Inflation – the first stage of grief is denial

February 18, 2021

10:54 am

Inflation – the first stage of grief is denial
  • At the sound of barking during a film, a dog looks up quizzically from its basket, head half-cocked as it recognises the type of noise but knows somehow that it’s different. It turns towards the TV and starts growling. Its owner pats it on the head and reassures it that it’s “just a TV dog” and that there is nothing to worry about. Right now, the Fed might be hoping that it is the owner, the dog is the bond market, and inflation is the barking on the TV. What happens if the film is ‘101 Dalmatians’?

  • There is a school of thought that you can’t have inflation without the velocity of money (the turnover or number of times it’s spent) increasing. This is true even with a huge increase in the amount of money in the system. The graph below (St Louis Federal Reserve Data) shows the M2 money supply (cash, sight deposits and ‘near money’ like time deposits and some mutual fund balances) in blue and M2 velocity in red. Clearly, in 2020 M2 has rocketed while the velocity has collapsed. No velocity, no inflation. Why is this so?
Graph

Source: Board of Governors; St Louis Fed, 31st December 2020.

 
  • The answer lies in the quantity theory of money. The equation MV = PQ has M (the amount of money) multiplied by V (its velocity – the two components shown in the graph above) balanced against P (price levels) multiplied by Q (the economy’s output, often stylised as GDP). At a given level of output or GDP (Q), inflation (a rise in P) only comes if the quantity of money (M) and its velocity (V) are both rising. With US GDP having fallen in 2020 along with the velocity of money, you can’t have inflation moving much higher. In theory.

  • Part of the fall in velocity is because of the sheer amount of money created by the Fed in 2020 coupled with lockdowns preventing people from spending it. The ‘real’ unemployment rate in the US is still over 10% per Fed calculations, and this also means a lot of folk don’t have as much money to spend despite lockdowns. While median US household income has risen in 2020, averages are misleading here. That said, as America opens up and gets back to work post-pandemic, the velocity should naturally rise.

  • The other reason for the falling velocity is that a huge amount of the newly created money has been invested in the financial economy. The personal savings rate peaked at a staggering 34% in April 2020 during lockdown 1.0, but the most recent reading as at December 2020 still shows an elevated savings rate of 13.7% versus an average of around 7% in previous years. Clearly, a lot of money has been parked in banks, money-market mutual funds (and the stock market…), and this doesn’t appear in M2 velocity calculations. It does arguably create asset price inflation though.

  • If M2 velocity is telling you there is no inflation, then the commodity market is revealing a bit of a different story. The graph below shows the Bloomberg Agricultural subindex (BCOMAG) which comprises of a basket of soft commodities including soybean, corn, sugar and wheat, and is often used as a leading indicator within the commodity suite for inflation. Commodity prices are always subject to supply and demand issues – for example China is importing more soybeans to build up its pig herd and more wheat due to a rain affected harvest in 2020. But as the graph below shows, the price of the basket is rocketing higher.
Graph

Source: Bloomberg, 10 February 2021. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Swiftly-rising prices are not just to be observed in the soft commodities. From a $216 low in March 2020, the March 2021 front-month copper future is currently at a multi-year high of $377 (vs. a peak of $463 in 2011). Lumber is at an all-time high of $947 (the prior peak was $624 per tonne in 2018). The West-Texas Intermediate oil future is at $58.5 – this is the same as pre-pandemic levels even with no one travelling. Commodity prices are surging everywhere.

  • Rising input prices from higher commodity prices are already making themselves felt in corporate earnings. We are currently in the middle of Q4/full year earnings season. Below is a selection of comments from corporates reporting in the last few weeks:

  • Eaton (EV.US): “with respect to supply chain, yes, we’re absolutely seeing it (input cost pressures). We’re seeing inflationary pressures in copper. We’re seeing it in some steel. We’re seeing some availability and some pressures also on microprocessors and the like around the company.”

  • Coloplast (COLOB.DC): “cost pressure from wage inflation and labour shortages”.

  • Atkore (ATKR.US): “working to quickly absorb and pass-through our higher input costs.”

  • NXP Semiconductors (NXPI.US): “we are seeing price increases, hopefully pass them on (to customers) pretty quickly”.

  • Microchip (MCHP.US): “We are seeing broad-based cost increases and some aggressive commercial terms from our supplier base, and we must pass these cost increases to our customers through a broad-based price increase.”

