A Song of Ice and Fire

You know how I went fairly big in predicting a surprising return to a rising inflation environment in the coming years and decades, in this newsletter a couple of weeks ago.

Bit miffed to come across this then:

Source: Financial Times

Annoyingly, as I write this on Wednesday 20 May in preparation for the bank holiday (hope you’re having a good one, future reader), I was actually already planning to write about the fact that we may well get deflation first, but reality has once again beaten me to the punchline.

Why was I already going to write to you challenging my own views? Because my point of view is just that. There are others, and they also have plenty of merit. They’ve even changed my views a bit in the process, as you’ll see.

One key point I’d like to address first is language.

Part of the current thrust behind the inflation case is the huge expansion of fiscal monetary stimulus. But if instead of calling it “stimulus” you call it fiscal life support, becomes something with vastly different connotations and consequences.

Stimulus probably brings economic expansion and inflation.

Life support probably means a delayed destruction of our economies, depending on when support is removed.

Fiscal “life support” indicates bankruptcy and deflation.

What happens to restaurants, bars and businesses of all sorts when the furlough and emergency loan systems end, and people still don’t go back and spend at previous levels?

Restaurants were already squeezed by incredibly thin margins and high competition. Regardless of the national stimulus package, it feels inevitable that many will go out of business – more on this on Wednesday.

Secondly, Louis-Vincent Gave, from Evergreen Gavekal, argued in a podcast on its website that the first thing we would see as a fallout of this pandemic was a nationalist relocation of industry.

He thinks this re-nationalisation of supply chains to the US (his focus) will be inflationary.

Why? After the global financial crisis, the oncoming wave of 500 million cheap Chinese workers was a deflationary force of immense proportions, which he sees as one reason why the much-feared inflation never came then (more on this further down). After the tech bubble, the promise of amazing new technologies was also deflationary.

This time though, separation of the two world orders is more likely, and as work is brought from China back to the US, rent and labour costs will go up drastically, which will end up pushing up prices for the consumer on all the kinds of things which actually affect inflation (ie, not houses and financial assets).

That’s not guaranteed though. With increased costs you could also get widespread bankruptcy which would be deflationary.

Because if companies were only generating meagre profits when they were paying Chinese workers a few dollars per hour, how will they ever make money when having to pay $10 or more? They certainly won’t be able to sell as many products at the higher prices that their new wage bill demands.

So re-nationalisation could lead to some pretty widespread bankruptcy, which would be deflationary, at least in the short term.

In my book this would only lead to more stimulus – both fiscal and monetary, which would cause inflation, but it would delay it. Lower rates and more stimulus would be good for stocks.

(That’s why I like the idea of balancing inflation protected precious metals assets with exciting green energy growth stocks which benefit from lower rates and loose monetary policy – it’s a perfect balance for the investor who doesn’t know where we’re heading, like me.)

The End of an Era

The current economic regime is a 40-year cycle of falling rates, falling inflation, low volatility, and central bank dependence.

Inflation will change all that. Rates will have to change inflation rates higher so they don’t get out of hand.

Why does this matter?

Because a change in the inflation regime would be a huge shock to markets (a move from 1.5% inflation to 2% doesn’t sound like much, until you realise markets are currently betting the reverse will happen).

This is a chart of long run inflation expectations, (US inflation for 2019 was 1.8%), and inflation has never been at 1.1% for a decade before, but that’s what markets are pricing in now.

Source: FRED

A change in the inflation regime might force rates to come with it, something which many corporates could not survive.

And it’s also something which people have forgotten can happen in a real hurry:

Source: Ardea Investment Management

It’s always nice when you come across a new source of ideas and inspiration. A few weeks ago, I came across (found online) Ardea Investment Management, who have written about inflation and stock bond correlation.

They challenged, advanced and informed my views.

One great quote was: “if you can’t predict the future, having asymmetry on your side is the next best thing.” Because at the moment, the markets are betting on lower inflation for longer – at levels never seen before for long periods of time.

Bearing in mind my mantra from last Monday – always be short extremity – this makes me want to bet on the opposite because of the asymmetrical returns.

“While it’s impossible to reliably predict whether inflation will in fact fall or not in future, what we can see is that markets are now back to betting heavily in one direction… lower inflation for a long time.

“Tying this all together, any upside surprise to inflation would be most unwelcome because it puts rate hikes back in play, quickly returning us to the early 2018 paradigm of bonds and equities selling of together.”

With lower rates, lower growth and lower inflation all comfortably priced in, the adverse shock is of positive inflation.

Rising inflation or fears of inflation affect both bonds and stocks negatively – a 60/40 portfolio suffered its worst drawdown since 2008 in late 2018 as inflation fears spiked.

That’s why it’s worth our time worrying about, but there are reasons why people are betting against it too.

I’d say the most likely scenario is some bankruptcy and deflation, followed by fiscal expansion, monetary recklessness and accelerating inflation further down the line.

But my opinion is but a drop in the ocean, in a worldwide debate between fire and ice, inflation and deflation.

The debate was genuinely so widespread to be given a name – the Fire and Ice debate, after the Robert Frost poem:

Some say the world will end in fire;
Some say in ice.
From what I’ve tasted of desire
I hold with those who favor fire
But if it had to perish twice,
I think I know enough of hate
To know that for destruction ice
Is also great
And would suffice

Reflecting on my article from last Monday – my unoriginal preference would be to continue trying to toe the line between too much and too little inflation.

Now just need to figure out what that level is…

All the best,

Kit Winder
Editor, UK Uncensored

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