This blog is going to be long. I blame the word inflation, be it transitory or not, for inflating its length. Many of the thoughts and words were compiled from articles written by two of my favorite authors on the subject of economics and investing: Vitaliy Katsenelson and John Mauldin (from whom I have borrowed liberally).
The number one question I am asked by clients, friends and random strangers is – “Are we going to have inflation?”
I think about inflation on three timelines: short, medium, and long-term.
The pandemic disrupted a well-tuned but perhaps overly optimized global economy and time-shifted the production and consumption of various goods. For instance, in the early days of the pandemic, automakers cut their orders for semiconductors. As orders for new cars have come rolling back, it is taking time for semiconductor manufacturers, who, like the rest of the economy, run with little slack and inventory, to produce enough chips to keep up with demand. A $20 device the size of a quarter that goes into a $40,000 car may have caused a significant decline in the production of cars and thus higher prices for new and used cars.
Here is another example. The increase in new home construction and spike in remodeling drove demand for lumber while social distancing at sawmills reduced lumber production – lumber prices spiked 300%. Costlier lumber added $36,000 to the construction cost of a house, and the median price of a new house in the US is now about $350,000.
The semiconductor shortage will get resolved by 2022, car production will come back to normal, and supply and demand in the car market will return to the pre-pandemic equilibrium. This is transitory inflation. It’s a strictly short-term phenomenon. High prices in commodities are cured by high prices. High lumber prices will incentivize lumber mills to run triple shifts. Increased supply will meet demand, and lumber prices will settle at the pre-pandemic level in a relatively short period of time. That is the beauty of capitalism!
Most high prices caused by the time-shift in demand and supply fall into the short-term basket, but not all. It takes a considerable amount of time to increase production of industrial commodities that are deep in the ground – oil, for instance. Low oil prices preceding the pandemic were already coiling the spring under oil prices, and COVID coiled it further. It will take a few years and increased production for high oil prices to cure high oil prices. Oil prices may also stay high because of the weaker dollar, but I’ll come back to that.
Federal Reserve officials have told us repeatedly they are not worried about inflation; they believe it is transitory, for the reasons I described above. I’m a bit less dismissive of inflation, and the two factors that worry me the most in the longer term are labor costs and interest rates.
Let’s start with labor costs.
During a garden-variety recession, companies discover that their productive capacity exceeds demand. To reduce current and future output they lay off workers and cut capital spending on equipment and inventory. The social safety net (unemployment benefits) kicks in, but not enough to fully offset the loss of consumer income; thus, demand for goods is further reduced, worsening the economic slowdown. Through millions of selfish transactions (microeconomics), the supply of goods and services readjusts to a new (lower) demand level. At some point this readjustment goes too far, demand outstrips supply, and the economy starts growing again.
This pandemic was not a garden-variety recession.
The government manually turned the switch of the economy to the “off” position. Economic output collapsed. The government sent checks to anyone with a checking account, even to those who still had jobs, putting trillions of dollars into consumer pockets. Though output of the economy was reduced, demand was not. It mostly shifted between different sectors within the economy (home improvement was substituted for travel spending). Unlike in a garden-variety recession, despite the decline in economic activity (we produced fewer widgets), our consumption has remained virtually unchanged. Today we have too much money chasing too few goods– that is what inflation is. This will get resolved, too, as our economic activity comes back to normal.
Today, though the CDC says it is safe to be inside or outside without masks, the government is still paying people not to work. Companies have plenty of jobs open, but they cannot fill them. Many people have to make a tough choice between watching TV while receiving a paycheck from big-hearted Uncle Sam and working. Zero judgement here on my part – if I was not in love with what I do and had to choose between stacking boxes in Amazon’s warehouse or watching Amazon Prime while collecting a paycheck from a kind uncle, I’d be watching Sopranos for the third time.
