Ronald Reagan (1978): “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
Joe Biden (2021): “A job is about a lot more than a paycheck. It’s about dignity. It’s about respect. It’s about being able to look your kid in the eye and say everything will be okay. Too many people today can’t do that – and it’s got to change.”
Janet Yellen (2021): “Neither the president-elect, nor I, propose this relief package without an appreciation for the country’s debt burden. But right now, with interest rates at historic lows, the smartest thing we can do is act big”.
Inflation will change everything
Inflation, if it does return, will change everything.
We’ve been living in a 40 year bull market for bonds – where inflation was subdued, and interest rates have largely been going down.
No portfolio today is prepared for inflation.
If inflation does return, it will be the biggest paradigm shift in investing since the 1970s.
The sheer possibility of this alone, requires that we spend some time to think about inflation.
And with US CPI inflation coming in hot this week at 5%, the highest since August 2008, I figured it was now or never.
Basics: What is Inflation?
Inflation is prices going up. Simple as that.
There are 2 types of inflation:
- Asset Price Inflation – Price of financial assets (stocks, real estate, bonds) go up
- Consumer Price Inflation – Price of a basket of consumer goods (eg. food, petrol, housing) goes up
Asset Price Inflation
Asset Price Inflation is what we saw the past 40 years.
Interest rates have been going down steadily since the 1980s, and with that, asset prices have been going up.
Inequality as well – because the rich tend to own more assets like stocks / real estate, that benefit from low interest rates.
Consumer Price Inflation
Consumer price inflation on the other hand, hasn’t been around for a long time.
The last time inflation was actually a problem was the 1970s, and it only ended by raising interest rates to 15% and beyond.
What is inflationary in 2021?
The latest US CPI inflation print is really interesting, because it shows that the key areas that are going up in price are:
- Energy (28.5%)
- Transportation (11.2%)
- Food (2.2%)
- Certain types of goods
Interestingly, rent has been low at 1.8%, but that could be because it’s the national average (certain areas would see much higher numbers as people move back to cities).
In Singapore – transport and energy has been up as well due to rising oil prices. Food has been up slightly.
So far, the CPI inflation seems mainly limited to energy and transport, which itself is mainly driven by rising oil prices.
This is fair since a year ago, oil price went negative for a while, so the year on year comparisons are bound to be high.
So I can definitely see why a lot of people are calling this inflation “transitory”.
BUT – CPI is a lagging indicator.
Trying to form a view on inflation based on CPI today is like driving a car through the rearview mirror.
By the time inflation shows up in CPI, you bet that every investor out there knows about it, and there’s no money to be made.
As investors, we need to look forward 6 – 12 months or more. And ask ourselves – is the future going to be inflationary for consumer prices?
Or will it be deflationary like the past 10 years?
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Arguments for inflation
The arguments for inflation, center around the unprecedented stimulus that governments are sending directly to consumers.
In 2008 it was Feds printing to buy bonds. The money stays in the financial system, driving asset prices up. No inflation.
Today it is Trump/Biden giving money directly to voters – who then go to the store and buy a Playstation, or have a nice steak. More money chasing the same goods, prices go up.
Then throw in rising demand because everybody is sick of COVID and dying to go for a holiday again or dine in a restaurant.
Throw in supply chain disruptions globally caused by COVID.
Throw in the rise of nationalism, deglobalisation, and rising cost of labour in China.
And you have a very powerful argument for inflation.
Arguments against inflation
The deflation guys though, will point out that Japan has been doing insane amounts of stimulus for 20 years, and what did they have to show for it?
The highest they got was 2.76% for 1 year in 2014, which promptly disappeared the next year.
Throw in Demographics (ageing population in developed countries), and the productivity increase from technology, and you have powerful deflationary forces in play.
What do I think?
Now no one knows the answer here.
In fact, if you disagree with me, I welcome you to share views below and we can discuss further.
But for me personally – I think this time is indeed different.
I think the world has been building to this point for some time, but COVID was the straw that broke the camel’s back.
COVID was going to create the worst global recession since the Great Depression.
Then governments decided to print unlimited amounts of money, and hey – suddenly we’re back at a red hot economy and stock market in less than 12 months.
And I think once governments and voters realise you can do this, you can never go back.
