I’ve been advised to follow Neil Patel’s wonderful hack and start this piece with a question and an answer to get more traffic on the blog, so here it goes:
Will higher inflation be transitory?
Well, yes, and no.
I hope this hack works like a charm, but as for now let’s get down to real business.
It’s been quite a ride on the equity markets so far this year. The estimated S&P P/E ratio is somewhere over 45 now, way above the “new era” average of the S&P 500, and more than two standard deviations above the fair value of the market. Well, let’s just presume that there is still such a thing as fair value of a stock market, and it is not something you can only find in the Sci-Fi & Fantasy section. Oldschool company valuations? Hold my beer… Forum based mobs kill short positions by the dozen through vega-game regardless of the underlying company’s free cash flow or earnings, thus creating a ponzi scheme ran buy online trading service providers and the hedge funds these provides are owned by. To top it all, a Jack-of-all-trades openly manipulates markets through tweets of a shiba-inu dog. What’s not to love about it?
In times like these markets often get some form of guidance from central banks’ predictions. Chances are however that this time monetary authorities have (or let’s say they communicate) quite different views on future economic developments than the market.
As soon as the first US headline CPI figures over 3% were released markets started to price in tapering and even a few rate hikes – despite the FED’s renewed inflation framework that focuses on average inflation over a certain period rather than a rigid number that applies to every single inflation reading.
Even with the recent fiscal spending spree and the expected strong rebound in GDP figures helped mainly by household consumption the FED kept its base rate persistently low and all that just screams high and sticky inflation… at least for the markets. The FED came up with the term “transitory”. How is it even possible to call something so blatantly obvious “transitory”? Well, the FED is right and wrong – it’s all a matter of perspective.
Market prices rise when demand surpasses supply or when production gets more expensive, and the pass-through effect is strong due to relatively rigid demand. Covid after-effects (and the new delta variant) caused disturbances in maritime shipping (see our blog entry “Bad times at Shenzen”), distribution channels became clogged, product shortages are getting more common week by week, demand is ticking up - both temporary (postponed due to lockdowns) and permanent (rising wages). Commodity and shipping prices are skyrocketing, and there are production capacity shortages in certain areas that suffered the lack of investment these last few years.
It swims like a duck, quacks like a duck, and looks like a duck, but it’s still not a duck. Literally everything points to higher inflation that is pretty much here to stay. But not for the FED.
The transitory part
There are several one-off factors pushing prices higher, the most obvious is the standstill of 2020. Lockdowns erased a decent amount of demand from the markets and that eventually pushed CPI readings close to zero in the US, and below zero in the Euro-zone. 2021 figures are bound to jump higher given the extremely low base.
Production issues in manufacturing surfaced recently, these are likely to add to the producer price pressures (we’ve already seen uptick in PPI numbers). Demand has returned so manufacturers have more pricing power – but it is also a transitory effect. Prices are expected to level off within a year as capacity adjusts to the new level of purchasing if (and it’s a strong if) semiconductor issues are solved soon.
Higher transport costs are already adding to price pressure: from soaring container prices to transport route bottleneck issues everything points toward higher inflation figures. Additional capacity is expected to appear only within 6 to 12 months but will appear eventually and is expected to smooth out recent bumps in pricing. Commodity supply issues (from oil to lumber) also look like one-off events.
These factors are only temporary, the effects are expected to fade or disappear during the next couple of quarters and central banks are more than ready to look through them.
On the macro front we must mention the rising chance of another global lockdown period as the delta variant of Covid spreads rather quickly even in countries with favorable vaccine rollout data. It might have less severe effect than the former wave, but still envisages a slowdown in global economy.
China’s credit impulse is another factor we must take into consideration: Asia’s largest economy is trying to slow down credit expansion. The closely watched credit impulse indicator (i.e., growth in new credit as share of the GDP) is already down at 25% from last October’s 32%. As a rule of thumb this credit expansion slowdown would mean lower Chinese GDP data that filters through and slows the world economy, softens global demand that results in lower CPI data. Recent transitions in Chinese economy however make this function-like relationship a bit more complex, and that is where we reach the CPI driving factors that are unlikely to wear off during the next 6 to 12 months.
The not-so-transitory factors
Chinese economy changed a lot recently. It transformed itself to one that is driven mainly by technology and services (requiring less fixed capital) shifting over from strong reliance on investment. This change alone would mean weaker correlation between credit impulse and global GDP. Furthermore, Chinese banks focused more on lending to the private sector getting more effective investments as a result, while the government curbed the housing/construction industry’s leverage ratios. The bottom line is that we can expect strong growth figures from China even with less stellar new credit numbers. In other words, the Chinese banking sector alone is highly unlikely to slow global growth and ease the CPI pressures in 2021.
Last year’s supply disruptions revealed problems that must be dealt with urgently. Heavy reliance on long supply chains caused unwanted fragility in production and brought most of the leading economies to a complete halt. As a result, many see production capacity scattered worldwide a less favorable option now. De-globalization and restructuring are in the spotlight, but as all the following factors these take time and have one-off (relocation) and ongoing (higher wages) costs.
We have multi-trillion financial programs in the pipeline on both sides of the Atlantic. Monetary policy tools had been used extensively with ever decreasing marginal effectiveness, now governments have the bat and it’s time to hit a few home runs. The problem we see here is that private sector investments are still lagging, and neither central banks nor governments show that kind of effectiveness when we are talking about capital allocation and improving competitiveness.
Artificially low interest rates redefined capitalism in the last decade. Cost of capital is close to zero, asset price bubbles formed (from lumber to dogecoin, you name it) and it redefined investment behavior: capital misallocation became the new normal, unproductive investments became profitable helped by tweets and sectors suffered decade long scarcity of new capital. There are wounds to be healed in the energy sector, transport and logistics and it will cost a lot, creating excess demand in a low supply environment.
Even the most alluring investment ideas – like “Going green” – have negative effects, namely these are not cheap, not fast, and with all the construction works considered, not that carbon neutral after all (see the diesel generators’ pollution at the new Tesla mega factory site in Germany). Add greenwashing to the mix and you’ll get an only reasonably effective and rather expensive allocation problem with decade-long after-effects.
These investments will improve competitiveness later on, but to finance the rapid credit expansion debtor countries must ramp up inflation in the first place or they would face a credit spiral. Perhaps it’s only negative real interest rates for a prolonged period, but as we see it the era of low inflation is over. Even if Mr. Bernanke had doubts that in a low-demand era full employment could only be reached with the help off bubbles, it is exactly what happened.
Those bubbles must be managed without significantly damaging the real economy but in the meantime central banks and governments must face the consequences of rising inflation: from the soaring building costs all the way through rising inequalities, from labor market issues like the cost-effect of the slow disappearance of the baby-boom generation to the minimum wage rise of unskilled workers. And tweaking the full employment definition or lengthening the period to observe average inflation in will not be enough this time.