To entice people to put down the TV remote and get off the couch, employers are raising wages. For instance, Amazon has already increased minimum pay from $15 to $17 per hour. Bank of America announced that they’ll be raising the minimum wage in their branches from $20 to $25 over the next few years. The Biden administration may not need to waste political capital passing a federal minimum wage increase; the distorted labor market did it for them.
These higher wages don’t just impact new employees, they help existing employees get a pay boost, too. Labor is by far the biggest expense item in the economy. This expense matters exponentially more from the perspective of the total economy than lumber prices do. We are going to start seeing higher labor costs gradually make their way into higher prices for the goods and services around us, from the cost of tomatoes in the grocery store to the cost of haircuts.
Only investors and economists look at higher wages as a bad thing. These increases will boost the (nominal) earnings of workers; however, higher prices of everything around us will negate (at least) some of the purchasing power.
Wages, unlike timber prices, rarely decline. It is hard to tell someone “I now value you less.” Employers usually just tell you they need less of your valuable time (they cut your hours) or they don’t need you at all (they lay you off and replace you with a machine or cheap overseas labor). It seems that we are likely going to see a one-time reset to higher wages across lower-paying jobs. However, once the government stops paying people not to work, the labor market should normalize; and inflation caused by labor disbalance should come back to normal, though increased higher wages will stick around.
There is another trend that may prove to be inflationary in the long-term: de-globalization. Even before the pandemic the US set plans to bring manufacturing of semiconductors, an industry deemed strategic to its national interests, to its shores. Taiwan Semiconductor and Samsung are going to be spending tens of billions of dollars on factories in Arizona.
The pandemic exposed the weaknesses inherent in just-in-time manufacturing but also in over reliance on the kindness of other countries to manufacture basic necessities such as masks or chemicals that are used to make pharmaceuticals. Companies will likely carry more inventory going forward, at least for a while. But more importantly more manufacturing will likely come back to the US. This will bring jobs and a lot of automation, but also higher wages and thus higher costs.
If globalization was deflationary, de-globalization is inflationary.
I am not drawing straight-line conclusions, just yet. A lot of manufacturing may just move away from China to other low-cost countries that we consider friendlier to the US; India and Mexico come to mind.
And then we have the elephant in the economy – interest rates, the price of money. It’s the most important variable in determining asset prices in the short term and especially in the long term. The government intervention in the economy came at a significant cost, which we have not felt yet: a much bigger government debt pile. This pile will be there long after we have forgotten how to spell social distancing. The US government’s debt increased by $5 trillion to $28 trillion in 2020 – more than a 20% increase in one year! At the same time the laws of economics went into hibernation: The more we borrow the less we pay for our debt, because ultra-low interest rates dropped our interest payments from $570 billion in 2019 to $520 billion in 2020.
That is what we’ve learned over the last decade and especially in 2020: The more we borrow the lower interest we pay. I should ask for my money back for all the economics classes I took in undergraduate and graduate school!
This broken link between higher borrowing and near-zero interest rates is very dangerous. It tells our government that how much you borrow doesn’t matter; you can spend (after you borrow) as much as your Republican or Democratic heart desires.
However, by looking superficially at the numbers I cited above we may learn the wrong lesson. If we dig a bit deeper, we learn a very different lesson: Foreigners don’t want our (not so) fine debt. It seems that foreign investors have wised up: They were not the incremental buyer of our new debt – most of the debt the US issued in 2020 was bought by Uncle Fed. Try explaining to your kids that our government issued debt and then bought it itself. Good luck.
Let me make this point clear: Neither the Federal Reserve, nor I, nor a well-spoken guest on CNBC knows where interest rates are going to be (the total global bond market is bigger even than the mighty Fed, and it may not be able to control interest rates in the long run). But the impact of what higher interest rates will do to the economy increases with every trillion we borrow. There is no end in sight for this borrowing and spending spree.
Let me provide you some context about our financial situation.
The US gross domestic product (GDP) – the revenue of the economy – is about $22 trillion, and in 2019 our tax receipts were about $3.5 trillion. Historically, the-10-year Treasury has yielded about 2% more than inflation.
