“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital”
- Warren Buffett
The year 2020 has been wild, no doubt about it, and it’s only 50% done. We have tried our best to keep investors updated at length on the markets, and we all know how they have behaved this year. As they begin to somewhat stabilize, re-openings take place, and some partial sense of “normalcy” starts to seep into our everyday lives, I thought it would be an interesting juncture to look ahead on a macroeconomic level with some thoughts.
The words “recession” and even “depression” have been put into print with quite a bit of regularity over the past 120 days. While there is little doubt we’ve experienced the former, with the huge amount of fiscal and monetary stimulus that has happened all over the globe, the powers that be are doing everything they can to prevent the latter, although some economic data would imply some sectors of the economy (like employment for instance) have experienced a depression-like impact.
Stimulus would be an understatement:
Source: Evergreen Gavekal
There are some that argue that the U.S. economy is currently undergoing a transition, from an economic depression to a recession – not a recovery. With these various economic expansions or contractions usually comes some other impacts, or “symptoms.” The various types of “-flations”: inflation, deflation, reflation, stagflation, hyperinflation, are the better-known -flations. Inflation has been low for an entire generation, while some of the others mentioned have never been experienced in North America. I think there is a good chance that before this cycle is all done, we could actually have a taste of all of them. So maybe it would make sense to start with some definitions:
- Inflation:
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.
- Deflation:
Deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0%. Inflation reduces the value of currency over time, but sudden deflation increases it.
- Reflation:
Reflation is the act of stimulating the economy by increasing the money supply or by reducing taxes, seeking to bring the economy back up to the long-term trend, following a dip in the business cycle. It is the opposite of disinflation, which seeks to return the economy back down to the long-term trend.
- Stagflation:
Stagflation or recession-inflation is a situation in which the inflation rate is high, the economic growth rate slows and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.
- Hyperinflation:
Hyperinflation is very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This typically happens when a nation reaches a level of over-indebtedness by “printing money” at a rapid pace.
Of those, I think the biggest risk is inflation. Inflation is poorly understood. It’s been absent for so long that few believe it exists anymore, and there are a lot of forces at work that could create it. Inflation speeds up an economy – it doesn’t make it better, it makes it faster.
For anyone seeking to understand the maze that is economic study – due to the fact that it is rarely stated – inflation, hyperinflation and deflation can follow one another in the same catastrophic economic period. In fact, theoretically, they can actually exist at the same time.
No doubt about it: COVID-19 was a deflationary shock.
The economy was hit with simultaneous bouts of demand and supply shocks. Given what’s gone on in 2020 already, we’ve probably had a decent case of deflation, as the global pandemic forced policy makers to intentionally put the global economy into a self-induced coma. It created a demand collapse by locking everyone in their homes, and it collapsed supply chains at the same time. When the U.S. unemployment rolls top 40 million people, I’d say those are depression-like numbers.
Not a single person in the world could have foreseen “highest unemployment since the Great Depression” as a possible headline for 2020.
As I mentioned earlier, inflation has been low for an entire generation. Interest rates peaked in the early 1980s at around 20%, as I started my career in finance, and are now at zero. There are a lot of people out there who think interest rates only go down. In psychology, they call that recency bias. Many readers are of the vintage who would think a 4-5% mortgage is historically “cheap.” If we saw those rates again in the very near future, there’s a good chance that half of the mortgages out there would be in trouble.
We had a lot of stimulus after the Great Recession of 2008–09, and yet inflation never crept back in. I think many factors kept a lid on it, including globalization, and the impact of productivity gains brought in by the forces of technology. Now there are some shorter-term forces that could alter the inflation outlook, including the incredible amounts of fiscal and monetary stimulus, tight labour conditions, the reduction of globalization and the rise of protectionism and tariff / trade policies. Think about this for a moment: the stimulus in the U.S. employed in the cycle of 2008–09 worked out to about 5% of U.S. gross domestic product (GDP). This time around? Almost 10%. Simply H-U-G-E.
The U.S.-China trade war was just foreshadowing what may come. Especially if President Trump wins again in November. The apex of globalization may be tied to the trade wars. Globalization has been the essential ingredient in the disinflationary recipe of the past several decades.
For all practical purposes, the trend in lower yields has likely bottomed as well. Sure, we could still see negative rates in North America, but when you go from 20% to zero over the past 30 years, the bulk of the move is likely done. U.S. core inflation peaked at 10.25% in 1975. By 1989, it was 4.25%. Other things trended during that period as well, like union membership, which peaked in 1945 at 33% of the U.S. labour force, fell to 16% in 1989 and is now around 10% (6% in the private sector).
