Asia’s rapid demographic transition over the past 30 years. Originally having high fatality rates and a large working population, there was not a lot of burden from the older generation. However, the occurrence of more people in the workforce retiring is deflationary in itself. This is because it increases the dependency ratio if you have fewer children, then a bigger labour force. Asia needed to create a lot of jobs and turned to exports. Now, this is reversing. When looking at fertility in South Asia and China, the rates have dropped off a cliff. There’s going to be far fewer workers coming through the workforce, and therefore a heavier burden of older people, meaning far more consumers. When you have more consumers and a smaller proportion of the population being productive, which is inflationary.
Why this has massive implications
As Fergus puts it “Investors have never been more poorly positioned for inflation.”
Inflation protection at the S&P is at a record low. Companies with high tangible assets: energy, utilities, materials have been largely underweighted at the expense of the technology sector.
“It’s the worst possible time to just be at a sort of a passive investor, then think that you'll be fine in a passive index, because you're hugely sensitive to inflation.”
John Hussman recently calculated the S&P has a duration of 60. Duration is the number of years to get your money back on an investment based on its current earnings. A duration of 60 means it takes 60 years to return your investment.
When inflation starts to be a concern, investors will typically opt for shorter and shorter durations. If there is 5% inflation investors are far less likely to wait for long periods for a return of your capital, with its reduced purchasing power. As value stocks and commodities are inherently shorter duration, they usually do well in inflationary environments.
Key Takeaways:
If you agree with the inflationary outlook:
- Avoid bonds, especially long dated bonds with higher durations
- Avoid technology stocks, in particular, those with no earnings (Uber, Lyft etc.)
- Avoid ESG which heavily weights inflation sensitive sectors, such as technology and consumer staples. It underweights materials, utilities and energy, which all provide inflation protection.
- Avoid being too US centric with passive indexes, since most have far higher weightings to technology than international indexes.
If you was to protect your portfolio against inflation, Fergus recommends you look at:
- Value based indexes
- Emerging market indexes and equity
- International stocks, particularly in Japan and Europe
- Commodities: presious metals, industrial metals and energy
Commodity royalty companies have historically been a good way to “invest” in an otherwise cyclical commodity industry.
When looking at real estate, it generally protects you from inflation, however it does not outperform the market in inflationary periods.
Finally, as this is a complex topic, it is important to conduct further investigations to truly understand both sides of the inflation argument. Fergus recommends you search the following names on YouTube to understand their views on inflation:
Inflationists:
- Lynn Alden
- Louis Gave
- Vincent Deluard
- Russel Napier
Deflationists:
- David Rosenberg
- Lacy Hunt
- Steve Keen
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