Quarterly Investment Update: 2020 Quarter 1

Source: The Economist 10/12/19

Who’s Afraid of Inflation?

Are you afraid of inflation?  Probably not, and if that is the case, then you are in good company.  In developed economies all around the world inflation rates are at all-time lows.  In the US, inflation rates have been falling since 1980.  In fact, the US average annual inflation rate over the past ten years was only 1.77%, the second lowest since 1965.  So, it stands to reason that with nearly 40 years of falling inflation that one might begin to find other risks to focus on mitigating.

The arguments for why inflation will stay low are certainly compelling.  First, globalization & outsourcing have reduced labor costs and allowed low cost producers to compete globally.  Second, technology has boosted production efficiency and dramatically improved the quality of virtually all products that contain microchips or services that are based on software.  Third, the internet has dramatically reduced the costs of communicating and unlocked additional cost saving opportunities.  Fourth, governments have built up credibility as inflation fighters.

While all of those arguments intuitively make sense, on closer inspection, we see reasons to be a little more skeptical.  Economic nationalism has taken root all over the world, causing trade barriers to rise and forcing businesses to rethink the risks imbedded in their supply chains.  Moreover, the “big tech” companies that have leveraged technology and the internet to grow globally have come under fire from consumers, regulators and foreign governments.  New regulations could hamper big tech’s ability to grow in the future.  And a more Balkanized global high-tech economy could be more expensive and less efficient.  Lastly, as we will explore further, governments may lack the political will to fight inflation if it means exacerbating inequality.             While we don’t expect inflation to pick up sharply in the short-term, our assessment is that financial markets are now pricing in virtually zero inflation risk in the future.  The beauty of financial markets is that a threat identified early enough can become an opportunity.  The best time to buy umbrellas is when the sun is shining.  Right now, inflation umbrellas are as cheap as they have ever been.

Executive Summary

  • The Quarter in Review
  • Sentiment & Value Update
  • Three Flavors of Inflation
  • Modern Monetary Theory
  • Inflation Winners?

The Quarter in Review

Global stock markets ripped higher as central banks continued to lower interest rates and trade war fears melted away based on reports of a “Phase One” deal between the US and China.  The Federal Reserve further bolstered optimism in asset prices by purchasing an additional $400B worth of T-Bills, almost completely reversing an attempt to shrink the balance sheet over the prior 20 months.  The combination of trade war optimism and Fed support helped the S&P 500 break out of its two-year trading range.  With the trade war on pause and the Fed supporting markets, recession fears faded and safe havens like bonds gave back some of their gains from earlier in the year.

Relevant Index Performance

Sentiment & Value

The chart above shows our opinion on where various markets are as of December 31st, 2019.  Many of the best purchase decisions are made when prices are cheap and sentiment is bearish or depressed (bottom left quadrant).  Conversely, many of the best sell decisions are made when prices are expensive and sentiment is bullish or euphoric (top right quadrant).  This chart and the comments below are intended as a behavioral guide, not as a timing tool.

It’s often said that stock markets “climb a wall of worry” and that it’s when they reach a euphoric state that we need to be fearful.  With trade war fears in the rear-view mirror, it certainly seems like US stock investors are approaching euphoria.  Unless fears about the US election or geopolitical risk crop up, the stage is set for a last-gasp, euphoric stock market rally.  Such rallies tend to be short-lived (less than a year) and often end up creating long-term market tops, but timing such things is virtually impossible.  Given that we see most financial assets as being relatively overvalued, we continue to have a conservative stance.  All things being equal, if the S&P 500 were to trade below 2,700, we would be interested in increasing our exposure to US stocks and if the 10-year treasury yielded more than 2.50% we would be interested in adding to our long-term bond positions.

Source: Goldman Sach Investment Research, Marc Faber

Three Flavors of Inflation

Most people understand that inflation means rising prices, but beyond that things get confusing pretty quickly.  We think it is helpful to break inflation down into 3 main categories:

Goods & Services – The inflation number most people think about is the Consumer Price Index (CPI).  The CPI measures the changes in price for basket of goods and services that roughly represent the cost of living for an urban consumer.  This rate has rarely been above the Fed’s 2% target since 2009.

