Chart of the Week (COW)

Today we will focus solely on the COW and we will return to our regular comment next week.

We get a fair number of questions about inflation and whether it is here to stay or not. Our view, which has evolved a bit over the past few months, is that the extreme levels of inflation we have seen over the past half year or so are likely to diminish significantly over the next year, but that inflation overall is likely to be higher than the prior 20-years when we lived in a world with extremely low levels of inflation. Let’s look at a chart and then comment:

We are looking at inventories. As you can see, inventories were already in decline ahead of Covid. This was because the global economy was strong and manufacturing could not keep up with demand. And then Covid hit and inventories plummeted largely because manufacturing shutdown, but also because demand, especially for stay-at-home stuff, rose sharply, so we had a perfect storm of plummeting supply and rising demand.

In the wake of the Covid-induced drop in inventories, we did see a rapid recovery as manufacturing was reactivated. However, after that initial rise, we have seen inventories once again decline. The factors driving this are threefold:

1. Manufacturing capacity remains below its pre-Covid levels largely because Covid remains an issue and is still constraining a full global restart;

2. The reopening of the economy in many areas has spurred pent up demand for non-stay-at-home stuff;

3. The global supply chain (remember that most stuff is manufactured in emerging Asia) remains damaged largely because of Covid, which ultimately feeds into lower finished goods inventory.

Now, the above explains why inflation is high today. However, at some point, we are going to move past some of these manufacturing challenges. In addition, demand will wane to some degree as we will not always be in a state of reopening. Thus, there will be a decline in inflation as we essentially return to a state of normality.

But - and here’s why we think there is a risk that inflation is likely to be higher than it was from say 2000 to 2020 – some of the manufacturing challenges are likely to become more permanent. We have already begun to see some “reshoring” of manufacturing capacity. This basically means that some capacity that was moved overseas has been moved back to North America. We are likely to see more of this in the years to come as Covid has inadvertently helped countries to see the challenges of supply chains that are too long. With reshoring will come higher costs largely because the cost of labor in developed countries is significantly higher than the cost of labor in emerging economies, even when one accounts for shipping costs.

So, what does this mean to us as investors? Inflation, as long as it is contained (which we think it will be), is generally good for stocks and bad for bonds.

Why? Most companies have two natural hedges against inflation – 1) They can raise prices (essentially pass on inflation to end customers) and 2) They can raise their dividends at a faster rate than the rate of inflation. Bonds do not enjoy this luxury as their coupons are fixed. Now, this does not mean we would not own bonds as they still provide an important layer of protection and if one digs deep enough, one can usually find interesting opportunities. However, it does mean that returns on bonds are likely to be challenged for some time to come, which will mean that putting together the puzzle pieces to get to say a 6% return will become more challenging.