Global trade as a percentage of global GDP peaked in 1913 at 28%, collapsed during WWI, recovered in the Roaring ‘20s, plunged again during WWII, bottoming at 8% in 1945, but by 1989 (that year again), it had built up to 28%.
China was admitted to the World Trade Organization (WTO) in 2000, and that number then surged to 62%, an all-time high in 2007. During the Great Recession, it plunged to 42% and has not recovered since to the old highs. Post-pandemic, I would guess that lower trend will continue, even accelerate. That reduces competition, and that raises prices.
Demographics are a huge driver of inflation. The “Greatest Generation,” as they are commonly known, grew up during the Great Depression. Hardened by shared sacrifice, they won WWII, rebuilt the entire world and then spawned the Boomers, who only knew prosperity and directed activism towards their favourite cause: themselves. They also cut investment in youth. Now, along come the Millennials, who have a different worldview. In 2019, the Millennials overtook the aging / dying Boomers as the largest generation demographic. The Boomers’ power, both in the economy and in elections, has most likely peaked.
In places where inflation has been absent for so long, it’s hard to remember what a curse it is. Warren Buffett’s quote above is highly relevant. Most recently, we have Venezuela as a poster child. In 2016, Venezuela entered hyperinflation. The inflation rate reached 274% in 2016, 863% in 2017, 130,060% in 2018 and 9,586% in 2019. Since 2016, the overall inflation rate has increased to 53,798,500%. This is what it looks like on a graph:
Source: “Venezuela: Poster Child for Socialism” by Troy Vincent, Feb. 15, 2019, mises.org
Before Hugo Chávez came to power, Venezuela was one of the largest oil exporters in the world. The currency (bolivar) was strong, and their standard of living was one of the highest in South America. Venezuela also had huge currency reserves, which Chavez decided to spend on social programs. When Nicolás Maduro took over, he nationalized the country’s energy industry. Foreign companies / managers were expelled and replaced with incompetent locals. Oil production collapsed, as did the bolivar. Maduro chose to print more money to make up for the loss of revenue – thus the seeds of hyperinflation were planted.
Before Venezuela, there was Zimbabwe. According to Trading Economics, the annual inflation rate in Zimbabwe was 540.2 percent in February of 2020. The annual inflation rate had risen to 676% in March 2020, with a bleak economic outlook due to the effects of a drought in 2019 and the COVID-19 pandemic. But wait, that’s just the past few months. Zimbabwe already had a bout with hyperinflation in the late 2000s.
Some are already saying that because of the immense debt load taken on in the west due to COVID-19, hyperinflation may be the end game and only way out. The debt added in the 2008–09 cycle was already massive, and global debt-to-GDP was at an all-time high already – just in January. That’s right, before all this new debt was even conceived.
The public is on board with bailing out unemployed citizens with massive monetary and fiscal stimulus. Corporations don’t mind all their junk debt (literally) being bought up by the Federal Reserve. When does the money run out? Well, I guess technically, the money never runs out – but it does have to be repaid at some point, and with an interest cost in the meantime. So, if we use failures in Latin American countries and others as examples, what are the options?
The obvious ones are fiscal austerity, paying off the debt in a reasonable manner and higher taxes, but neither of these can be big enough to even make a dent.
Here is a good flow chart from Evergreen / Gavekal:
There are two more possible outcomes not listed on there: hyperinflation, so the debt is worth less to pay back in the future, or something never even tried before: a default to the Fed, which would be the next great policy twist.
Global debt-to-GDP hit a record 322% in January, and the U.S. debt-to-GDP was sitting at around 107%. Those numbers are going higher, no question.
The U.S. Fed has promised zero interest rates through 2021 at this point, and possibly 2022. How will it fight inflation, should it begin to run? We’ve already seen it in groceries and staples. I’ve heard haircut, health care and dental prices have already increased. Many are trying to make up lost months that they will never get back due to the COVID-19 lockdown.
There wasn’t enough policy space in interest rates before the crisis happened to boost economic activity without printing extreme amounts of money. It might not happen right away and we might actually get another bout of deflation, especially if a second wave of COVID-19 forces the economy to shut down again.
