Pig Through the Python: The Current Threat of Inflation (August 2021 Update)
Benjamin M. Lavine, CFA, CAIA, RICP
Co-Chief Investment Officer, 3D/L Capital Management
A year ago, we published “Pig in the Python – The Growing Threat of Inflation,” as we posited the potential implications that would emerge following unprecedented levels of global monetary and fiscal support following the initial surge in hospitalizations/deaths resulting from the March/April 2020 COVID-19 pandemic wave. We also posited the implications to global input costs resulting from a combination of negative real (inflation-adjusted) interest rates combined with labor/material shortages resulting from the pandemic shutdowns. In short, we saw an emerging threat of inflation when the world was still gripping with the prospects of deflation as the 10-Year U.S. Treasury Yield dropped to as low as 0.50% in mid-August and gold prices surging above $2,000/ounce.
Since then, yields have risen and gold prices have fallen as the world tries to move on from the pandemic. As we reflect upon the market movements and economic/political events over the past year, it has become clear that an inflation pig did, indeed, become stuck inside the global economic python. There is little doubt that the inflation pig turned out to be real (accentuated by last November’s election and unprecedented short development times for COVID vaccine rollouts), where pent-up pandemic demand collided with an underinvested supply chain resulting in a surge of prices from used cars and suburban housing to lumber and semiconductors.
But the debate now centers around how and to what extent that inflation pig is digested – whether with ease over time as inflation pressures proves to be transitory (demand-pull Goldilocks with a flu) or with major indigestion as higher inflation remains resilient well beyond the initial pandemic recovery, COVID Delta Variant infection wave notwithstanding (the stagflation scenario of higher cost-push inflation combined with slowing economic and employment growth).
In last year’s article, we were initially alarmed by the double-digit percentage surge in broad money supply (cash and credit or M2) resulting from the pandemic relief support programs from both the U.S. Federal Reserve and from the government, which had resulted in real (inflation-adjusted) interest rates dropping deep into negative territory, the kind of conditions that would normally spark inflationary fears. We then stepped back and considered that the money supply pig would only turn into an inflationary pig if money velocity would also pick up, which seemed less likely at the time we wrote last year.
Fast forward one year to now, who would have guessed that interest rates would drop even deeper into negative territory (Figure 1) against a backdrop of 6.5% 2Q2020 GDP growth as year-over-year Consumer Price Index (CPI) prints have now exceeded 5% against a backdrop of low nominal interest rates? Interest rates are higher from a year ago but have not kept pace with inflation with headline inflation exceeding 5% (core above 4%). Inflation-adjusted interest rates had dropped to new post-pandemic negative levels earlier this month before rising as the bond market grew fearful over the spread of the Delta Variant and hawkish comments from Federal Reserve officials that may indicate an earlier than expected pullback of quantitative easing and zero-targeting interest rates (comments that were back.
Figure 1 – Real (Inflation-Adjusted) Interest Rates Drop Deeper Into Negative Territory as Long-Term Nominal Interest Rates Do Not Keep Pace with High Year-over-Year Inflation Prints
At the time of our writing last year, we neglected to identify two pigs rather than one: an inflation pig and a money supply (M2) pig (more on that below). The inflation pig is manifesting itself in several ways, whether high producer prices or cost-of-living adjustments for social security (Figure 2) and other pension schemes. A longer-term question is whether the ‘psychology’ of higher inflation expectations begins to kick in as the broader population groans from pig indigestion and starts to wonder whether the heartburn will pass relatively soon (base effects dissipate and resolution of labor/supply chain shortages) or indicative of a more serious digestive ailment (and to expect to be compensated accordingly via higher wages/benefits).