You cannot put the genie back in the bottle.
How can any government justify allowing another 2008 – people going jobless and suffering, when the solution is as simple as printing money and spending it.
Just take Singapore for example. In 2020 we spent $100 billion propping up the economy. And when COVID flares up in 2021, it’s another $800 million in financial support again.
The zeitgeist has changed.
The solution to any problem going forward (for developed nations), is going to be to spend more money.
Just take a look at the chart below.
The last time the US spent this much money, Hitler was running wild in Europe and the Allies were fighting to defeat the Axis Powers. That’s how unprecedented we are today.
So unlike 2008, I think this time around, we will eventually see inflation.
Will we see inflation in 2021?
To be very clear, I’m not saying go out and hedge your portfolio for inflation tomorrow.
I still don’t think we will see sustained inflation in 2021.
We’re emerging from a very deep recession, and any small shock can easily derail the recovery.
I think real inflation is going to be more of a 2022 / 2023 story.
Just look at market expectations on inflations. It barely even budged after the recent 5% CPI print.
Went down in fact.
Ok, you can argue that bond market is distorted by Fed buying, but Fed buying has remained constant for about a year now. If the market sees serious sustained inflation, yields are going to be trading way higher than where they are now.
So for now, investors are not unduly worried about inflation, and I think that’s fair.
But again – markets are forward looking. The mere hint of sustained inflation, and possibility of rate hikes, could spark a big correction in stocks, very quickly.
Why inflation is so scary for central banks
The past 40 years, the solution to every single economic problem was to cut interest rates.
If inflation is an issue, cutting interest rates is like throwing fuel on the fire.
The only real solution to inflation is to raise interest rates. It increases the cost of money, reducing spending. And almost every time in the past this was tried, it has resulted in a recession.
There is real risk of policy mistake
Investors today are conditioned to think of central bankers as omnipotent. We cling onto every word out of Jerome Powell, and scrutinize press releases for changes in a single word.
But going forward – Powell will need to maintain low rates to support government spending, manage market fears about inflation, and avoid having runaway inflation.
That’s like trying to pilot a 747 in the dark, with fog. With data that is delayed by 5 minutes.
Maybe he does it perfectly, maybe he screws up one tiny bit.
But he is human after all.
And politically, the US 2022 mid-terms are key. A key lesson from Obama’s administration is that if you lose the mid-terms, it affects what you can do with your presidency. You bet that Biden has learnt that lesson well, and he’s going to want easy money in 2022 to avoid derailing any recovery.
So Powell’s task in the coming months is tough, really tough. I wouldn’t rule out the possibility of a policy mistake here.
How to hedge against inflation?
The textbook answer to hedge inflation – buy hard assets: real estate, gold, commodities, stocks of companies with pricing power.
But the more realistic answer – very few investors alive today have any experience investing in a climate with inflation.
The last time inflation was a real problem, it was 1970. Most of today’s investors hadn’t even been born yet.
So I suspect that if inflation does make a comeback, it’s going to be a lot messier than we think.
How to hedge against inflation, in 2021?
In 2021, I think the answer has become more digital.
In today’s world, digital IP like semiconductor chip designs, can be as good an inflation hedge as real estate.
So it requires investors to be more open minded in our approach.
Don’t just look at the traditional gold, real estate and commodities. Look beyond that.
Facebook is a massive platform operator, where people spend their time on. Is that like owning digital real estate?
Airbnb allows listing of properties and takes a cut each time. Is that like a digital newspaper?
And the most controversial – Bitcoin.
In an inflationary world, is Bitcoin the ultimate hedge against inflation? Is it the 21st century gold?
Now I don’t have easy answer for these questions, but my point is to be open minded, and reason from first principles.
If I ask you to build a car today, would you do it the same way it was done in 1970?
If the entire world has changed, then the way we invest must change as well.
Closing Thoughts: What am I doing?
For now, I haven’t made significant moves to position for inflation.
I already own fairly significant real estate, REIT, oil, and gold positions, so if there is inflation my portfolio won’t be caught entirely off guard.
Oil is an interesting one. Oil is a major input into CPI, because it powers everything from cars to delivery of goods. If oil price goes up, CPI goes up, so owning some oil is a good inflation hedge traditionally. Oil is even priced in USD, so any USD weakness will drive its price up.
