- While we still believe as detailed in the Annual Letter dated March 9th that:
- Real interest rates will stay low for the foreseeable future (think years);
- COVID-19 has hijacked the year 2020, and the risk associated with it is real and still not quantifiable;
- COVID-19 will be contained with a vaccine/treatment at some point; and
- Upon the containment of COVID-19 and the resumption of normal economic activity, equity markets will snap back due to pent up demand and significant monetary stimulus.
- We want you to consider the risk that the unprecedented monetary expansion will cause a devaluation of fiat currencies, including the US dollar.
In the months since the COVID-19 pandemic, there’s been a lot of concern about the consequences for our country, especially the 100,000-plus deaths and the economic catastrophe. Amidst unemployment claims topping 40 million, there hasn’t been a lot of attention paid to the threat of inflation which, perhaps, shouldn’t be that surprising. We tend to associate inflation with economies that are growing too fast or suffering a shock in prices like the oil embargo of the mid 1970s not with ones facing record unemployment. Indeed, the annual inflation rate was a mere 0.3 percent for the 12 months ending in April. U.S. consumer prices actually dropped 0.8 percent in April and, as we know all too well in Houston where I’m based, energy prices collapsed. Prices at the pump dropped some 20 percent in April.
But there is a reason for investors to be worried about future inflation and to consider what to do now in preparation. We wanted to share a few thoughts –not as specific investment guidance but as things to think about in the weeks and months ahead.
Why are we worried about the possibility of serious inflation? There are a few reasons. First, is the money that’s been helicopter dropped into the economy–trillions in direct payments to businesses, individuals as well as state and local governments. Congress has approved one $3 trillion package and there’s surely more to come. Then there’s the Federal Reserve not only cutting rates to near zero but engaging in quantitative easing that makes the 2008 financial bailout look like a payday lender. You don’t need to be a tight money zealot to believe that this deluge of money is the classic precondition for devaluing the currency and producing inflation.
You might be comforted by the fact that the economy was not racked by inflation following the Great Financial Crisis of 2008-9. But there’s little solace to be had from that example. Unlike the financial crisis, where the nation’s housing stock was overbuilt and there was lots of excess supply, this time there’s no such surplus. Furthermore, the banking system was in desperate need of support, and much of the money went to shore up banking reserves. Today, the banks are in much better position and do not need balance sheet support. Finally, the size of this government bailout dwarfs the Troubled Assets Relief Program (TARP) or other programs from the decade’s first century. TARP started as a $710 billion program which sounds almost quaint these days and it was cut down to under $500 billion. Eventually, someone is going to stop buying U.S. debt and when that happens, the dollar gets slammed and prices rise even more. Large government deficits lead to continued large debt issuance, which must keep expanding in order to hold government purchases the same. It’s a vicious circle.
Then there’s “cost-push inflation” — what happens when prices go up because it costs more to make things. Consider restaurants. They’re starting to reopen which is great, but most can only open at limited capacity. Already operating on a narrow margin, they not only can’t afford to cut their prices, they would likely have to raise them just to stay in business. The same goes for airlines which may have to cut back the number of seats in each plane not to mention gyms and salons when they start to open en masse. They’re not going to be in a position to cut prices. Hotel chains are going to have to spend more on cleaning to lure customers back. What’s more, there are other cost-push factors now that could well contribute to inflation. The Trump administration is ramping up rhetoric towards China and tariffs and other trade restrictions could well be in our future. This effort to “on shore” manufacturing and other businesses that produce at lower costs in places like Taiwan and move them to Toledo will add to price hikes.
Other prices will start to rise because of “demand-pull inflation,” which arises from the shortage of supply. Oil plunged drastically this spring and winter but that’s going to shoot back up as people come out of lockdown. Who’s going to want to utilize public transportation in the near future? There’s huge pent up demand to travel after being stuck in the house and people are going to do this in their own vehicles. That’s going to send oil demand up. Meanwhile, the crash in oil prices combined with the shrinking of oil investment dollars will reduce supply – leading to an increase in oil prices.
It’s entirely possible we could end up not only with inflation but stagflation, which first emerged in the 1970s when inflation combined with high unemployment. We could get rising prices from all that debt as well as residually high unemployment as jobs in sectors like retail or commercial real estate never bounce back to pre-pandemic levels. I’m not saying this as a prediction, only as something for you to think about.
Finally, we are worried that the Federal Reserve cannot and will not crush inflation like it did in the 1970s and 1980s when Chairman Paul Volcker dramatically raised interest rates. Volker deepened economic misery but dramatically halted rising prices and put the global economy on a good course for 40 years. That hard-earned credibility is atrophying, in part, because it’s widely assumed that the Fed can’t shrink its balance sheet. If the market loses faith in the Fed’s ability to crush inflation, then money expansion is here to stay.
What might be good investments if inflation is on the horizon? Equities should remain a central part of one’s long term strategy. I’ve never really recommended gold but there is a reason to look at it now because it’s a classic hedge against devaluing currency. Residential real estate is also worth examining, especially affordable housing, which a troubled economy will need.
We’ve been through an incredible period as a country in just a few months–a health crisis, an economic crisis, and civil unrest. After all of that, it’s worth thinking about and preparing for different challenges ahead.
David E. Andrew
Autumn Lane Advisors, LLC
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