| | Inflation For Now, But Should We Worry About Deflation Later?
May 29, 2021
Summary Supply side shocks are driving the substantial inflation we are currently seeing in raw material prices.Money printing can cause inflation, but it depends how it's being put to use.It also causes the dollar to decline, interacting with the peculiar situation of US government finances.It's tough to say what will happen, but rampant inflation is by no means a foregone conclusion. Even deflation could be incoming.We think that regardless of what happens with price levels, the USD is set to suffer relative to other major currencies.
There is no question that raw material prices are rising. There is also no question that prices of important elements of the typical consumer's basket are also rising, just listen to calls from any consumer staples companies like Kimberly-Clark ( KMB), Danone ( OTCQX:DANOY) and Unilever ( UL) among others.
By definition, that is inflation. So the question then becomes what is driving it, and will inflation sustain?
In our opinion it probably won't, at least it won't spiral out of control into a total disaster for the economy and shareholders. We believe that the inflation is primarily being driven by supply-side forces, and that will sort itself out, but there will need to be a slowdown in the economy to really control it. Regardless of that, we think the effects on the USD are unambiguously negative. That is our main concern as it pertains to US markets. We'll do our best to explain our logic below.
Effects of Money PrintingMore money sloshing around will cause inflation if the money is put to purposes that don't generate a return on investment, i.e. a growth in economic productivity. Will that happen in the current case for the US? Probably slight productivity improvements can be expected, but not enough to offset somewhat higher inflationary pressures, which are themselves indirectly mitigated by the money printing. Moreover, as discussed later, the likely Biden tax increases will probably take care of any net inflationary pressures, reducing the chances of reaching the Trump-era lows in unemployment levels.
What are the moving parts that we see will bring on some net inflationary pressures, absent further government intervention?
Much of the money is being used for speculative purposes in asset markets. Retail investors are likely to lose out to wealthy entities, and this is probably going to have a net negative effect on GDP. If they don't lose to wealthy entities, it will be from having invested in tangible cash flow streams, where the buoyancy of the stock price will generate no effect on overall productivity, since it will still be more worth it to raise debt. So on one hand, the printed money not being used for consumption should not have any direct effect on inflation, as it is not being spent on products nor increasing productivity, but might later have negative effects through the destruction of value if speculative markets turn, leading more likely to deflationary forces.
Printed money going into consumption will clearly have some inflationary impact, but the fact that consumption patterns under COVID-19 are emphasizing digital business models so much may end up having an expansionary effect on the US economy's productive capacity, which would have an offsetting deflationary impact. However, these positive effects will be tempered by greater income inequality, and are likely not going to be sufficient to offset the greater money supply, simply due to the quantum of printing and the already mature campaign of ousting traditional business models even without the impulse from COVID-19.
Supply-SideThe more pressing issue is to do with temporary supply side impacts that have reduced productivity during the pandemic, where money printing has concurrently boosted consumption.
Why do we assert these supply-side effects are temporary? We can use industrial logic and common sense to assume that they are, at least in part. Force majeure has been flexed as much as possible by commodity producers under the pandemic, which slowed production and led to a shortfall in supply now, where a quickly recovering demand cannot be caught up with by industry recovering much later and already operating now at full capacity. Moreover, rallied prices in highly transmissible basic commodities will lead to slowdowns in activity by producers further downstream as they wait for opportunities to raise prices, or for those inputs to normalise to make a wider incremental margin.
The Winter Storm 2021 and the Suez Canal debacle also have contributed to these issues. Moreover, the government paying people to not work and stay at home is also concurrently stifling productivity. Indeed, supply side issues are very important for prices, but they should resolve over the next couple of years.
Biden and TaxMore money sloshing around right now with decreasing unemployment as things reopen and a supply-side deficit is going to cause some inflation. What's certainly notable is that inflation begets inflation through the cycles of wage negotiation and raising prices. Even though we think that inflationary pressures longer-term are rather limited, the fact that we have inflation now could drive more serious inflation later regardless. We think this plays into the likely moves that the Biden administration will make in increasing taxes on both the enlarging tech monopolies and endowed individuals. This will be deflationary to be sure, and with the net inflationary pressures already potentially reducible by a bad ending for retail speculators, with a more healthy deflationary pressure from changing shares to digital models increasing productivity, we might have a new problem to worry about.
Maybe Deflation? Still the Dollar SuffersWith the potential value destruction in markets among retail investors, and deflationary pressures coming from likely tax changes, inflation shouldn't be the main concern. In fact, the economy may not altogether reopen so easily, and unemployment levels may not entirely recover either due to the substantial structural changes in the employment markets that the pandemic has induced. Unemployment will not be helped by greater corporate taxes either.
We think that deflation could even occur.
If deflation occurs, then the situation becomes even more serious. It'll have to be tackled hard by the Fed, since deflation really gets out of control thanks to the death spiral. Further monetary accommodation would wreak further havoc on the dollar, which has already been punished by the planned monetary profligacy. The interaction between the dollar strength and the US 'exorbitant privilege' as the world's reserve currency could compound these problems making the tail risks fatter in the evolving economic situation. Nonetheless, a deflationary situation will have to be dealt with by more money printing and government spending, which would further hurt the dollar and potentially complicate the US financing situation.
While disinflation is far more likely than actual deflation, it would still take its toll on the dollar and US markets.
Conclusion We hold pretty standard views on the reopening, and we think that together with reopening and with a bit of time, the supply-side induced component of inflation should go away. Regardless, more money sloshing around means higher inflationary pressure, that is unlikely to be offset by potential net productivity gains resulting from responses to the pandemic. Tax changes are coming, and we think that unemployment will not recover to Trump era lows. Overall, we think a more deflationary (disinflationary) environment than expected is a very real possibility.
Regardless, we think that there are several eventualities, either inflation or deflation, where the dollar will continue to dive relative to other major currencies, ranging from slight further declines due to definite differences in monetary profligacy between the US and other economies, to more serious declines due to threats to the USD as the reserve currency, in interaction with the US deficit financing situation, the Biden regime spending plans and the increasing relevance of China in world politics.
So while we're worried about some inflation for now, it's not a particularly long-term concern. Instead, we fear for the dollar, and have moved substantially out of USD investment with the exception of stocks with unusual upsides or exceptional innovation that can only be found on US soil. More than 80% of our portfolio is now in Europe, where markets are also generally more discounted relative to frothy US markets. |
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