Red Pill on Inflation. Act now to De-risk and Re-balance
What does High Inflation Mean for YOU? More importantly, How should YOU Hedge against Inflation, and Position your bets?
‘A constant in the history of money is that every remedy is reliably a source of new abuse.’ - Famed economic historian John Kenneth Galbraith.
Inflation is the rate at which prices rise. Inflation affects mortgages, savings interest, pensions and your investments. Understanding inflation is key to understanding the economy, but measuring it is difficult.
Why Does Inflation Matter?
We have been hearing a lot about the rise in interest rates and yes, Inflation. Inflation matters and Yes, it matters very much to you. How?
Imagine trying to negotiate a pay rise with your boss without knowing what the recent level of inflation has been. You might tell your boss that the cost of the things you buy has increased over the course of the past year, while they might argue that their experience has been that prices are falling.
Inflation can be slow cancer, which adds up to a lot. But it does not have to creep in over decades, it can also gallop into terminal hyper-inflation.
One of the biggest fears investors and markets face today is Inflation. It has been called 'the silent killer—and for good reason.
Equity Market Risk as explained by Aswath Damodaran.
Nominal riskless rate = Real riskless rate + Expected inflation rate
For investors, value is created only when returns exceed inflation. So watch out for INFLATION.
Where are we today?
As we move into the Inflationary decade of the 2020s, we face an enemy almost forgotten to generational memory since Central Bankers began money printing after the Dotcom bust.
Like the Hydra from Greek Epics, High Inflation is a multi-headed monster, which is hard for central bankers to control, and one which poses a significant risk to our livelihoods and portfolios. As, Inflation can erode your wealth fast, without you really noticing that it is happening.
The Danger sign was flashing Red
In early 2021, Bank of America's inflation meter noted both Transitory and Persistent Inflation hit highs, while in late 2021, Germany 👇reported the highest Wholesale Price Inflation in 3 decades.
High Inflation: A Monster created by Central Banks via an ‘Act of God’.
Inflation is a derivative, not an input. It is an effect, not a cause. It is not easily controlled by governments and central bankers, who set target inflation numbers, and when out of control, it is often seen as an anomaly in the financial system.
Inflation is normally driven by two factors: Demand-Pull or Cost-Push.
The problem with cost-push inflation is that it reduces the level of aggregate output, but leads to an increase in the price level due to supply-side constraints.
The Cantillon effect: Income Distribution
Is Central Bank "printed" money evenly distributed amongst every person or does it fall into the hands of the few? How does that money affect society? What happened during COVID?
Richard Cantillon was an economist in the 18th century who wrote about money and how it circles around the economy. The so-called Cantillon effect describes the uneven expansion of the amount of money when a central bank pumps more money into the economy. If Mr. Cantillon was alive today, this is how he would have explained this effect.
So, Rich understood that these New Money/Tax-rebates are temporary windfalls, and hence they will tend to save a large proportion of this NEW MONEY.
Furthermore, If corporate profit is greater than GDP, it means inflation will not be 4-5%, it will be 8-10%. And, remember during periods of inflation, not all prices and wages rise proportionately. As mentioned above, the rich are NOT spending much, so most of their consumption is stagnant, however for poor, their consumable will have a HIGH demand Pull. This will eventually affect income distribution.
Can you Model this?
Inflation co-varies with and depends on other variables among which are GDP growth, Unemployment, Tax rates, Core & Headline Inflation, Wage Growth.
Thus, Modelling Inflation is hence seen as a complex financial engineering problem like the modelling of Interest rates, which are considered to be random and unpredictable.
You are an Anomaly, Neo, the only flaw in a harmony of Mathematical Precision
But that does not stop Central Bankers from playing God?
What happened in the 2020-2021 period ? The Central Bankers tinkered too much with money supply, then Covid struck.
Central Bankers felt that target inflation was well within the mathematical precision of their Quantitative Easing (read money printing) and bond-buying programs (read money tapering).
Biggest Question about Inflation: Transitory or Persistent?