Figure 2 – Inflation is Here and Real (At Least Those with Cost-Indexed Benefits): Highest Cost of Living Adjustment (COLA) for Social Security Since 2010
Since we published “Pig in the Python”, we’ve written several follow up articles over the course of the past year (here, here, and here) as well as hosting several podcasts (here and here) highlighting the ‘Inflation is Transitory’ risk and what the implications were for future asset pricing and investor/consumer risk appetite. Would negative interest rates continue to fuel the risk appetite that has driven global equity valuations (and other ‘hard’ assets such as housing and commodities) to record highs and borrowing costs (especially for risky corporate borrowers) to record lows, and would such euphoric investor sentiment distort risk asset pricing to such an extent sow the seeds of their own destruction? Does inflation even matter in the New Normal of aging demographics (low birth/death and worker/retirement replacement ratios), high debt levels and excess global capacity?
Over the past year, our views have been neutral to cautious on the inflation front as we acknowledged the labor/material shortages with pent-up demand from the pandemic have collided with a labor/supply-chain market that had been largely shutdown throughout 2020. Key industrial commodities such as copper (Figure 3) and energy (oil, coal, natural gas) are forecasted to run in net supply/demand deficits for years to come even if the persistency of COVID infections weighs on near-term demand (worldwide transportation perhaps but not necessarily demand for industrial products such as steel (Figure 4)).
Figure 3 – Copper Expected to Remain in Net Supply/Demand Deficit for Years to Come
Figure 4 – COVID Variant Infections Infecting Demand? Certainly Not Steel Prices
And agricultural prices (Figure 5) continue to rise as worldwide harvests fall short of expectations (Figure 6), primarily due to poor growing conditions (weather-related).
Figure 5 – Surge in Wheat Prices Will Likely Add to Inflationary Pressures
Figure 6 – USDA Monthly Forecasts for the August Period: 2021/2022 Corn Inventories (Red Line) Trending Towards 10-Year Low Levels on Top of a Poor 2020/2021 Harvest (Black Line)
We believe these structural imbalances will remain for the time being; hence, we maintain a small allocation to broad basket commodities in our risk-based models.
Yet, the prevailing narrative (at least the consensus view among economists and central bank officials) is that inflationary pressures are likely to remain ‘transitory’ due to year-over-year base effects as several high profile COVID-sensitive market segments (transportation, travel, health care) are now seeing price deceleration from peak growth rates (Figures 7a and 7b). We may be suffering from inflation heartburn now, but relief will come later as demand is expected to cool off from pent-up pandemic shutdown levels and in response to higher prices. What likely remains is housing cost pressures as the eventual expiration of mortgage/eviction moratoriums make their way into higher shelter costs going forward.
Figures 7a and 7b – Inflation Pig Heartburn Now but Relief Later as COVID-Sensitive Price Pressures Start to Alleviate
And that leads us to the other pig – money supply growth. Over the past year, we’ve observed that for the capital markets to view U.S. inflation as a sustained problem:
- Money velocity (the amount of per capital consumption fueled by excess money supply) would need to see a meaningful pickup from its moribund levels and
- Inflation pressures not only need to sustain themselves in the U.S. but across much of the global industrial economies (primarily Europe, Japan, and China). Otherwise, sell-offs in rate-sensitive assets (notably long duration bonds) are being bought as witnessed by the 2nd quarter drop of the 10-year U.S. Treasury yield from a post-pandemic high of 1.75% at the end of the 1st Quarter.
As to the first point, the excess money supply pig has yet to find its way through the real economy python as indicated by excess bank reserves (Figure 8), which remain parked at the U.S. Federal Reserve rather than fueling commercial/residential loan growth. This confirms what we wrote last year:
“The general consensus among economists and Wall Street strategists is for inflation to remain moribund and not surface as a problem as global demand remains weighed down by the COVID-19 pandemic (not to mention long-term demographic trends of high debt levels and declining labor replacement ratios due to low birth rates). This outlook remains a reasonable baseline scenario as one need only observe the juxtaposition of a plunging money supply velocity rate against the exponential increase in broad money supply (M2) as all that money printing remains stuck with the major money center banks in the form of excess reserves held with the Fed.”