These negative real (after inflation) interest rates are unlikely to persist while we are issuing trillions of dollars of debt. But let’s assume that half of the increase is temporary and that 2% inflation is here to stay. Let’s imagine the unimaginable. Our interest rate goes up to the historical norm to cover the loss of purchasing power caused by inflation. Thus, it goes to 4% (2 percentage points above 2% “normal” inflation). In this scenario our federal interest payments will be over $1.2 trillion (I am using vaguely right math here). A third of our tax revenue will have to go to pay for interest expense. Something has to give. It is not going to be education or defense, which are about $230 billion and $730 billion, respectively. You don’t want to be known as a politician who cut education; this doesn’t play well in the opponent’s TV ads. The world is less safe today than at any time since the end of the Cold War, so our defense spending is not going down (this is why I favor several defense stocks).
The government that borrows in its own currency and owns a printing press will not default on its debt, at least not in the traditional sense. It defaults a little bit every year through inflation by printing more and more money. Unfortunately, the average maturity of our debt is about five years, so it would not take long for higher interest expense to show up in budget deficits.
Money printing will bring higher inflation and thus even higher interest rates.
If things were not confusing enough, higher interest rates are also deflationary.
We’ve observed significant inflation in asset prices over the last decade; however, until this pandemic we had seen nothing yet. Median home prices are up 17% in one year. The wild, speculative animal spirits reached a new high during the pandemic. Flush with cash (thanks to kind Uncle Sam), bored due to social distancing, and borrowing on the margin (margin debt is hitting a 20-year high), consumers rushed into the stock market, turning this respectable institution (okay, wishful thinking on my part) into a giant casino.
It is becoming more difficult to find undervalued assets. I am a value investor, and believe me, I’ve looked (we are finding some, but the pickings are spare). The stock market is very expensive. Its expensiveness is setting 100-year records. Except, bonds are even more expensive than stocks – they have negative real (after inflation) yields.
But stocks, bonds, and homes were not enough – too slow, too little octane for restless investors and speculators. Enter cryptocurrencies (note: plural). Cryptocurrencies make Pets.com of the 1999 era look like a conservative investment (at least it had a cute sock commercial). There are hundreds if not thousands of crypto “currencies,” with dozens created every week. (I use the word currency loosely here. Just because someone gives bits and bytes a name, and you can buy these bits and bytes, doesn’t automatically make what you’re buying a currency.)
“The definition of a bubble is when people are making money all out of proportion to their intelligence or work ethic.” – The Big Short
I keep reading articles about millennials borrowing money from their relatives and pouring their life savings into cryptocurrencies with weird names, and then suddenly turning into millionaires after a celebrity CEO tweets about the thing he bought. Much ink is spilled to celebrate these gamblers, praising them for their ingenious insight, thus creating ever more FOMO (fear of missing out) and spreading the bad behavior.
Unfortunately, at some point they will be writing about destitute millennials who lost all of their and their friends’ life savings, but this is down the road. Part of me wants to call this crypto craziness a bubble, but then I think that’s disrespectful to the word bubble, because something has to be worth something to be overpriced. At least tulips were worth something and had a social utility. (I’ll come back to this topic later in the blog).
When interest rates are zero or negative, stocks of sci-fi-novel companies that are going to colonize and build five-star hotels on Mars are priced as if they already have regular flights to the Red Planet every day of the week. Rising interest rates are good diffusers of mass delusions and rich imaginations.
In the real economy, higher interest rates will reduce the affordability of financed assets. They will increase the cost of capital for businesses, which will be making fewer capital investments. No more 2% car loans or 3% business loans. Most importantly, higher rates will impact the housing market.
Up to this point, declining interest rates increased the affordability of housing, though in a perverse way: The same house with white picket fences (and a dog) is selling for 17% more in 2021 than a year before, but due to lower interest rates the mortgage payments have remained the same. Consumers are paying more for the same asset, but interest rates have made it affordable.
