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✨ How To Make Sense of All These Inflationary Pressures
Preparation for my upcoming US Inflation webinar next Tuesday
Interview date: 2nd April 2022
Maggie Lake (interviewer) & Raoul Pal (interviewee)
Inflationary pressures: The amount of spending required to transition to ESG, and lack of commodities; supply chains also need to normalize with new factories needing to be built.
Deflationary pressures: Demographics is always the larger story, and commodity prices are ultimately driven by economies - fiscal spending may be ineffectual if households start spending less. No recession indicators have started flagging yet, but many slowdown indicators are.
This Time Is Not Different: Front-end of 2’s curve doesn’t suggest rate cuts, and 3-10 curve hasn’t inverted yet - this feels a bit like 2006, where the yield curve remained inverted for over a year before the actual bad news came.
Leading indicators are telling a different story, despite Lagging indicators (e.g. markets, employment) still indicating a strong economy:
The recent spike in commodity prices have destroyed aggregate demand: Wages +5% minus Inflation +7.5% (before latest inflation print) = Aggregate demand collapsed -2.5%; if the trend rate of growth was 2.5%, it’s now down to 0%.
ISM Inventories-to-new orders suggests US is pretty close to recession; leading indicators such as shipping & freight YoY rates have all gone to recessionary levels (RL); U of Michigan consumer sentiment indicator at RL, consistent with yield curve; small business optimism also at RL; ISM new orders falling but not yet at RL; ECRI survey near zero.
ISM Manufacturing PMI is likely to get down to 50-52 sometime between June-July 2022 - and usually when that happens, the Fed stops tightening.
Stocks-to-use ratio of Wheat (excluding China’s massive stock) is as high as it has been in past 20 years - as long as we don’t have a terrible harvest in wheat this year, we won’t run out of food. Markets might have overextrapolated the trend - and if ISM comes down to 50 by summer and Fed has hiked 50-75 bps by then, they might just say “let’s wait and see”.
We saw this playbook in 2016 - the Fed said they would hike rates 4 times that year, but they only hiked once; and didn’t do anything in 2017.
As yield curve inversion tends to occur later in the cycle, Raoul doesn’t think that this time will be like 2016, where the Fed paused and hiked later - if they stop hiking this time, they are done.
Neutral real rates: As we came out of the GFC, the market was saying that the long-term Fed Fund rate could be 2%-2.5% - which remained unchanged from prior to the GFC despite the downturn. Markets at the time were pricing in 2% real rates throughout the next cycle.
Only when the Euro crisis and US austerity occurred in 2011 did near-term expectations collapse and markets assumed lower-for-longer - but even then, markets were expecting that we would return to positive long-run real rates. However, in the past 2 years that has turned negative - some markets aren’t just pricing lower-for-longer, they’re pricing in lower forever. Once again, the resilience of the view that “nothing has changed” might prove to be a mistake.
The interest rate required to have a “normal” inflation rate is now higher than it was post-GFC; and the peak in rates this cycle is going to be higher than what the market expects.
Is It Different This Time?
We’ve never been through this exact set of macroeconomic events before in history:
Is this 1973-74, when the USA underinvested in oil infrastructure & the oil embargo happened, causing oil prices to go up? What actually ended up happening then was that the economy collapsed when Volcker raised rates (where inflation shot up and then shot right back down) - which is unlikely to happen today.
Or is this the 1940’s and 50’s again, where there was massive fiscal stimulus and inflation spiked post-WW2 due to lack of supply - but what you got instead was a period of extended growth, inflation remaind okay, and bond yields stayed low while equities did really well?
Most people are expecting something much more dramatic today - where inflation remains a lot higher (e.g. 4-5%); however, Raoul thinks long-term CPI stays at around 2-3%. In that case, bond yields will trade sideways - he doesn’t see them breaking out from 3%, which would indicate a new cyclical high; something which hasn’t happened before in the past 35 years.