  • Arrow Electronics (ARW.LN): “the price increases are coming now.”

  • Kimball (KE.US): “Margin pressure experienced due to spiking freight costs and the inflation impact on raw materials”.

  • Powell Industries (POWL.US): “we will see some inflation in commodities going forward”.

  • Century Communities (CCS.US): “material and labour cost increases.”

  • Peloton (PTON.US): “shipping costs were about 3x of what we would normally pay”.

  • Valvoline (VVV.US): “passing through cost increases”.

  • Assa Abloy (ASSAB.SS): “starting to hike prices due to raw materials”.

  • Clearly tracking the velocity of M2 money is not a luxury that actual businesses can afford. Inflation is here, and the question is whether it is here to stay. Market measures of inflation are moving sharply higher. The graph below shows the implied inflation breakeven on 5yr US Treasury TIPS (inflation-adjusted bonds). At 2.34%, not only is this through the Fed’s medium-term target of 2%, but it is way higher than it was pre-pandemic and is in touching distance of the pre-global financial crisis level.
Graph

Source: Bloomberg 10 February 2021.

  • This graph also offers a hint a why inflation is on the march. If one compares the ‘V’ in the graph above from 2008-9 and 2020, one can see that the market never priced in outright deflation the second time around. This is because the Fed was already doing quantitative easing (QE) before the pandemic struck, and merely turned it up to 11 during lockdown. First time around, the Fed only started QE in December 2008. The volume of QE in 2020 also dwarfed not only QE 1 but also QE 2 and 3 combined. The big difference between then and now is the US deficit – the austerity of 2009 has been replaced by fiscal largesse. When the government is expanding credit and the Fed is monetising the debt to do it, it looks like you get inflation. This isn’t theory – this is just an observation of market prices as they stand early in 2021.

  • The Fed has already set out its stall. The new ‘average’ inflation policy means the Fed will tolerate inflation above 2% in order to play catch up for the time when inflation was below 2%. The Fed is already expecting higher inflation in 2021 in part from base effects – this is the year-to-year comparison of prices which will, in 2021, involve comparing prices to those in 2020 which were considerably lower due to the lockdown which started in March 2020. In a speech on February 9th, President of the Dallas Fed, Robert Kaplan, reiterated the stance – he won’t be surprised by a temporary rise in inflation, although cyclical elements of inflation may grow over time. Importantly, he said neither rate hikes nor the tapering of QE is imminent. It’s just a TV dog.

  • When you add up the possibility of a splurge of spending with the end of the pandemic, the reshoring of supply chains due to the trade war, rising transport, shipping and commodity costs, an economic recovery juiced by massive US infrastructure spending, a new $15 minimum wage, and new child-support payments, there is a confluence of inflationary pressures which one might expect in a recovery but also a genuine political shift to demand-side economics by the new Biden administration. The output gap is large in the US, as is the rate of unemployment. The huge stock of debt mitigates against inflation too (debt servicing diminishes consumption and is deflationary, all else equal). But when you talk about government deficit spending getting to 25% of GDP over a year or so, it is a sort of now or never moment for inflation.

  • No fear though. Secretary of the Treasury Janet Yellen has been quoted on the weekend of February 6th as saying, “I’ve spent many years studying inflation and worrying about inflation. And I can tell you we have the tools to deal with that risk if it materialises”.

  • Not only do they not expect inflation to be anything but a transitory phenomenon, they can also deal with it. The last time they had to do this was in the early 1980s when Paul Volker at one point in 1981 took rates to 20%. Back then, the stock of debt (public and private) was a fraction of what it is now. We know from Jay Powell’s auto-pilot rate hiking in Q4 2018 and the subsequent collapse of the equity market and the closing of the credit market that aggressive monetary tightening with a large stock of debt is fatal to markets. The stock of debt in 2021 is a lot higher even than in 2018, largely due to the pandemic.

  • While some question whether anyone has the guts to do what Volker did, the real question should be whether the tools even exist to control inflation with such a large stock of debt outstanding. The Fed is in a trap – you hike rates and crash markets through deflation and default, or you continue with the expansionary monetary policy and inflation eats away at capital. It’s like choosing to be electrocuted by AC or DC. The best thing for now is to say you expect some inflation but add that it’ll be transitory. The question is for how long the denial can continue.

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In case you missed it…

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.

This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.

RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.

Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.

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Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.

AIFMD and Distribution in the European Economic Area (“EEA”)

The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.

In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).

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