Inflation is a serious problem for monetary policy makers and financial markets alike.
In Platinum’s view, a reckoning approaches: (central banks will) either allow inflation to run rampant or raise interest rates and threaten to seriously affect asset prices.
In the former case, cyclicals like industrials, materials and financials could do well, in Platinum’s opinion. In the latter case, crowded trades like US technology and consumer stocks could be affected.
In this article, we will limit our discussion largely to the US, as it is still the financing cycle that matters given the US dollar’s dominant global role.
Market-derived expectations for inflation in the US in five years’ time sit at 3% at the time of writing this article (Source: Bloomberg). Yet the yield on five-year US Treasuries is 1.3%.
In other words, “investors” buying five-year Treasuries are happy to lose 1.7% per annum for five years in real terms, for the luxury of owning a five-year Treasury Note. That does not make a lot of sense as an investment. That’s because it is not an investment.
In Platinum’s view, this reflects the use of sovereign bonds not as a yield-bearing investment, but rather as collateral which can be lent out or borrowed against.
With more collateral in the system, participants can gear themselves (borrow) more and asset prices can inflate (rise). This is a consequence of more than a decade of monetary experimentation, of Quantitative Easing and the Ample Reserves Regime.
In the initial post-GFC world (after 2008-09), with governments trying to use austerity to return to growth, super low rates appeared a natural consequence of the global economy’s slack growth.
Today, we see massive government spending in the post-COVID-19 environment, plus catch-up capital expenditure across many fundamental industries like shipping, energy and mining, and longer-term the staggering capital requirements of decarbonisation loom.
In this new world, the weirdness of the dollar-based international monetary system is being made obvious by inflation (more on this below).
The dollar system is flooded with bank reserves (which are the accounting and systemic offset of government bonds). In June 2008, there was US$47 billion in reserves in the US banking system. Today, there is US$4.2 trillion.
The flood of reserves in the system is largely caused by bond buying by the Federal Reserve, whose balance sheet has grown from US$900 billion in June 2008 to US$8.7 trillion today.
So, even as the supply of reserves and bonds exploded, the price of bonds soared. The largest buyer (the US Federal Reserve) is not just price insensitive – it wants high prices (which equate to low yields), on bonds.
Central to the inflation debate is what will happen to wages. Wages are not directly measured in the US Consumer Price Index (CPI) or Personal Consumption Expenditure (PCE), but they are central to the cost of services, and growing wages can result in a “wage-price spiral”.
US wages, as measured by the Atlanta Fed, are currently increasing at their fastest rate in the post GFC period, at 4.1%.
At the same time, US consumers expect inflation one year ahead to be nearly 6% and three years ahead to be over 4%. Google Trends shows that people are searching for “inflation” in the US at about the highest rates on record, going back to 2004.
And all this is before measured inflation really heats up in the US rental market. “Owners’ Equivalent Rent” (OER) is one third of US CPI. This is a survey-based metric, attempting to capture the US rental market on average.
OER has been running at rates below historic trend during the pandemic. The most recent data point was a 3.1% increase in October 2021.
This is very low: the Case-Shiller Index of US home prices recorded its highest ever annual rate of change in its latest observation in August 2021 – up 19.8%. Zillow’s US like-for-like rental data point was up 11% per annum in October 2021.
The result: is strong upward pressure on the one third of US CPI, which is composed of rents.
US households have record exposure to equities, taking out the prior all-time high in 1999 in recent months. Margin debt recently posted explosive growth of 70% year-on-year in the US – a rate only recorded in 1999 and 2007 previously.
In Platinum’s opinion, this looks much like the late 1990s, the late 1920s or 1980s Japan: staggering levels of excess in valuation in favoured stocks and odd behaviour of retail favourites like Tesla or GameStop (in Platinum’s opinion) and complacency among market participants, willing to dance as long as the music plays (at best), or else oblivious to the risks inherent in such times, as in “stocks always go up” (at worst).
Policy makers must now choose between ceasing bond purchases plus raising rates to fight building inflationary pressures, or allowing the party to continue.
If the massive growth in supply of government debt is not met with central bank buying and aided by record low policy rates, yield curves are likely to reset much higher than current levels.
Higher rates mean lower bond prices and less collateral in the system against which to borrow and speculate. This is likely to see large drawdowns in the most crowded stocks of all time, characterised by huge retail participation, lots of gearing and at all-time-high valuations.
If on the other hand monetary policy settings are not adjusted adequately, inflation will continue unabated, benefitting financials, industrials and materials, all of which are deeply out of favour.