Today, the Russian situation mirrors the oil embargo (so we’ve seen that before); but then there’s also this massive shift to ESG (which is a huge type of global stimulus - as Europe needs to retool its entire economy). But we’ve also never had both of those at the same time as the largest aging population in all recorded history, plus the largest debt loads; while coming out of a pandemic which has broken all supply chains.
Is It Really Different This Time? The prevailing macroenvironment wasn’t just about aggressive monetary policy; but also fiscal policy stepping in like they haven’t before:
If we assume that long-run monetary policy oscillates around zero globally - then the only remaining policy tools are 1) fiscal stimulus, and 2) using the central bank’s balance sheet in times of stress to bolster it.
The Rubicon has already been crossed with Direct Transfer Payments (DTC - or “helicopter money”) - everyone around the world did it. And now that they’ve used it once, they’ll do it again - Europe is already saying that they will have to transition away from reliance on other nations & fossil fuels, and this is going to create higher prices; so the only way of dealing with it is to give households money to offset it (as opposed to just cutting taxes). Spain is even doing DTC for companies, as Spain has variable oil prices for their utilities - they’ve already started subsidizing companies as oil price went up +50%.
Raoul thinks this will become the “new normal” - if governments adopt a war approach (i.e. if we’re going to do this together, we’ll help you offset the impact), that sounds like the Euro is going to parity or below to the dollar - as that implies endless stimulus. However, we’re also seeing the same thing happening in the USA - California has already said that they wanted to give $800 per household, and 10 other states have also already made announcements around stimulus; which will surely be exploited by the Democrats for midterms.
And when the economy slows down again, there will be more stimulus - implying a scenario of currency debasement in the face of endless stimulus and endless debt (MMT?), where everything ends up on the Central Bank’s balance sheet (e.g. Japan, where everyone tries to sell bonds and the BOJ buys it up by printing money, which weakens their currency). Then the Japanese - which has the largest savings pool in the world - goes to the US bond market and stops bond yields going up in the USA (or goes into US stocks). It’s a global issue that revolves around having too much debt and interest rates can’t rise enough; but you still need to stimulate and there are too many old people in the workforce. It’s a really big macro picture - on top of all the shocks that are taking place now.
Nobody knows what the underlying trend is now, as we had a massive 2-month recession immediately followed by a massive rebound - e.g. what part of it is structural vs. driven by supply chain disruption, how much is caused by US firms reshoring and actually affecting prices. And the answer to all this is: We Don’t Know.
The harder question is: How Do We Position Ourselves? The bond market is already pricing in 7.5 rate hikes and thus can’t be shorted; Commodities have already priced in a lot; we’ve seen how Equities can go down 30% and then rebound overnight. Gold didn’t do anything over the past 2 years despite being the default recession trade, and the USD only appears to be going higher.
There are times where macro is boring like during 2013-2015; but there are times like now where everything in macro is happening all at once. Raoul can’t remember a time similar to this - he thinks this is a really, really difficult market.
Bond yields: Raoul thinks that 10-yr bond yields top out at 3%, but a lot has already been priced in. This is the fastest % rate increase in history (low base effect notwithstanding) - drawing comparisons to 1994’s bond collapse.
US households have increased their debt load by 62% since 2010 - how sensitive are they to interest rate hikes? Household debt service costs have been pretty low thus far as interest rates have been low, so it really depends on when & where they refinance. Discretionary income has already started falling off - but in terms of aggregate household debt, the sad truth is that the Fed will never allow households to go bust. They’ve already bought corporate debt in the past, funded households with DTC, and waded into the bond market - in all likelihood, the Fed will spread out the pain going forward and penalize everyone by debasing the currency (e.g. Japan’s Lost Decades - nobody went bust).
“Exponential Age” Tech stocks (i.e. Cathie Wood disruption stocks): Nothing will stop the upcoming rise of technology - all of these new technologies are coming together at the same time. This is a secular trend, not a cyclical one - so even if markets correct in the short-term, they will catch up in the long-term to underlying real productivity growth from these Exponential Age businesses. Some Tech stocks have fallen by -75% already (2 standard deviations from the 10-yr trend), and Raoul thinks that it doesn’t get better than this.