At higher interest rates housing prices will not be making new highs but revisiting past lows. Declining housing prices reduce consumers’ willingness to improve their depreciating dwellings (fewer trips to Home Depot). Many homeowners will be upside down in their homes, mortgage defaults will go up… well, we’ve seen this movie before in the not-so-distant past. Higher interest rates will expose a lot of weaknesses that have been built up in the economy. We’ll be finding fault lines in unexpected places – low interest has covered up a lot of financial sins.
And then there is the US dollar, the world’s reserve currency. Power corrupts, but unchallenged and unconstrained the power of being the world’s reserve currency corrupts absolutely. It seems that our multitrillion-dollar budget deficits will not suddenly stop in 2021. With every trillion dollars we borrow, we chip away at our reserve currency status (Vitaliy Katsenelson of Contrarian Edge has written about this topic in great detail, including our national complacency and arrogance, and things have only gotten worse since). And as I mentioned above, we’ve already seen signs that foreigners are not willing to support our debt addiction.
Am I yelling fire where there is not even any smoke?
Higher interest rates are anything but a consensus view today. Anyone who called for higher rates during the last 20 years is either in hiding or has lost his voice, or both. However, before you dismiss the possibility of higher rates as an unlikely plot for a sci-fi novel, think about this.
In the fifty years preceding 2008, housing prices never declined nationwide. This became an unquestioned assumption by the Federal Reserve and all financial players. Trillions of dollars of mortgage securities were priced as if “Housing shall never decline nationwide” was the Eleventh Commandment, delivered at Mount Sinai to Goldman Sachs. Or, if you were not a religious type, it was a mathematical axiom or an immutable law of physics. The Great Financial Crisis showed us that confusing the lack of recent observations of a phenomenon for an axiom may have grave consequences.
Today everyone (consumers, corporations, and especially governments) behaves as if interest rates can only decline, but what if… I know it’s unimaginable, but what if ballooning government debt leads to higher interest rates? And higher interest rates lead to even more runaway money printing and inflation?
This will bring a weaker dollar.
A weaker US dollar will only increase inflation, as import prices for goods will go up in dollar terms. This will create an additional tailwind for commodity prices.
If your head isn’t spinning from reading this, I promise mine is from having written it.
To sum up: A lot of the inflation caused by supply chain disruption that we see today is temporary. But some of it, particularly in industrial commodities, will linger longer, for at least a few years. Wages will be inflationary in the short-term and will reset prices higher, but once the government stops paying people not to work, wage growth should slow down. Finally, in the long term a true inflationary risk comes from growing government borrowing and budget deficits, which will bring higher interest rates and a weaker dollar with them, which will only make inflation worse and will also deflate away a lot of assets.
Question: How do I invest your money to prepare for the possibility of higher inflation?
Answer: Thoughtfully and humbly.
We need to recognize that inflation in the long-term is a probability but not a certainty. Macroeconomics is a voodoo science; it appropriately belongs in the liberal arts department. The economy is an incredibly complex and unpredictable system.
Here is an example: Japan is the most indebted developed nation in the world (its debt-to-GDP exceeds 260%, while ours is 130% or so). Its population is shrinking, and thus its level of indebtedness per capita is going up at a much faster rate than the absolute level of debt. Anyone, including yours truly, would have thought that this forest full of dry wood was one lightning strike away from a disastrous conflagration. And yet Japanese interest rates are lower than ours and the country has been mired in a deflationary environment for decades.
Admittedly, Japan has a lot of unique economic and cultural issues: Companies are primarily run for the benefit of employees, not shareholders (unproductive employees are never let go); there are a lot of zombie companies that should have been allowed to fail decades ago; and the Japanese asset bubble burst in 1991, when debt-to-GDP was only 60%. The point still stands: Long-term forecasting of inflation and deflation is an incredibly difficult and humbling exercise.