LET JANET BANK-SPLAIN TO US HOW EVERYTHING IS UNDER CONTROL
Central Bankers argue that the "demand-pull" inflation has been heavily influenced by aggressive, pandemic-inspired fiscal and monetary stimulus and therefore it is temporary or transitory.
Transitory Inflation includes a rise in prices of Vehicles, Commodity prices and the CPI. Sticky or persistent inflation on the other hand leads to an increase in house-rents, housing prices and wages.
Not all Inflation is bad. Usually, target inflation of 5% annually in developing economies and 2% in developed economies is seen as the economic ideal, as that provides for a solid midpoint where consumption and investments feel tailwinds, but where the average consumer is not hurt too much by the price increase. However not everything is in control of Central Bankers, and Inflation is tough to model and can spiral out of their control.
Conflicts of Interest: It’s a Grey World
What complicates things is that Governments - as separate from Central Banks - may or may not enjoy complete control over the monetary policy. Governments are elected by the people and will concern themselves less with financial stability, and tend to have looser fiscal policies that encourage inflation and put them in conflict with Central Bankers who want to keep inflation under target. A messy consensus is often reached, as was seen in the US with the Infrastructure Bill and the debate around the Debt Ceiling.
Some debt-laden OECD governments may in fact find high Inflation desirable as inflation also reduces the true time value of corporate and personal debt. For example, 8 years at 5% inflation will reduce debt by about a third, in today’s dollars. But there is also record levels of outstanding debt that is sensitive to interest rates, and a spike in interest rates could lead to defaults and financial instability.
Let’s think more deeply about Inflation:
'One key ratio to monitor is the Debt / GDP ratio. While high growth periods often see spikes in inflation, the resulting GDP growth and rise in corporate earnings often ensures inflation is only transitory, as supply catches up with demand constraints. High inflation also erodes the real value of past debts and interest payments, so the Debt / GDP ratio can be maintained even with lower GDP growth.
The other key sensitivity to monitor is real interest rates, or inflation-adjusted interest rates. Real interest rates are still low, when seen historically. China is keeping real interest rates positive on its bonds and it is seeing a flight of capital to buy Chinese debt. This plays into its long term plan to have the Yuan replace the Dollar of treasury bills but it also has the effect of defaults like Evergrande, where companies must pay more interest rates on their bonds than inflation and go under.
So there are complicated inter-relationships at work and it is not fair to say Inflation is good or bad.
Developing democratic nations like India will not, in general, want high inflation as it severely impacts buying power, unless they are commodity exporters that benefit from rising prices like Russia or Brazil.
There is therefore no consensus on what is good versus bad inflation, or target inflation across jurisdictions, no more than within the same country between Central Banks and Governments. There is a global consensus though on one thing: hyper-inflation is bad.
Transitory, Persistent or Hyper-Inflation: Where CAN we go from here in 2022 and beyond?
Scenario 1 "Best-Case" Transitory Inflation: If prices rise temporarily (commodity prices for example) then there is every chance that those prices will decline again, reverting back to the mean. This describes transitory inflation and its case is strengthened most by the fact that demand-pull inflation best describes the post-COVID surge in prices of commodities such as natural gas, steel, semiconductors and lumber.
Scenario 2 "Base-Case" Sticky Inflation: If prices rise once but on a permanent basis then technically inflation increases in the year of the price rise but then flattens in subsequent years. This is not truly transitory inflation as it devalues the spending power that we have and so exerts upward pressure on more than commodity prices, on sticky price rises like housing values and wages (our salaries) leading to de-facto devaluation of the currency. This is sticky inflation.
Scenario 3 "Worst-Case" Hyper Inflation: If prices continue to rise year after year then inflation is clearly out of control. The case study is Turkey, where the local currency and the economy lose all basis and see severe devaluation. This is hyperinflation.
The scary thing is inflation can be seen as a time series moving average where Scenario 1 can trigger Scenario 2, which in turn can trigger Scenario 3. Global economic shifts like de-globalization can further hasten the process as China is a global supplier of goods and raw materials.
