“Inflation is taxation without legislation.”
-- Milton Friedman
I have had very little “new” to say for much of this year so decided to skip writing the last 2 quarterly letters largely as an experiment. I actually expected to get a few calls on my missing missives but much to my surprise (and disappointment!), nobody seemed to have noticed! We get such little feedback on these publications, it is hard to know how many clients actually read them so please do let us know if you get something out of them!
In my last couple of letters I stressed that “liquidity is winning” and this has continued through 2021. By liquidity, I am referring to the fact that every major central bank embarked on massive Quantitative Easing programs at the outset of the pandemic. This is when central banks create money and use those funds to buy bonds from the bond market which essentially injects cash into the markets when the bond is sold to the central bank. This cash then gets recycled into other bonds (driving bond prices up further and yields lower) and to other assets like stocks, real estate etc.
When the pandemic first dislocated markets, the US Federal Reserve (the largest and most influential central bank so it is the one I reference the most!) pushed massive sums of liquidity into the markets. It said it was prepared to backstop the system so everyone can just relax. To encourage continued stability, it announced that it would drip a steady $120 Billion per month into markets each and every month and it was going to do this for as long as deemed necessary. This has continued to this day and if you don’t have a calculator handy, that amounts to over $2 Trillion of additional liquidity.
Other countries including Canada have conducted their own programs in comparable amounts. These central bank monetary efforts are distinctly separate from each government’s fiscal pandemic assistance efforts that have helped consumers and businesses directly. These programs have stretched budgets like never before and taken debt levels to formerly unimaginable levels. The US debt has gone from about $8 Trillion before the Great Financial Crisis of 2008 to tapping on the door of $29 Trillion just 13 years later. We are not even sure how Canada is fairing since the last federal budget was almost a year before the pandemic arrived. Prepare for some sticker shock (and likely tax increases) next spring!
Why am I going on about all this? Well we are now approaching peak liquidity as the Federal Reserve is set to announce a reduction in the $120 billion per month either next month or in December. Plans for this taper has been well telegraphed to markets so it should not result in another Taper Tantrum like we witnessed in 2013 when the Fed attempted a similar maneuver. But less additional liquidity is no doubt going to be an adjustment for the markets. That said, even if the Fed cuts by an even $20 Billion each month, we are still talking about net additional new liquidity of $300 Billion before the punchbowl goes dry. Tapering is still adding liquidity but trying to wean the patient off the medicine. It has to be done slowly and methodically and I suspect any meaningful withdrawal symptoms will be accommodated with pauses.
To continue with the metaphor, I see the economy as a patient that has been using a walker for over 17 months and we are transitioning to crutches, then a cane before the patient can eventually walk on their own steam. By that I mean we are a long way from normal as it is thought that the Federal Reserve wants to completely wind down its bond purchase program before it embarks an interest rate tightening cycle. So perhaps towards the end of next year we will see the first increase in the overnight borrowing rate from the 0-0.25% level it has been anchored at since the pandemic arrived. And depending on how these 2 activities go, we may see a reversal of some of this liquidity (referred to as QE tightening) even further down the road.
All of this massive liquidity has depressed interest rates and inflated all assets as everything is priced off of interest rates and perhaps not that coincidently, inflation has come roaring back. Long-time readers know that I have been an inflation hawk since the financial crisis. Inflation keeps the economic wheels spinning as the consistent degradation of purchasing power spurs on financial activity to stay ahead of inflation. In a world of no inflation, cash can sit idle in bank accounts and maintain its purchasing power so economic activity can stall. So central banks like the Federal Reserve target a 2% inflation rate to keep the economy growing. The Fed has said for some time it will tolerate even above target inflation before it becomes too concerned but now we are seeing posted inflation rates above 5%! We are being assured that this is just a transitory blip as we have supply chain issues during the restart of the global economy.
I think this inflation uptick will prove to be more than just a transitory event for a couple of reasons. It is going to be very difficult to normalize this extraordinary amount of liquidity. The Fed had a very hard time doing as such on a much smaller scale after the financial crisis and will not want to jeopardize the reflation in asset prices that it has achieved. Also the pandemic has highlighted the fragility of global supply chains and I think we also have perhaps witnessed peak globalization as many companies have realized their folly on their dependency on complicated global supply chains. A move to bring some critical manufacturing home will take time but will ultimately raise manufacturing costs which no doubt will flow down to consumers. Lastly, there has been huge underinvestment in the energy patch since 2014, the year oil prices crashed. Investor disdain for oil and gas in favor of green energy investment has led to a very tight market with upward pressure on oil and gas prices.
The longer inflation remains elevated, the more likely it will end up in wage inflation as employees begin to react to higher prices. If wage inflation takes root, there will be nothing transitory about higher prices. There will be pressure to raise interest rates at a time when we have historic debt levels. So while tension will build, I think governments want and need negative real interest rates to monetize their debts so they will be more likely to tolerate elevated inflation for a sustained period.
We are maintaining our investment posture with inflation and the risk of higher interest rates in mind. We are underweight fixed income (bonds) and for the exposures we have, we want less interest rate risk going forward. And we remain overweight dividend growing equities and businesses that have pricing power. Lastly we are maintaining some traditional inflation hedges through select holdings.
As always, call if you have any questions!
Derrick