Thursday, September 9, 2021

Rethinking Inflation

Last year our correspondent @pdxsag wrote up his notes on Grant Williams and Bill Fleckenstein's podcast interviews of Russel Napier and Lacy Hunt. I called his services, "siting through podcasts so I don't have to." Grant Williams has two new interviews on his own podcast with two guys that I already follow: James Davolos from Horizon Kinetics (he manages their Inflation Beneficiaries ETF, $INFL) and Harley Bassman (aka @convexitymaven).

First, some highlights from his interview with James Davolos:

  • [T]here’s another area that we’ve actually been working on at the firm, in some cases for 30 years, and also in particular in the past five years, which has been different areas within the commodity complex. There’s been a lot of changes compared to the past cycle. We looked at upstream producers in the commodity complex, thinking well, under an inflationary scenario they have to do well. We do differentiate fundamental outlook on these markets, which I think we can discuss later, but the biggest deficiency of these names, whether it be an upstream E&P company like a Chevron or a Barrick Gold or Rio Tinto or Vale or BHP, is that they are incredibly capital intensive, both in the sense that they have a lot of working capital requirements, and they also have a lot of balance sheet leverage to lever up an inherently low return on assets.
  • Basically what ends up happening is unless you time the cycle perfectly, you can have a really miserable experience going upstream into these companies, which should ultimately be inflation beneficiaries but very difficult to time the cycle. I think a lot of people have been hurt. Some good historical examples going back to the past peaks in these end markets. What we arrived at was a method of trying to look at asset-light ways of playing these hard asset end markets. Hard assets have been something that Murray and Steve and these guys have been focused on, as I mentioned, for decades, but particularly so in the last five to 10 years.
  • We begin with the hard asset mindset. What a hard asset is, is just simply a finite high quality asset that there is a very large base of fundamental demand for. Think land, raw land, or energy, precious metals, base metals. And there’s unique fundamentals to all of these hard asset end markets today that I think are really different from past cycles. But we begin with the premise of identifying these quality finite hard assets with a requisite amount of fundamental demand, and then trying to figure out a way to express that view in the most efficient manner possible in a portfolio.
  • What we arrived at is these asset-light companies, where they have exposure to these hard assets, but through a business model that has very little working capital requirements, has very low variable costs, and does not require and/or has zero leverage.
  • What this has created is these businesses that not only survive but can actually thrive during the down cycle. You never have the insolvency risk. You don’t have the necessity to divest core assets. And then you can compound in the up cycle. That’s why it’s a very efficient mechanism to play an otherwise volatile, precarious industry, rather than going into the higher beta, higher risk upstream names.

And then his interview (with Bill Fleckenstein) of Harley Bassman:

  • Why do rates have to go up? The Fed can keep them down. They kept them down post-World War II. Maybe that is what the plan is. They will just buy like Japan. They’ll just buy the bonds and balance sheet them and keep rates at one, one and a half. Even if we have 4% inflation, you’ll have a massive negative rate. That’s really the question here is that once you break the linkage of inflation to rates, a whole lot of things are possible. Now, the answer I think is this. Let’s say they have the three or four-handle inflation. Let’s say the Fed or the government or someone, I mean the government could do it by demanding that banks buy treasuries. They could force banks to do that because they’re regulated entities. So there’s a whole lot of ways for the government to keep rates at the current levels, if they want to. So what happens then, the other side of the balloon gets squishy, which means currency devaluation possibly. We don’t become the reserve currency of the world anymore, which seems unlikely, but whatever. There’s a whole other host of things that could play out where you keep a massive negative interest, real interest rate, which is unclear. But the usual game, if we weren’t the world’s reserve currency, we’d have a devaluation.

I've been thinking about inflation and hard assets a lot recently. "Inflation or deflation?" is a political question; you can't determine the outcome from modeling of macroeconomic variables without reference to what the people who control the central bank want.

In the past when we have had deflationary episodes, elites were much more conservatively invested. The book The Framers' Coup (see notes) by Michael Klarman (brother of Seth) says that the supporters of ratification of the U.S. constitution were creditors who were "determined to suppress state debtor relief laws and inflationary monetary schemes." 

In other words, the wealthiest colonists with political power were fixed income investors. They felt that their economic interests as wealthy people would have been hurt by inflation, and so the overriding goal of the constitution was to prevent inflation and legal abrogation of debt contracts, while also preserving the existing balance of power between north and south and big and small states.

