I’m thinking of starting a new segment called, “Contrarian Corner.” In these posts, I will try to point out the other side of a company perception, trade, or view that I see as pervasive in the market.
When everyone crowds to one side of the boat, there are typically better opportunities to sit on the other side.
Right now, it seems “inflation is coming” is a pretty consistent view. (Somehow, the people shouting inflation think they are contrarian?) Every report, article, or tweet is talking about it…. I really try to avoid macro talk, but this is too good to pass up.
My favorite example of this is pointing to lumber prices as an indicator of runaway inflation. This totally ignores prior supply / demand dynamics that led to this surge. To me, its picking a data point to support a view.
I follow lumber prices, so I know why they are up. Canadian lumber is high-cost supply. The crash in prices in 2018 meant many mills to the north were unprofitable and were curtailed. Add in forest fires and impact from the Pine Beetle and supply was constrained. Lastly, Canada implemented caribou protection which curtailed logging activity. Lumber prices were still very low so even mills in the US shut. Now that housing has come back strong, this caught supply off guard and prices surged.
Is that inflation? Or is that a short-term supply demand imbalance? Prices are now at a level where everyone can make money if they can get supply back online. Would you make a bet with me that lumber prices will be higher than where they are right now in 3 years?
There are other examples of this. I’ve discussed oil (prices are up and rig count is at multi-year lows) as well as housing (underinvested post-GFC), and used car prices. Each of these are specific supply / demand issues or the bullwhip effect.
Is that persistent inflation? Is a one time rise in prices due to a demand shock (COVID lockdown), that resulted in a supply shock, inflation?
The reason why *persistent* inflation matters is because that is what is going to move long-term interest rates.
So Why Deflation vs. Inflation?
First, its that the government’s use of debt to stimulate is suffering from declining marginal returns. Second, its that M2 is NOT what drives inflation. Its also velocity, which continues to decline.
As the National Bureau of Economic Research stated in a 2010 study (my emphasis added):
The median growth of the 20 advanced nations in this study fell by half as their debt levels moved from less than 30 percent of GDP to 90 percent or more. The drop-off was particularly significant at the 90 percent threshold: between 60 and 90 percent of GDP, median growth was still 2.8 percent; above 90 percent it was 1.9 percent. The drop in average growth between countries with debt ratios of 60-90 percent of GDP, and those above 90 percent of GDP, was even greater: 3.4 percent to 1.7 percent
What happens when you go from 100% to 120%? Japan is approaching 200% debt to GDP and we all know the impacts there (their central bank also straight up buys equity ETFs)
Essentially, the marginal benefit we get from adding a new dollar of debt is going down. And has been for quite some time.
Yes, the coronavirus stimulus was big. But a lot of it also went to plug a big hole in the economy.
We had stimulus checks. That put money directly in the pocket of consumers, but it didn’t create a new income stream for them. Wages didn’t go up and in my view and so the spending will be a 1x boost in some select sectors. Unless all the debt we just used goes to create a new income streams, all we’re doing is exchanging current consumption for future consumption.
Velocity of money is going down.
I’m going to let Dr. Lacy Hunt explain the next bit. For context, he’s a manager on Hoisington bond fund and has been right on bonds for about 40 years (i.e. he’s been long duration). I highly recommend his investor letters. All of these are quotes from his Q1’2020 letter, with my emphasis added:
- When the Fed buys government or agency securities from the banks, holdings of government debt declines and the banks’ holdings of deposits or reserves at the Fed go up.
- The bank balance sheet is unchanged except that the banks are selling government paper of longer maturity and they receive an overnight asset at the Fed. Those deposits do not circulate freely within the economy. (Diligent Dollar Note: QE is not just printing money)
- If the Fed’s purchase of the debt is from non-bank entities, there will be a transitory rise in M2. Further M2 expansion from that new level will depend on the banking industry. The banks high level of reserves at the Fed will result in no further increase in money unless they and their customers make the collective decision for new bank loans to be originated and the loans are used to expand economic output
- This is what happened in 2010-11. M2 surged transitorily to a nearly 12% rate of growth along with an increase in loans. The money and loans were used to shore up financial conditions rather than channeled into the purchase of new goods and services. As such, the velocity of money fell dramatically, and the Fed’s purchases of securities did not lead to increased economic growth and inflation. After financial conditions were stabilized, the depository institutions held large amounts of excess reserves.
I feel like the first two bullets need re-emphasizing, because a lot of people associate QE with money printing. Joe Weisenthal put it (again, my emphasis added):
When the Fed buys a Treasury, what it’s really doing is replacing one kind of government liability (maybe a 10-year Treasury) with another kind of government liability (an overnight reserve held at the Fed). If you’re a bank that sold a Treasury to the Fed, you’ve given a long-term asset that yields something for a short-term asset that yields something else. No new money has entered the system. The government doesn’t have any less debt. All that’s happened is that the consolidated government balance sheet (the Treasury and Fed combined) has shortened the term structure of its liabilities. After the Fed buys a Treasury there’s less long-term debt outstanding and more short-term debt outstanding. That’s it.
Bottom line: in order to actually get a boost to GDP and inflation, you need the velocity of money to go up.
All these headlines of GDP growth in 2021 tend to be missing the point. If we have 8% growth in GDP following a year where GDP was down 3.5%, then you just have 2% growth on a 2-year basis. That’s not that great considering all the debt taken on. And then you actually need the banks to lend out the capital, but that depends on risk they see in the market, returns, and whether people need the capital for investment.
Add in worsening demographics (and I think its possible we are sitting where Japan and Europe are sitting 5 years from now.
I think what will happen is inflation expectations will continue to rise short-term as the economy re-opens and we have some supply constraints that gives further pseudo-inflation scares, but long-term the writing will be on the wall.
So bottom line: Do I think reflation will happen? Yes. We will be lapping a serious decline in our economy and there are supply constraints. Do I think those supply constraints will be overcome? Yes. And therefore, I think we will continue on the longer-term deflation trend.