May 25, 2021
THE TIDE IS HIGH
by Michelle Mathieu
The most common question we are asked these days is about the implications of impending inflation. Supply constraints, inventory backlog, shipping bottlenecks, flooded consumer and corporate bank accounts, and reopening economies are driving prices up from both the supply side and the demand side. Eye-popping price increases over the past year in everything from lumber (up 300%) to oil prices (up 100%) have many people concerned. Wages are rising, too, especially in industries experiencing reduced foreign wage competition as countries onshore manufacturing.
Around the world, broad-based price inflation is here, make no doubt about it. In April 2021, consumer price inflation rose 4.2% year-over-year, – the fastest rate since the Great Financial Crisis and well above the 1.7% annual average for the past 10 years. A sustained rise in inflation is concerning because it erodes purchasing power. An inflation rate of 1.7% reduces the value of a dollar by half in about 40 years. A 4% inflation rate takes just 16 years to cut purchasing power in half. However, it is worth keeping in mind that inflation isn’t really all that high from a historical perspective, despite the scary headlines. Compared to pre-pandemic February 2020 levels, the consumer price index is up 3.1%, which is in line with where it was in the 1990s and a far cry from the 7.1% average experienced in the 1970s.
Spenders aren’t the only ones concerned about inflation. Investors fear that a wage-price spiral could ignite structural inflation, prompting central bankers to raise interest rates to cool an overheated economy. Rising interest rates would raise corporate funding costs and incentivize individuals and businesses to save rather than spend or invest. These higher borrowing costs would also place pressure on stock valuations, which have been buoyed by low interest rates.
The developed world has deep scars from high inflation. Butter stockpiles in Weimar Germany, food riots in emerging markets, and long lines at American gas pumps are not-distant nightmares. In the U.S., the perfect storm started in 1971 with the abandonment of the gold standard, which allowed volatile petrodollars to hold hostage an energy-starved global economy. At the time, labor unions had powerful influence over wages and benefits. Soaring demand from the boomer generation – fueled by the introduction and allure of the credit card – drove consumer spending to record levels. The Fed attempted to control high inflation with punishing double-digit interest rates.
Today the question is whether the current surge of inflation will eventually subside or is here to stay. We believe the most likely scenario is that the surge is temporary for several reasons.
First, inflation is a lagging, not leading, economic indicator. Inflation surges in recoveries following recessions and after crises such as wars and, yes, pandemics. Physical goods currently make up only about 40% of the economy, so aggregate supply and demand have reset to equilibrium levels more quickly than in past cycles such as the 1970’s. Supply chains are nimbler than ever, and price wars take advantage of disruption. History tells us time and again that the cure for high prices in an open economy is, ultimately, high prices.
Second, productivity also surges during economic recoveries, especially after deep recessions. Development and adoption of technologies that improve productivity were accelerated by the pandemic-induced shutdown. We expect new ways of working and new technologies will drive productivity higher going forward, and rising productivity – more output per unit of labor – is one more thing that keeps a lid on inflation.
Finally, we see several big pockets of unused capacity and other disinflationary forces in the economy. For example, recent strength in housing prices has been offset by weakness in urban rents. Global demographic shifts such as the aging population are also disinflationary. When the sugar-high from stimulus subsides, in our view, global growth will return to the lower levels that we experienced pre-pandemic. These three factors combine to remove both the supply and the demand side of the “inflation supercycle” theory.
The tide is high, but we’re holding on for now. We believe the Federal Reserve can and will tolerate 3-4 quarters of elevated price gains before telegraphing that they will take their foot off the gas pedal, at which point inflation will likely settle at a healthy 2.0 – 2.5% level consistent with a developed economy.
While we believe the surge in inflation will eventually prove transitory, we acknowledge the possibility that inflation may persist above 3% or 4% for longer than a few years. In that environment, investments that offer inflation protection would be increasingly attractive, such as real estate, high-yield bonds, and stocks of quality companies with low debt levels and strong pricing power. Countries that import commodities would be less attractive than exporters, all else being equal. Niche investments like asset-backed securities and insurance-linked securities would also be attractive sources of income. At some point, however, the Federal Reserve would need to raise rates to slow the overheated economy. In this scenario, we would expect that economically sensitive sectors such as energy, financials, industrials, and other value-style sectors would underperform as the economy slows.
Over the past several months, these cyclical and value-style stocks – especially in the financial and energy sectors – have risen double-digits on the promise of a reopening economy and increasing interest rates. Meanwhile, high-flying, high-growth stocks with nosebleed valuations have been brutally punished. Rising interest rates mean higher cost of capital and a higher discount rate. Taken together, these factors mean future sky-high expectations may not be as valuable today as they were when those rates were closer to zero.
There’s an old investment saying: “Rent value. Own growth.” In our mature economy, countervailing market forces and policies are designed to keep factors like inflation, employment, and productivity in line with a reasonable, modest-growth trajectory. We remain on watch for signs of excess, especially given the unprecedented amount of debt-financed deficit spending. That’s why we invest in enduring businesses with quality cash flow, instead of fantastical stories and squiggles on a screen. We believe a disciplined, bottom-up investment strategy focusing on quality growth and reasonable valuations will prevail over the long term.
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