As investors we have to think not in binary terms but in probabilities. The acceleration of our debt issuance and our government’s seeming indifference to it and to ballooning budget deficits raise the probability and the likely severity of inflation. At the same time, we have to accept the possibility that the economic gods are playing cruel games with us gullible humans and have deflation in store for us instead.
Inflation and higher interest rates are joined at the hip. The expectation of higher inflation will raise interest rates, as bond investors will demand a higher return. This in turn will result in larger budget deficits and more money printing and thus more borrowing and even higher interest rates.
Here is how I am positioning your portfolio for the risk – the possibility, not the certainty – of long-term inflation and higher interest rates: More than half of your assets were chosen specifically for their likely ability to withstand higher inflation.
· Value-oriented companies that have “pricing power”, i.e., the ability to raise prices without losing sales.
· “Real assets” such as global infrastructure, utilities, US energy infrastructure (pipelines), commodities and gold.
· Natural resource companies focused on basic needs such as food, water, timber, energy and industrial metals and materials.
And here’s how I am positioning your portfolio for the risk – the possibility, not the certainty – of long-term price stability, deflation and continued low interest rates: The other half of your assets were chosen specifically for their likely ability to flourish during periods of low inflation.
· US and global bonds
· US and global high growth companies
· Innovation including young high-growth companies focused on artificial intelligence, virtual reality, robotics, 3-D printing, internet security, electric and self-driving vehicles, internet of things and other disruptive technologies that flourish when the cost of capital is low.
Valuation matters more than ever. Higher interest rates are an inconvenience to short-duration assets whose cash flows are near the present and devastating to long-duration assets. Here is a very simple example: When interest rates rise 1%, a bond with a maturity of 3 years will decline about 2.5%, while one with a maturity of 30 years will decline 25% or so. This is why I keep most of your bond portfolio in short-duration assets.
The same applies to companies whose cash flows lie far in the future and who are thus very sensitive to increases in the discount rate (interest rates and inflation). Until recently they have disproportionally benefited from low interest rates. They are the ones that you will most likely find trading in the bubble territory today. But their high valuations (high price-to-earnings ratio) will revert downward. Value stocks will be back in vogue again. We have started seeing the rotation from growth to value recently.
Inflation will benefit some companies, be indifferent to others, and hurt the rest. To understand what separates winners from losers, we need to understand the physics of how inflation flows through a company’s income statement and balance sheet.
Let’s start with revenue. Higher prices across the economy are a main feature of inflation. We want to own companies that have pricing power.
Pricing power is the ability to raise prices without suffering a decline in revenue that comes from customers’ inability to afford higher prices or from the loss of customers to competitors.
Companies that have strong brands, monopolies, or products that represent a very small portion of customer budgets usually have pricing power.
If Apple raises prices on the iPhone, you’ll curse Steve Jobs and pay the higher price. (A friend of mine curses him every time the iPhone frustrates him. I keep reminding him that Steve is no longer with us. Doesn’t help.) Of course, if Apple raises iPhone prices too much and its products become unaffordable, consumers may just start buying iThings less often.
Food, water, and utility companies have pricing power. We own plenty of these stocks, too. The same applies to most consumer staples.
What the pandemic showed us is that humans are adaptable creatures – you throw adversity at us, we’ll indulge in angry outbursts but we’ll adapt. The rate of change of inflation matters even more than absolute rate of inflation. If inflation remains predictable, even at a higher level, then businesses will plan for and price it into their products. If the rate of growth is highly variable, then there is going to be a war of pricing powers for shrinking purchasing ability of the end customer. We want to own companies that are on the winning side of that war.
Let’s go to the expenses side of the income statement. Companies whose expenses are impacted the least by rising prices do well, too. Generally, companies with larger fixed costs versus variable costs do better.
