HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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May 9, 2021

The Case Against Inflation

- Time to allocate back towards growth

Staying-in, the new going-out

 

The current dominant concern for investors is the prospect of higher and sustained inflation over the medium term. Last year, retail price inflation was almost non-existent, and the benchmark ten year Treasury yield was 0.6%. Real interest rates were close to zero, and we valued tomorrow much higher than today. The world had just flipped the off switch on the economy, US WTI oil prices had gone negative, “going out stocks” had tanked while “stay at home stocks” soared. The future looked a lot better than the daily reality of growing infection rates, shortages of intensive care beds and rising death tolls. Investor confidence increased in Boohoo and Amazon compared to EasyJet and Restaurant Group.

Damn the future

 

Today things are much different. The 10-year benchmark Treasury yield is c1.5%, a massive increase, but still modest in any historical context, and inflation is everywhere. Oil reference prices are in the mid $60s, US lumber is three times the price of a year ago and copper 40% higher. Consumers are re-emerging from lockdown with higher levels of purchasing power than we have seen in a generation, and we are all set for the onset of the Roaring Twenties. Hold onto your hats because inflation has arrived, meaning we collectively favour instant gratification today, and damn the future.

Mind the deflation

 

However, the risk of deflation remains at least as prevalent today as the risk of inflation. QE and fiscal stimulus are not letting up; they are accelerating. The Biden administration has moved the stimulus needle from a mere $2tn last year to $6tn today. Monetary and economic policy are in uncharted territory, as central banks and treasuries go all out to reach economic escape velocity to repair their balance sheets. The Fed now has the twin objectives of inflation and employment. They need to run things hot, but they cannot afford to allow interest rates to let rip.

More productive

 

Tellingly the US payroll statistics released on Friday came in significantly lower than expected. The economy grew jobs by 266 000 rather than the expected figure of 1m. While it is premature to draw any firm conclusions from this, several factors are likely at play. First is that people will require more significant incentives to return to work as they remain content and well-remunerated, not working. (The unexpected rise in hourly earnings indicates this might be the case). Second, employers are cautious in taking on more staff while working through productivity improvements. As labour returns, it won’t just be more expensive; it will be more productive, a potentially deflationary risk. Expect talk of a “jobless recovery” in due course.

The supply-side 

 

There are a couple of other deflationary factors to consider. First is the risk of inventory unwinds. We don’t know the impact on US lumber prices caused by housebuilders double or triple ordering their requirements. This demand might well be re-stocking supply lines to, just in case, rather than just in time.  As we know, the gospel, according to ESG, tells us we need to build resilience into what we do. The dot.com boom had its Minsky moment when investors woke up to the reality that telco’s and cable companies had massively over-ordered equipment (the fact that most long haul traffic carriers were insolvent didn’t help matters either). It is too early to know how this plays out, but history tells us that supply does recover. The health and resilience of our supply chains is a crucial factor to monitor.

Schumpeter's revenge 

 

Another deflationary force is the re-awakening of creative destruction. While equity markets show signs of mean reverting to value (YTD energy and financial services have both performed strongly), it is worth noting that there remains a government moratorium on corporate failure. Government assistance schemes are masking the necessary adjustment and re-allocation of capital now overdue within the economy. In short, what happens when we take the safety net away, and capitalism’s creative destruction is allowed to play its part again? Cathie Wood of Ark Invest reckons that 50% of the constituents of the S&P 500 are vulnerable. In her view, companies have spent decades pandering to short term investors, gearing up their balance sheets to fund share buybacks while failing to respond to the threat of innovative disruption. Growing debt and lower revenues destroy equity.

Exponential-age

 

Indeed the Ark Invest and Raoul Pal world view, that we are in the midst of an all-encompassing exponential age, sheds a whole new light on the prospect for deflation. For example, the increased adoption of AI in healthcare and higher education offer the medium-term potential of seeing deflation in two significant components of consumer spending, which have only seen structural price increases over the last 30 years. Just as Google, Facebook, Amazon and Apple deflated our world in the previous decade, a more broad range of innovative applications to other areas of our lives will do the same over the coming decade.

Reversion to growth 

 

If the current obsession with inflation becomes overwhelmed by such deflationary forces, then the flip to value in equity markets will prove transitory. The equity market has overcome some pretty tough road bumps so far this year. These include heart-attack-inducing rises in the benchmark 10-year interest rate, US bank capital ratio regulations tightened back up, and significant increases in US capital gains tax rates. The market has carried on, but it has broadened out into more sectors. This adjustment is a finite process, and if the pandemic has taught us anything, the world and our financial markets have speeded up. It is now time to start allocating back towards growth.

Jeremy

Ealing

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