What happens when the central banks stop printing money? Right now, the U.S. economy is addicted to stimulus. Look what happened briefly in 2018, when the Fed hinted at selling off balance sheet assets and hiking rates? The market collapsed 20% in December.
Coming out of the crisis, especially if we get a COVID-19 vaccine, and all this stimulus is still in place, consumers will do what they do best: consume. Even if they are overloaded with debt, for now. So don’t rule out hyperinflation as an intentional option.
What if the Fed just allows government and corporations to default to it? Politically, it may be a disaster, but it would be the ultimate “kick of the can down the road.” The Fed is already buying junk bonds, putting worthless debt on its books. Heck, they even owned Hertz debt when it went broke.
This approach will somewhat follow the Japanese model for the past couple decades. Many think that Japanese-type deflation is the path forward. But there are vast differences between the U.S. and Japan. Demographics, for one, and the yen is not the fiat currency of the world. Also, Japan never ran the annual deficits that the U.S. is, has never had a large negative public / private savings rate and never grew its money supply as fast.
Often the precursor to hyperinflation is a structural government deficit that loses financing from domestic tax revenues (like Venezuela) or foreign bond creditors (like Greece), leading to debt monetization. The U.S. has structural twin deficits and foreign investment has been falling.
The correlated nature of the credit cycle is likely something that can contribute to delaying a true recovery, until we see a wave of “impairments” via charge-offs and write-downs later this year. This is evidenced by the fact that U.S. corporations have issued over $800 billion in new debt in Q2 2020 alone. Investment-grade issues totalled $1.23 trillion in the first half of 2020. That’s roughly equivalent to the largest year of issuance over the past decade.
I would guess interest rates will stay low in North America for the foreseeable future because of near-term fragility in the economy, and high debt loads in all levels of government, corporations and individuals. You know why central banks have stopped even mentioning a path to raising rates again? Because there is no path right now. They can’t, or things start falling apart. They can’t and won’t raise rates until a sudden burst of inflation forces them to. I will go on the record right here and now in saying that inflation is the biggest consideration in finance right now.
Mr. Buffett knows inflation can damage even the safest portfolio by eroding value. In principle, equities are a good hedge against inflation because business revenues track consumer prices and allow pricing power. But markets also tend to allocate a lower value on cash flow streams when inflation rises, and a higher price on cash flow when it falls.
Since it currently seems that deficits don’t matter, there really is no limit for the time being. It could be that the next economic shock will turn out to be inflationary, and although it’s unlikely to appear imminently, I would suspect that when it begins to show up, it will happen slowly, then fast. Making matters worse, inflation from monetizing global debts and deficits will likely become a global phenomenon. Here is what the macro landscape looks like to Evergreen / Gavkal:
So if I am correct, and inflationary pressures will build due to massive fiscal and monetary stimulus, populism and nationalism hurting global trade, de-globalization and a worldwide pushback against the U.S. dollar, what’s an investor to do?
The simple answer is with an economy slowing, and then inflation creeping in, the obvious one is gold, which is considered a store of value, to us. Healthcare and consumer staples also tend to be defensive, maybe even real estate investment trusts (REITs), once the COVID-19 fallout is done and we see who the strongest survivors are. Commodities in general tend to do well. This might finally be when, after 12 years, the often-anticipated shift between growth and value names finally takes place. That should do well for Canada, but it will be a trade-off. Longer-term, we have our own fundamental issues that are now engrained and must be dealt with. Foreign currencies will increase in volatility, as well, I would guess.
This quadrant framework from summarized it well:
Source: Evergreen Gavekal
Focus on the top-right quadrant / corner, if we get inflation. But these tend to be more volatile areas, so maybe not for all investors.
For now, the least point of resistance in markets is higher. I mentioned it many times over the years – the most important thing I learned early in my career was “don’t fight the Fed.” The stimulus out there and liquidity are huge, plus, it’s a U.S. presidential election year, which tend to be bullish. Sure, shorter-term, we’ve had a decent run since late March, so are due for a rest / pullback, but I think it will be contained and I think we will see new all-time highs on the S&P 500 by year’s end.
We’ve been lucky (maybe a bit talented?) with our asset allocations and strategic moves so far in 2020. Most of our portfolios are positive on the year, with the S&P 500 still down 4%, and the TSX about 10% as of this writing. We will stay focused and keep our fingers on the pulse of these challenging, and truly unprecedented times, in the financial markets.
Stay Tuned,
Vito and Eric
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