Blog post| Areté market review Q121: Incorporating inflation
Several positive developments over the last several months have dramatically improved the near-term outlook for the economy. Accelerating vaccine rollouts, increasing business activity, continued easy monetary policy and huge new doses of fiscal spending are all contributing to the potential for higher economic output. All these factors, however, are also increasing concerns about inflation, and rightly so.
The good news is there is plenty of commentary that provides useful updates and insights for investors to monitor the situation. The less good news is there is no easy answer to the debate between inflation and deflation/disinflation. A significant challenge, then, is figuring out how to incorporate an uncertain path for inflation into an investment strategy.
One of the interesting characteristics of commentary about inflation (or most investment topics for that matter) is the one-sided nature of arguments. Most commentary makes a pitch, for or against, and rattles off as much supporting evidence as possible.
This tendency is exacerbated by another interesting phenomenon: There seems to be something of a competition to produce the cleverest insight. This is understandable to a large degree since authors are keen to build their reputations on the basis of insights that prove to be right. However, the very notion that there even exists a "right" answer from which attentive investors might reap a windfall belies the grinding uncertainty of an issue like inflation.
These characteristics can be observed in the arguments for inflation. Arguably the most common argument for inflation is massively increasing money supply. It doesn't take much of an economist to look at a chart of money supply or central bank balance sheets to wonder how long existing trends can be sustained.
There are different permutations on this theme. One view relies to some degree on faith that huge piles of money will eventually find their way into the economy but is agnostic as to how that happens. Another view is that governments will increasingly get involved in the lending process (by backstopping loans, for example) which will significantly ramp up the speed of the money creation process. Both are supported by a longer-term historical perspective that points to inflation as the preferred manner by which to manage excessive levels of sovereign debt.
As is often the case, these arguments are compelling. If you listen to a few of these reports and then observe food and gas and lumber prices going up, it is easy to start getting nervous about any cash you may have laying around.
The arguments for deflation/disinflation are also extremely compelling, however. One of the more prominent commentators in this camp is Lacy Hunt at Hoisington Investment Management. His case is straightforward as he reveals in Hoisington's first quarter review:
"The two main structural impediments to traditional U.S. and global economic growth are massive debt overhang and deteriorating demographics"
He goes on to explain, "high debt levels undermine economic growth. This causality is supported by the law of diminishing returns, derived from the universally applicable production function." He concludes, "The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation."
So, the arguments for deflation are also compelling. This creates quite a challenge. If the rationale for both inflation and deflation are believable and well substantiated, how does one reconcile the perspectives? Which is right and which is wrong?
A good place to start, as is often the case, is with the assumptions. How strongly do we believe in them? In other words, what needs to be believed in order for the argument to hold?" Any dearth of conviction weakens the argument.
For example, in the inflation argument much of the rationale is based on rapidly expanding money supply. That isn’t too hard to buy into but that money also needs to get into the hands of people who will spend it (rather than just getting stuck in the financial system) and that has been a tougher nut to crack. Increasing labor costs could be part of the formula, but after the beat down by the union organizing effort at the Amazon facility in Bessemer, AL, there appears to be little systemic pressure in that direction either.
An expanded program of loans backstopped by the Fed, such as the PPP loans, could work but seems most likely to be episodic. Additional fiscal spending could also work but would require large and regular outlays. Given the polarized political environment, that too seems unlikely.
Further, because the US dollar is the dominant global reserve currency, the US dollar would also have to underperform on the international stage for inflation to really take hold. This is no small feat since the US still compares well to major developed markets as well as most emerging markets. For example, Lacy Hunt points out, "The comparatively worse debt overhang in the Euro Area and Japan indicates the U.S. should continue to be the growth leader."
Add to all these reasons the inertia of nearly forty years of disinflation and declining inflation, and the possibility for significant inflation seems like a tall, albeit still surmountable, order.
That isn't to say the assumptions behind the deflation case are any less demanding. In order for deflation to prevail, one would have to assume the Fed dramatically and sustainably reverses the course of monetary policy. After continuing "emergency" measures for thirteen years after the financial crisis and basking in the media as "the only game in town", the Fed would have to suddenly, and humbly, unwind its monetary interventions. In the event of significant market turmoil (such as what occurred in March 2020), it would have to quietly sit on the sidelines. Hard to believe.
Additional assumptions behind the deflation thesis rely on current laws and conventions remaining in place regardless of the future environment. For example, the Fed could not violate its charter to lend and not spend. The Fed would not, as Harley Bassman proposed, buy gold from citizens at $5,000 an ounce. Nor would the Fed’s liabilities ever be allowed to become legal tender.
As a result, it is easy to arrive at a similar conclusion. While the case for deflation is compelling, it’s just not hard to identify ways it could be thwarted, especially in the event of extremely adverse conditions.
Any loss in the value of the dollar would also have to overcome the significant demand for dollars in the Eurodollar market. In order for this to happen, huge volumes of trade contracts would have to be rewritten and safer and more liquid assets than US Treasuries would need to be established.
A different perspective
This presents quite an impasse. While there is plenty of data to provide informational clues about inflation, it is inordinately difficult to get one's arms wrapped completely around it. As Rusty Guinn from Epsilon empathizes in, "What Do We Need To Be True?", however, uncertainty is an inherent characteristic of the phenomenon:
"I don’t know how to predict how and when the old narrative [e.g., “we live in a deflationary world”] will die. I don’t know how to predict when the new narrative that replaces it will be born."
This perspective subtly but importantly reframes the debate about inflation. It is not a contest to be won or lost between two competing entities. Rather, it is a social construct that arises from common knowledge, or what everybody believes everybody believes.
In reframing the debate about inflation, Guinn not only comments on the inherent uncertainty of the debate (the birth and death of narratives is unpredictable), but goes one step further to identify the gauntlet of pre-existing beliefs that must be overcome for a narrative to change:
"And if we want to know what will cause the crowd to change its mind about the water in which it swims [current narrative of disinflation], I think that we also must get in the habit of asking a different question – a question that is at once a fundamental query of both information theory and game theory ... What do we need to be true?"
Guinn's use of the words "What do we need to be true?" refers more specifically to the set of assumptions used to build business models, power structures, and investment plans in an environment of low inflation. The belief that "we live in a deflationary world" has been deeply embedded in many of these. Because any change in beliefs will pose ostensibly existential risks to a number of vested interests, such interests serve as barriers to change.
One takeaway from the discussion is the debate between inflation and deflation/disinflation is inherently uncertain. Not only are the assumptions behind each case credibly at risk of being invalidated, but the narratives behind each case are also inherently unpredictable.
As a result, it doesn't make much sense to try to "win" the argument by figuring out whether inflation or deflation will prevail. For example, if you believe inflation will prevail, are you willing to bet everything that financial asset values are well supported and can’t be revalued much lower? Because if asset value collapse there will be a massive deflation.
By the same token, if you believe in deflation, are you willing to bet everything that when the crap hits the fan, that rules limiting the Fed’s actions won’t suddenly become much more optional? Because if that happens inflation would jump quickly.
While the tendency to make directional bets is understandable, the increasing ambiguity around the inflation issue suggests a portfolio approach is more appropriate. In a sense, constructing a portfolio designed to weather very different possible future environments isn’t an especially innovative proposition.
What it is, however, is a break from the past. It is a break from the 60/40 mindset, and it is a break from almost everything that has defined the investment landscape over the last forty years. It is also a break from the conditions that have guided the fortunes of a couple of generations of business leaders, money managers, and financial advisors. So, a portfolio approach regarding inflation might also be just the thing to prevent you from going down with everyone else who could not adapt to a new reality.