Forex: The recent USDJPY move was a 7 standard deviation event - these are huge moves, and nobody knows what they mean yet; it’s like looking at a train crash but still not understanding why it happened. Raoul thinks we need to watch forex like a hawk - the recent USDJPY move broke a 20-yr trend (despite the country having the oldest population, largest savings nation, highest debts, and traditionally being a non-volatile currency). The same breakout is being demonstrated by the 30-year trend of the Euro with the currency basket (as extrapolated by Bloomberg) - if the Euro breaks out from there, it could go down to 0.80 Euro/USD.
There’s something about these highly indebted nations which can’t raise interest rates anymore and are seeing inflation, which are causing currencies to collapse. A strong USD is a wrecking ball for emerging economies - what happens to RMB if the USD continues to strengthen? Will Japanese money pile into US and Euro bond markets due to a weakening yen? Will that stop UST yields from rising? It’s possible - but these are all really big things and it’s not clear what the outcomes are yet. But watch it, as these are the kind of things that blow things up.
Also worth pointing out that economists don’t know yet if the recent global inflation is structural or cyclical (i.e. supply chains) in nature - the BOJ is finally getting the inflation it’s been targeting for a decade; but how should it respond? If this inflation actually turns out to be structural, does that mean that the BOJ has to YCC from 25 bps to 125 bps? That would imply a complete implosion of Japan’s economy.
The Structural Inflation Argument: the Eurozone is doubling down on ESG, but we’ve run out of commodities to reach the end goal - we have neither the resources (e.g. lithium) or supply chains to fully realize ESG today; and nuclear power stations take 10 years to build. Yet the opposite could also be true - we didn’t have high inflation in the early 2000’s despite the commodity supercycle whilst China was entering into the global economy. It just depends - nothing is written in stone yet.
In the recession after the early 2000’s dot-com bust, China was fully introduced into the global economy after the WTO agreement. This represented an entrance of 1.2 billion people into the global economy - who were building roads, bridges, cities, tunnels, etc - it was the largest consumption of commodities the world had ever seen, which fuelled a huge commodities bull market. And yet the average inflation rate between 2000-2008 was only 3%.
If this long-term inflation trend holds going forward and LT bond yields hold at 2.5%, that implies negative real yields of -0.5% - which doesn’t sound too crazy. The balance of probabilities has definitely shifted to a 60:40 chance of things moving in the direction of further inflation - but virtually nobody is saying there is an 80% certainty of either occurring.
The Structural Deflation Argument: The Rise of the Robots is here - it’s a hugely deflationary force. Remember that both wages and inflation are lagging indicators - and both are usually the last shoes to drop. Labour might have a temporary window to get some wage rises back before being replaced - but once you get down to an unemployment rate of 3.6%, it’s pretty much followed by a recession every single time.
What’s the best asset class to be in today? It depends - if you think that growth is slowing & inflation will slow, own equities & crypto. If you think that secular stagnation is coming, then you don’t want to own equities - but what do you own? Gold’s gone nowhere (the usual secular stagnation trade).
Raoul admits that he doesn’t know what the best trade is today, but he does reveal his own portfolio: he’s portfolio is currently 100% long crypto, he’s long USD and starting to buy “exponential age” equities, and he’s still waiting to try and pick the top of the bond market. But in terms of broad portfolio allocation, he says he doesn’t know what the best trade today is, but just don’t assume too much risk.
What about Commodities? The secular commodities theme should work, but if we’ve got a slowdown that leads to demand destruction - in which case commodities will correct first. And copper hasn’t gone up, so it’s hinting at a slowdown. Raoul would rather buy commodities in a downcycle - at this point of the cycle it feels like a flip of a coin; but assuming we get a recession and commodities sell of by -50% from here, then we can buy commodities again.
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