Later on in the country's history, the rich were invested in government debt and also debt issued by the big private enterprises of the day, the railroads and canals that had not only big fixed costs but also big operating costs. Forget about owning equity in something that would go bust during the next panic, the old money wanted a first mortgage so they could get their principal back with reasonable interest. When money was sound, that really meant something. 

It even looks like deflationary panics were deliberate squeezes of the middle class, by the rich, who could relieve them of their assets at cheap prices at the height of the panic. In order for this to work, the rich had to be conservatively invested or at least more conservatively financed than the people they were squeezing. 

Up until the mid-20th century, it was not even considered appropriate for trustee fiduciaries to invest in common stocks. It was only the inflationary post-war era that changed this, as limitations in trust instruments specifying fixed income investments became inconsistent with the always implicit goal of preserving the trust corpus in real terms.

That conservatism is long gone. Our elite - the politicians and the people who back them - have continually upped the financial risk they take as real interest rates have fallen. Now even the inner circle of central bankers with eight figure net worths are day trading to eke out more return on their capital. We just found out that the Dallas Fed president Robert Kaplan was trading in and out of $FLOT, the iShares floating rate ETF, during 2020. We know that Pelosi likes to get super long the market as well. 

It always felt like someone in the Trump admin (Jared & Ivanka?) was repeatedly leaking info, trading on it, walking it back, and repeating for all kinds of economically sensitive matters. And of course Trump spent his career comically over-leveraged in the most leveraged industry of all, real estate.

As I said once, "0% inflation feels like deflation for people who have made commitments that depend on gradual currency devaluation." Remember Trump carping about the Fed and interest rates? How much of that was his reelection prospects, and how much was his own personal balance sheet?

So it starts to seem that the people in this country who make the decisions are not even interested in playing the old deflationary squeeze game because, even if their precarious balance sheets could withstand it, their political Mandate of Heaven probably couldn't. Plus, baby boomer rich are very unlike the old school rich - they do not like seeing things marked down on their net worth spreadsheet. (Every baby boomer has a net worth spreadsheet.)

If a big devaluation is going to happen, it would be best to own attractively priced assets that will grow earnings at least as fast as the currency is devaluing.

Luckily for us, a major inflationary shock is brewing at the same time that people allocating capital are under the delusion that electric vehicles have "disrupted" oil.


CP said...

“I want a labor market so tight that you don’t even have to cover up your tattoos to get a job. I want employers camped out in front of my office begging for my help in how to hire people getting out of federal prison.”

CP said...

From Horizon Kinetics' Q2 2021 letter:

Just over one year ago, the pressing question was whether the largest oil companies in the world might become stranded assets, victim to the divesting of energy stocks by financial institutions, to the displacement of oil by renewable energy technologies, and to the shockingly steep drop in consumption during the early months of the Covid-19 pandemic. Our suggestion that the important risk to protect against was not of permanently low prices, but of permanently high prices, of an oil price shock, was also completely absent from the public discussion. It remains so.

Yet, oil is no longer $42/barrel, as it was in July last year, or $20/barrel, as it was in April last year, the last times we covered this issue in some detail. Last week, it was over $70, which it hasn’t been since 2018. We’re now at a point where the excess inventories of last year have finally been drawn down to within a historically normal range – as was bound to happen – and many forms of travel are already back to historically normal levels – as was bound to happen. What happens after this current point, if these measures of demand continue to rise, but supply does not? Still, the concept of an oil price shock remains completely absent from the public discussion.

CP said...

Some of the world’s biggest economies are seeing oil consumption turn the corner and even surpass pre-pandemic levels as falling Covid-19 infection rates drive a recovery in activity.

Oil demand in China, the world’s top energy consumer, will be 13% higher next quarter than in the same period in 2019 before the pandemic, according to SIA Energy. Indian fuel sales extended a rebound last month, while American consumption of petroleum products just hit a record high. Europe has also just had its best August for gasoline demand in 10 years, IHS Markit said.

World’s Top Oil Guzzlers Surpass Pre-Pandemic Consumption - Bloomberg

CP said...

More from Horizon Kinetics:

People – and the Federal Reserve – speak often about just when the central bank will raise interest rates in order to forestall inflation. But it’s not a matter of raising interest rates in the active sense. It’s a matter of allowing rates to rise, of permitting investors to again establish a market-based price. Because the Fed has been buying $120 billion of bonds every month, in order to push prices up and yields down. That’s $1.44 trillion a year. That’s 6.5% of GDP. In order to have the money to buy those bonds, the Fed has been creating that much more money, which is debasement, which is inflationary.