And despite growing with the Fed’s balance sheet (now north of $8 trillion and growing $120 billion per month), those banking reserves remain stuck at the Fed. Central bank quantitative easing (a.k.a. money printing) produces the Milton Friedman-esque monetary inflation only when the excess growth in money supply somehow translates into real economic activity, and whether such activity produces such gross distortions as to cause an inflationary spiral. Regardless, the only sustained inflation that has manifested so far from excess money supply has been in asset prices as evidenced by rising equity and commodity valuations.
Figure 8 – This Pig Remains Stuck as Excess Money Supply Growth from Federal Reserve Quantitative Easing Has Yet to Make Its Way Out of the Banking Channel and Into the Real Economy
As to the second point (global inflation), expectations for higher inflation is at least starting to get priced into inflation derivatives (Figure 9) as the U.S. inflation swap curve is pricing in 2%-plus inflation over the long term while the United Kingdom is pricing in 3%-plus inflation. Yet, inflation expectations remain low across Europe and Japan (and now China with the recent Variant outbreaks) even as emerging markets (ex-Pan Asia) are now struggling with higher inflation (most likely due to the higher mix of food/energy within the consumption basket) (Figure 10).
Figure 9 – Expectations of Higher Inflation (But Not Inflation Spiral) Priced into U.S. and U.K. Inflation Swaps Curves but Remain Low for Europe and Japan
Figure 10 – Higher Inflation Expected Across Ex-Asia Emerging Markets (as Proxied by Brazil and South Africa Breakeven Rates) Likely Due to the Higher Mix of Food/Energy in Inflation Baskets
As we concluded last year’s article:
“Inflation may not be a problem now for investors, nor it may not become a problem over the near term as the world tries to recover from the coronavirus pandemic. But cyclical assets that track real rates are starting to price in a higher probability that inflation will eventually become an issue – an achieved policy goal that the Fed may not want to see.”
Well, that moment has arrived; the inflation pig is moving through the python, but whether we end up with a satiated anaconda or one groaning with stagflationary indigestion remains to be seen. This past year’s sharp rally in global risk assets strongly suggest that inflation is not expected to be a problem (at least not enough of a problem to prompt the Fed to sharply course correct into a hawkish direction), but global markets may also be myopically basking too much in consumption-driven recovery (and running the risk of a Mr. Creosote moment) with little attention paid to what may come next.
What if the supply constraints and labor shortages do not resolve themselves in a timely fashion at prevailing prices? This is a real risk because industrial production, whether mining for metals, drilling for energy, or fabbing semiconductors, requires lots of investor capital (increasingly shrinking for the former two) as well as long capital expenditure cycles, the length of which exceed those of most politicians’ terms. What if the psychology of higher inflation expectations takes root, and how would global citizens react if their current wages are not able to maintain pace with higher prices? Would consumer sentiment ‘go to ground’ in the face of higher inflation?
In addition, the near-term bipolar effects of the COVID Variants (renewed lockdowns juxtaposed against bottleneck congestions across key transportation hubs such as Chinese shipping ports) are still wreaking havoc with the reflation recovery narrative. Yes, COVID risk is still real here in the U.S., but an indoor mask mandate does not equate to whole hog lockdowns for communities who boast relatively high vaccination rates, so one would not expect adverse price declines from a collapse in demand like what we witnessed last year.
And Fed officials seem itchy to convey a 2022 timetable for tapering balance sheet purchases, which may be interpreted as deflationary resulting in a flight to safe haven assets (e.g. the U.S. dollar) that would pressure the global financial system. Not to mention that the U.S. government is on the precipice of pushing through a multi-trillion dollar infrastructure spending package, much of it to be financed with future borrowings.
The upshot? The inflation pig is making its way through the python even though the money supply pig remains stuck at the Federal Reserve. Barring a sudden deflationary reversal or a surge in cost-push inflation (driven by spiraling wages), this bodes well for financial and real asset prices even though the risk of economic indigestion grows with ever higher debt levels and central bank balance sheets, not to mention potential distortions and misallocated capital as investors view the easy financial conditions as a green light to light up their commission-free margin trading accounts.
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By: Benjamin Lavine