It is important to differentiate whether the capital intensity of a business lies in the past or in the future. A business whose high capital intensity is in the past benefits from inflation. Think of a pipeline company, for instance (we own plenty of those). Most of its costs are fixed, and they have been incurred in yesterday’s pre-inflation dollars. The cost of maintaining pipelines will go up, but in relation to the total cost of constructing pipelines these costs are small. However, companies that operate pipelines have debt-heavy balance sheets, which can become a source of higher costs. Pipeline companies we own have debt maturities that go out many decades into the future. They’ll be paying off these debts with inflated cash flows.
I’ve seen studies that looked at asset prices over the last few decades and declared “These assets have done the best in past inflations.” Most of these studies missed a small but incredibly important detail: The price you pay for the asset matters. If we are entering into an inflationary environment today, it is happening when asset prices are at the highest valuation in over a century. (This was not always the case during the period covered by these studies.)
For instance, one study showed that REITs have done well during past inflations. This may not be the case going forward. Aside from its being a very broad and general statement (not all REITs are created equal), low interest rates brought a lot of capital into this space and inflated valuations. Investors were attracted to current income, which was better than from bonds, and they paid little attention to the valuations of the underlying assets.
I cannot stress this point enough: Whatever landscape is ahead; we are entering into it with very high valuations and an economy addicted to low interest rates.
We have to be very careful about relying on generalized comments about past inflations. We need to be nuanced in our thinking.
We get asked a lot about gold and cash
Gold: I don’t have a great love for gold. We own a modest amount in your portfolio as a hedge. We discussed it in the past in great depth, so I won’t bore you with it here.
Cash: I am basically referring to short-term bonds, which seem like the most comfortable asset to be in today. However, their ability to keep up with inflation has been spotty in the past. It is okay in the short term but likely to be value-destructive in the long term. Our view on cash has not changed: In a portfolio context cash should be a residual on other investment decisions. In our portfolios cash is what is left when we run out of investment ideas.
Investing outside of the U.S.
The U.S. government was not the only one borrowing and paying people to stay at home. But the US has done it to a much greater degree than others. Most importantly, we are not slowing down our spending (and thus borrowing), which will likely lead to a weaker dollar. If nothing else, a declining dollar makes foreign securities more valuable in U.S. dollars. The probability of a stronger dollar is low.
But there is more.
The next decade will likely belong to ex-U.S. investing. If you invested outside the U.S. over the last decade, your returns were overshadowed by the gigantic outperformance of the U.S. markets. Today the US is the most expensive developed market. Take Europe, for instance; most European stocks are still trading below 2007 highs. UK stocks trade at a half of the valuation of U.S. stocks.
Our approach to investing is very simple: We are diehard value investors looking for high-quality companies that are significantly undervalued and run by great management. We do not change into flamboyant value-indifferent investors when we cross the border. International investing just gives us a greater palette with which to paint our investing canvas.
We’ve been doing ex-U.S. investing for a long time. Today, about half of our portfolio is outside the US.
If you thought I had a silver bullet and easy answers, I don’t. I know what I am about to say may fall on deaf ears, especially since we are in an apparently never-ending bull market. But as steward of your capital, my most important objective is survival (avoiding permanent loss of capital and maintaining purchasing power) in both inflationary and deflationary environments. Our goal is to achieve market-like returns with less than market-like risk.
Last decade risk did not matter. Risks were only figments of our imagination, as money printing by the Fed, which was trying to fix a lot of sins and became the biggest sin of all – significantly distorting the price of money and thus the economy. But as Charlie Munger said, “If you are not confused about the global economy, you don’t understand it.”
A suddenly appearing iceberg is life-threatening to a speedboat (or cruise ship), but it is just an unpleasant inconvenience for an icebreaker. Our goal is to have a portfolio of icebreakers. We are playing a different game – we are not racing against the speedboats. We take comfort in knowing that, while the speedboats may outrace us for some time, they are bound to eventually hit an iceberg and sink. One iceberg that we have an eye on today is inflation and higher interest rates (though we are prepared for deflation and lower rates too).