Yet, what would happen if the Fed were to stop suppressing rates? The interest rate on the Federal debt is the lowest it’s ever been. If rates were permitted to rise by as little as 2% points, that would bring the 10-year Treasury yield to 3.2%, which is what it was as recently as 2018. That doesn’t seem very high. Except, applied across $28 trillion of Federal debt, it would add $560 billion of interest expense to the deficit, and that would be 2.5% of GDP, which means that much more debt and cash creation. Plus, there is an additional $56 trillion of state, local and private debt in the country. An additional 2% interest expense on that would add another $1.1 trillion of interest expense burden each year: that’s 6.5% of GDP. The additional interest expense would not be different, economically, than a $1.1 trillion tax hike on the populace. That’s almost as large as total individual income taxes last year, which were $1.6 trillion. How could the economy handle that?

If this very simplified reasoning is correct, that raising interest rates at this late stage would be self-defeating, that there is no solution that way, then perhaps the Federal Reserve has already privately determined that it will not raise interest rates. The remaining pathway is for the central bank to inflate its way out, to continue the money supply increases, so that eventually debtors can pay back their fixed obligations with cheaper, more plentiful money. Which, after all, has been done throughout time.

If all this sounds circular, that’s a characteristic of self-reinforcing cycles.

CP said...

More Horizon Kinetics::

The problem is that on the supply side, production for many of these commodities is not increasing. For many of them, that’s related to cyclical price collapses of nearly a decade ago, and the consequent decision by producers to reduce spending and not develop new reserves. That disinvestment process has been happening for many years. Likewise, many years would be required to reverse that trend, even under ordinary circumstances.

But supply is subject to a recent add-on constraint, and that is political and regulatory pressure on the extractive industries to not increase their carbon dioxide and other greenhouse gas emissions. The goal for almost all of these companies, brandished in their most recent annual reports, is to decrease emissions by about 3% a year. The only way to accomplish that is to not expand production in any meaningful way. Even if they wanted to, such companies are unlikely to secure external funding for expansion projects.

Allan Folz said...

Also, don't forget the Boomers in charge of these companies are older this time around and will greatly prefer to milk a secure income stream versus playing growth at any price trying to build an empire.

CP said...

Wanted to link this inflation essay up with this thought:

I want to make money when life catches up with Musk, I want to use his overvalued stock promotion as a hedge against drawdowns, but what I really want over the next decade is to collect dividend checks from my portfolio of real assets: tobacco, hydrocarbons, pipelines, other minerals, land and timber. The more Tubmansthey print, the more our businesses will charge for a pack of smokos, a barrel of oil, a ton of met coal, etc.

And because rich people are levered long assets, they do not tolerate deflation. They will scream if they are getting squeezed and the central bank will devalue (Martingale) and only the most leveraged rich (financially and/or operationally) will lose their seat at the table. That is why I am very interested in industries that are concentrated and/or Lindy, with stable revenues, with small enough operational and financial leverage for robustness through panics, and available now at reasonable valuations.

CP said...

Ask Andy with Andrew Redleaf Episode #24 @ 6:33 in, he says that the "distribution of future inflation has a fat right tail".

Team Inflation!,2162/38734

CP said...

The preponderance of evidence suggests that inflation is not transitory, the rub is that interest rates may no longer be correlated with inflation. I appreciate how this can be a short-term financial salve; but let’s be clear, it is a long-term public policy blunder. What is indisputable is that Implied Volatility is way too low since the range of outcomes is now much wider.

CP said...

Thinking about inflation lately, since we are living through another major inflation. Robert Samuelson thinks of 1960-2010 as a half century that was "one long economic cycle dominated by inflation's rise and fall". During the first half with constant inflation, "large price increases were the norm, like a rain that never stopped. Sometimes it was a pitter-patter, sometimes a downpour. But it was almost always raining. From week to week, people couldn't know the cost of their groceries, utility bills, appliances, dry cleaning, toothpaste, and pizza. People couldn't predict whether their wages and salaries would keep pace. People couldn't plan; their savings were at risk. And no one seemed capable of controlling inflation." Issues with inflation and accounting: "As inflation rose, companies' sales and profits grew rapidly. Managers believed they were doing better than they were; they paid less attention to the many small daily operational matters that improve efficiency. From 1964 to 1974, after tax profits jumped from $41 billion to $95 billion." Here's something funny: "Inconvenient bursts of inflation were blamed on onetime events: spending for the Vietnam War or global surges in oil prices." Crooked moron Lyndon Johnson tried to "persuade and bully" people not to raise prices: "When egg prices rose in the spring of 1966 and Agriculture Secretary Orville Freeman told him that not much could be done, Johnson had the Surgeon General issue alerts as to the hazards of cholesterol in eggs."