"Base Case" for Persistent Inflation in 2022 and beyond
Will persistent inflation lead to hyper-inflation? The key sensitivity here is wage growth. While price increases can reverse relatively easily and without much resistance, salaries are entirely different. Once they go up they are very difficult to bring back down. Commodities have probably seen a ~100% increase over the last 12 months, which will likely work its way into retail pricing over the next few months, which will lead to upward pressures on wage growth.
More technically, the stationary mean of the moving US inflation is comprised broadly of core PCE, headline inflation, core inflation, things of that nature, which have made a higher base relative to where they were in the post-crisis era. Such an outcome often results in an abrupt upward adjustment in Inflation down the road.
History also suggests that modest inflation may increase the risk of an unintended inflation acceleration to double-digit levels, as happened in 1947, and in 1979-1981.
What’s your Hedge against High Inflation?
India’s debt-GDP ratio has been falling for over a decade. India’s ratio is now lower than in Japan (226%), Greece (175%), Italy (130%), France (93.4%), Britain (92%) or even the US (71.8%). So we are in a fairly good position.
Overall, inflation tends to benefit speculators and the wealthy while penalizing poor wage earners and the middle class. As readers of the Grey Swan will be mostly high-earning speculators in asset prices, we will tailor the message on positioning as below:
What to Monitor:
Welfarism - With state and general elections, Indian Government raising the Minimum Support Price which in turn increases food inflation
Wholesale prices - Unlike food inflation, Wholesale inflation depends less on Government Policy and more on global Commodity Prices, where India is a price taker
Chinese policy and economics - China is an exporter of deflation, as it controls supply and demand. Particularly, the direction of Chinese housing prices will be a good sign of real inflation
US 2 year treasury yields - Short term treasury yields are a sign of whether the bond market thinks Inflation is transitory or persistent. When yields drop it is a sign that Inflation is thought to be temporary
Actionable Insight: How to Position your Portfolio:
Put options on US long tenor Treasury ETFs. Fed will eventually need to raise interest rates which will lead to an increase in bond yields thereby causing long tenor (10-20 year) treasury bond prices to fall, leading to profits on Put options
Overweight Energy and Commodities. Energy utility businesses are generally inflation-free as they are fixed non-discretionary expenses. Commodities may be in for a super-cycle due to a new inflation regime and de-leveraged commodity manufacturers and exporters will enjoy multi-year tailwinds.
Tollbooth and Cash Flow positive Software Companies. Software companies with subscription-based cashflows or platform companies with a tollbooth model should continue to be seen as safe, together with cash flow positive IT outsourcing companies. Avoid story-based tech companies (For example many are overweight on Infibeam on it’s over-optimistic narrative and the Fintech hype, but please see the decline of it’s Market Share, and if you have to give you a HINT, see the image below). without free cash flows valued on revenue multiples
Precious Metals and Bitcoin. Historically, precious metals do well in periods of high inflation. Gold and Silver ETFs are seen as safe-havens. Additionally, Fiat currencies in emerging economies may be devalued to relieve pressure from rate hikes in OECD countries, making Gold and Bitcoin attractive
Cash is Trash. Avoid cash-based products and deposits as their real value depreciates rapidly in high inflation regimes
Real assets. It may be a good time to make that long-pending land or real estate purchase, as high inflation regimes can see sticky inflation in home prices and a capital flight away from growth stocks or even corporate bonds back into real assets
Conclusion
We at Grey Swan feel that while fears of Hyper-Inflation are unfounded and in the realm of conspiracy theories, there are fair odds of Inflation becoming sticky or persistent from transitory, and looming beyond the targeted inflation of Central Banks in 2022 and beyond.
There are long term drivers of a new inflation regime that could last a decade or more but we do not see it playing out as a steady, linear trend, but rather as periods of spikes, peaks and deflationary troughs determined in part by the Dollar and the direction of OECD/Chinese economic policy. Investors must therefore adjust to this new economic reality by de-risking and re-balancing their portfolios.