Financial Assets – The key thing to remember about financial assets is that these prices tend to move inversely with interest rates.  In other words, when interest rates fall, financial asset values generally rise.  Given that wealthy people own more financial assets, low interest rates tend to exacerbate inequality.  During this most recent period of very low interest rates, financial asset price inflation has been very high!

Labor/Wage Rates – Just as we all buy goods and services, we all have something to sell, our time and energy through labor.  Wage rates are a very important component of inflation forecasting because if wages don’t rise in line with the price of goods and services, consumers and economic growth suffer.  Conversely, when wages rise faster than the price of goods and services, it can fuel inflation and create an “inflationary spiral.”  The history of the past 40 years of inflation fighting has basically been about raising interest rates enough to cause a recession when wage inflation starts to break out.Rising wages are an equalizing tool for society.  We are skeptical that the Fed still has the political will to risk triggering a recession in order to nip wage growth in the bud.  

Modern Monetary Theory

With populist candidates gaining so much traction, we wouldn’t be at all surprised if the 2020 election turns into a contest to see which candidate can present the most audacious unfunded spending program.  One school of thought that supports aggressive spending plans for candidates on both sides of the aisle is “Modern Monetary Theory” (MMT).  We expect you will hear more and more about MMT, so here is a quick primer.

MMT proponents believe:

  • MMT asserts that the federal government does not need to borrow money that it doesn’t have, rather it can just print more money.  Note: under the current system the US government must borrow by issuing bonds (a financial asset) to spend money it doesn’t have.
  • Government spending is an important source of jobs & economic growth.  More is better.
  • Massive government spending & debt do not cause inflation, just look at Japan!
  • Government will still use tax policy to create economic incentives and generate most government revenues.
  • Government still borrows money by issuing bonds, but is not constrained by a “budget.”
  • Government reduces spending and does not print money if inflation rises “too much.”

FC’s take:

MMT makes some valid points, but it has a significant flaw.  It cuts the link between the supply of money and the amount of assets in the economy.  Inflation is only half math; the other half is psychology.  Without a direct link to assets, governments eventually justify printing too much and consumers question the integrity of the currency.  Once faith in a currency falters, it’s very difficult to win back.

Throughout most of the history of the US, there has been either a link to hard assets (gold, most of pre-1971) or a link to total assets (financial assets + hard assets, 1971-present).  But the US has experimented with currencies that are only backed by promises & faith in government.   Continental currency (during the American Revolution) and the currencies of both sides during the Civil War are notable examples.  In each case significant inflation followed in short order.

Economic policy and politics are inextricably linked.  Despite our concerns, we believe that MMT and other aggressive, populist, policies are likely to continue gaining support.

Inflation Winners

Many asset classes are pricing in close to 0% odds of rising inflation anytime soon, that means we can buy assets that are likely to be relative winners in an inflationary environment at very attractive prices.  Moreover, with inflation expectations so low, we don’t really even need a sharp uptick in inflation, all we need is for investors to begin to fear the possibility of higher inflation.  Here are some of our favorite inflation winners:

  • Short-term bonds & cash vs long-term bonds: as of 12/31/19 30-year treasury bonds were yielding 2.39%, meaning that for the next 30 years inflation would need to average 1.39% per year or less for investors to make at least an average of 1% per year over inflation.  As of the end of December the CPI rate of inflation was 2.30%.
  • Gold & gold miners: gold prices tend to do very well when fear of inflation is rising.
  • Energy stocks: commodities that people & businesses have to buy tend to do well when inflation rises.  Global demand for natural gas and oil is unlikely to fall for many years.  Recently many of these businesses have significantly reduced the number of new wells they are drilling.  The stage is set for rising energy prices and the stocks are dirt cheap.
  • Internet advertising: advertising revenue tends to keep up with rising prices fairly well.  We expect these businesses to continue growing nicely in an inflationary economy.
  • Asset rich businesses vs high growth businesses: very high growth businesses are similar to long-term bonds in that investors are counting on the cash flows many years into the future to justify current valuations.  As inflation rises, these businesses will almost certainly lose their luster.  Meanwhile, businesses that control productive assets and infrastructure are likely to have pricing power in an inflationary economy.  Many of these businesses have been tossed aside by investors looking to buy high growth businesses.

If you have questions about these topics or any other financial needs, please contact

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