CP said...

Because economies are now experiencing self-reinforcing growth, the natural workings of the economic machine will continue to sustain a high level of nominal growth that is likely to produce a level of inflation that is well in excess of policy targets. For central banks, asymmetric policy alternatives leave an unlimited ability to tighten and a limited ability to ease on their own, which encourages delay and falling further behind, which is likely to make it increasingly difficult to balance economic growth and inflation. Given the inertia in the system, it is unlikely that the current level of nominal spending growth and its impacts on inflation can be contained without aggressive monetary tightening in the very near term. In contrast to this unfolding story, the markets are discounting a smooth reversion to the prior decades’ low level of inflation, without the need for aggressive policy action—that it will mostly just naturally happen on its own. We see a coming clash between what is about to transpire and what is now being discounted. [...]

In addition to the recirculating flow of income and spending, wealth and balance sheets have dramatically changed as a result of these MP3 policies. This is a future source of lending, borrowing, spending, and income. Of particular importance is the fact that this increase in wealth has accumulated in the middle- and lower-income groups which were previously getting squeezed. Because MP3 policies directed money to the middle- and lower-income deciles through the fiscal pipe, these groups have received a lot of the printed money and have either paid down debt or accumulated cash in the bank. The biggest asset of the middle-income groups is their home, and home prices have risen well above mortgage balances. And looking at the banks, which are a source of stimulation or restraint, you see a giant pile of liquidity on bank balance sheets that is earning next to nothing. Banks have the incentive to produce an expansion of credit that would finance spending. Bank deposits are now well above loans to an extreme degree, and the average bank asset mix has shifted to include a lot more cash reserves at the central bank and more government bonds.

CP said...

I think it's really hard for most people to grapple with the existence of a flawed (crooked) system that benefits the elite and will therefore be kept around, with modifications and tinkering, to the extent possible.

CP said...

Since the pre-Covid days (February '20), the non-currency portion of M2 has increased by about $6 trillion, or 43%. Since early-summer '20, that same measure of the money supply has increased at about a 13-14% annual rate, a bit more than twice it's long-term average growth rate.

CP said...

Faced with much-higher-than-expected inflation, the Fed is nevertheless taking great pains to assure markets that they will address the problem in a slow and gradual fashion, by taking 25 bps baby steps per month to raise the federal funds rate beginning next month. They seem to be aligning with a school of thought that says the economy these days is too weak to sustain a rapid increase in interest rates, so it's better to be slow and gradual than shock and awe.

While this reinforces the point of my last post (i.e., the Fed poses no near-term threat to the economy), it will likely only make things worse in the long run. Why? Because by pre-announcing a gradualist approach they have given investors and the public a green light to take advantage of incredibly cheap financing costs, and that will only make inflation harder to control in the future. Why harder to control? Because increasing the incentive to borrow money to buy things (cars, houses, commodities, property, plant and equipment) is equivalent to decreasing the incentive to hold money. Borrowing money means going short money: you win if the value of the dollar declines. Paying off debt means going long money: you win if the value of the dollar increases. With the supply of money (e.g., M2) obviously in over-supply, the Fed is incredibly trying to undermine the demand for holding that money.

CP said...

Great comment (ibid):

"Maybe inflation is a feature, not a bug. That is, they're inflating the national debt away. This has the effect of making the poor pay down the debt while the wealthy investor class makes money on stocks and real estate."

Not sure why Scott Grannis isn't considering this.

If having negative real yields were more politically palatable (or even desirable, to leveraged elites) than tightening, you'd expect them to talk and talk and jawbone about tightening, but keep printing money.

And that is exactly what they are doing.

James Bullard at the Fed is the hawkish "matador" to the boomer "bulls".

Anonymous said...

The 2008/9 Obama and the Fed was a watershed incident. The rich had lost everything. Absolutely everything. It didn’t matter if they had “won” the bet like Goldman Sachs, because if I win a bet with you and you lose all your money, I’m fucked too. The Fed and other central banks bailed them out to the tune of trillions; Obama and other political leaders immunized them from their crimes (and the entire bubble was based on fraud), and our elites then KNEW, without a doubt, that they were in complete control and that they could do anything, and that the violent authorities would bail them out and protect them from their victims.