I do have some crypto as well, so we’ll see if that turns out to be a good inflation hedge. I’m not fully convinced on inflation hedge, but I think enough people out there believe it that it could be self-fulfilling.
You can check out my full portfolio on Patron if you’re keen.
If inflation does make a comeback, central banks are going to be powerless.
We will be moving from a regime where monetary policy reigns supreme, to one where fiscal policy reigns supreme.
That will have massive consequences for investing. Either way, if you’re an investor today, you will eventually need to have a view on inflation heading into 2022 / 2023. Pays to start early.
Love to hear your thoughts!
As always, this article is written on 12 June 2021 and will not be updated going forward. Latest thoughts (and my stock watch and personal portfolio) are available on Patron.
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I like your article. Generally I share your views on inflation except for crypto as a hedge against inflation. Crypto is risky n not an asset Per se.
I generally agree with this. I see crypto as being correlated to risk assets.
The interesting thing is that it can be self fulfilling – if enough people see crypto as an inflation hedge, and if price action supports that, it could be self-fulfilling. I think it’s too early to conclude either way, when we haven’t seen sustained inflation, and crypto as an asset class is only about 10 years old (vs gold which is thousands of years).
Great article again thanks. I have read/heard similar notions from other very smart people and I am more than convinced of the trajectory, though whether I/we as investors can stop dancing before the music stops is another matter..(Citi’s Chuck Prince comes to mind). Key theme seems to be the labor shortage in China and the exporting of China’s PPI inflation.
Though one matter I still can’t fully comprehend, which is Real Estate to hedge inflation. On one hand yes, inflation will inflate away the mortgage debt. But on the other hand, interest rate will elevate the interest cost and ultimately suppress the price of the Real Estate. In this case, does the hedge only work to maintain a neutral position and not intended to produce a gain?
Thanks! Yes agree with the comment that this is the rough direction, but the exact path is hard to predict.
Yes – neutral position in theory. Rent goes up, but interest rate will affect returns. But at some point, interest rates will be dropped again, while rents stay at the elevated price, potentially producing good returns.
Anyway, that’s just in theory. In reality, if inflation makes a comeback, it will be very messy. There will be lots of opportunity to get in via market timing.
What about bank? Rate in crease bank will profit more, Can buy DBS or WFG?
It’s tricky because banks benefit from higher rates, but if rates stay high they cause a recession and loans go bad, affecting banks.
So banks like a sweet spot in inflation. Medium inflation to keep rates up, but not so high that it triggers a recession. But yeah, I would hold some as a diversifier, which I do.
The key questions are if inflation is back how much and for how long? I think 3 – 4% is something the Fed is willing to accept for 2 – 3 years as employment/incomes will slowly increase due to the massive fiscal and infrastructure stimulus. Once again, the US is reaping the benefits of having a reserve currency. I am of the view that EM exporters and manufacturers, having yet to recover from the virus, are causing a supply shock resulting in the inflation that we now see. So perhaps in 5 years things won’t be so bad. But who knows?
Haha true. Like the saying goes – all of inflation is transitory, but how long that transitory is matters a great deal!
Given how the world is structured today (so long duration), I think even inflation in the 3% – 4% range is enough to blow a lot of things up. Really interesting to see how the next few years play out.
Wow great knowledge FH. In your previous article explained why the 10yr Treasury yield crept up from 0.5% from 2020 Mar to 1.78% Dec 21. The Fed cannot keep pace and also has decided to slow down buying. The private institutions figured this is going to be the extra stimulus maybe via useful vaccine purchases etc. So there is an extra supply of these treasuries in fact the whole developed world is awashed with these extra treasuries (that’s the amount of debt) at the moment and there is no demand to soak it up. So to entice investors the 10 yr yields went up & up issued at the auctions. Fast forward to 2022 the Fed has decided to sell its shorter term <1yr assets to bring the CPI and fuel prices down. So the private institutions start selling too their different maturities assets. Then we brace for the recession and the Fed steps in again. Is this going to be played out provided as you said Biden will have no problem with that with his term in office and his revenue department. Please help
Yes that’s broadly the idea. Have shared latest macro views here! – https://financialhorse.com/how-i-will-invest-100000-in-2022s-market-crash/