The Witching Hour for Inflation

Friday the 13th has always been a day of ill-omen to the superstitious among us and perhaps no instance of that date has so lived up to its black reputation than the one whose fiftieth anniversary has just passed: Friday 13th, 1971.

On that day, as many of you will already have been reminded, President Richard Nixon, signed Executive Order 11615 and with it sundered the last remaining links between the US dollar and gold. As the quip went at the time, the preceding Johnson administration had simultaneously declared war abroad on the Vietcong and war at home on Poverty and was in imminent danger of losing both, with dire consequences for the budget, the balance of payments, and domestic prices.  

Though an attempt was soon made to reconfigure the so-called Bretton Woods system which had prevailed since the end of the Second World War to better reflect contemporary realities, the Smithsonian Agreement which enshrined that new arrangement could itself not long bear the twin forces emanating from the Federal Reserve’s loose money policies and the speculative pressure unstoppered by Nixon’s first capitulation.

Within a few, short months the perennial weak link of Sterling had rocked the framework only to be followed by a burst of selling which targeted the Italian lira and evinced a famously scatological expression of frustration from deep inside the White House.

When, in a further attempt to relieve the pressure, the US announced a second devaluation in February 1973, it was greeted with a rapid rise in the price of gold alongside worryingly modest capital inflows. In signalling that few thought this was the last ‘adjustment’ to be made, this effectively meant that the game was up. No longer willing to jeopardise their own stability in the vain attempt to prop up the ailing Greenback, one by one, America’s major trading partners abandoned their pegs to it and allowed their currencies instead to float.

This loss of the world’s main monetary anchor – however imperfect its operation had long been – soon combined with a number of geopolitical crises abroad and mounting labour unrest at home. Such aggravating factors were further excited by the ready acquiescence of newly-liberated central banks in what seemed like the last hurrah of Keynesian economic policy to produce the worst, most widespread, longest sustained episode of inflation of modern times.

Over the next decade or so, prices rose at trend annual rate of around 10% in the likes of the US, Japan, France, and Canada and at 15% and more in the Sick Men of Italy and the UK. Only the resolution of the German and the Swiss authorities – of course empowered by the very different mindset of their citizenry – limited the damage to the mid-single digits.

The experience of ‘The Great Inflation”, as it came to be called, would inform debate and shape policy for much of the next quarter century until that series of intensifying earthquakes – arguably starting with the Mexican “Tequila Crisis” of 1994 and culminating in Lehman Brothers’ role in triggering the “Great Financial Crisis” of 2008 – would see the rulebook once more torn up and rewritten, largely on the hoof, under the boldly crayoned rubric: “Whatever It Takes”.

The elevation of central banks to the unparalleled primacy and freedom from meaningful restraint which they enjoy today – an apotheosis given its final crowning by the world’s panicky response to the COVID19 outbreak – has now brought us to the stage where they have conjured truly mind-boggling amounts of money into existence in the space of months, ostensibly to finance government supplements to and substitutes for the frozen incomes and impaired productive assets of people denied their regular livelihoods by a Draconian, wholly uncosted siege warfare policy of lockdown and limitation.

Ever since this flood of money was first poured into people’s pockets, the majority of the pundits have tried to argue that it could not be inflationary – or, at least, not in anything more than a ‘transitory’ manner, as the buzzword has it.

Nonetheless, as the prices of everything from packet boats and paints to paper, packaging, and petrochemicals, from pharmaceuticals and polysilicon to pork, potatoes, peanut oil, pulses, and potash began to rise and as it became all too apparent that it was a great deal easier to unleash monetary demand than it ever could be to re-order physical supply, gradually the suspicion arose that what we’re seeing is an active case of what the hoary, old simplification describes as ‘too much money chasing too few goods’ – i.e., inflation – being acted out before us.

Tip-Toe Taper

For the most part, central bankers have responded huffily to this lack of faith by saying that the ‘basis effects’ from last year’s deliberately fostered slump would soon work their way out of the system, if perhaps a little more slowly than their first over-sanguine projections had entailed.

True, some at the Fed are talking about ‘tapering’ soon if the economic numbers keep coming in as strongly as they have of late, but this is a very weak tea, indeed. “Tapering” only means “tightening” in the sense that a heavy smoker ‘tapers’ when he cuts down from two packs per day to one in the hope of improving his health. It means, initially, at least, no more than “smaller regular injections of stimulus”.

The Bank of England, too, generated breathless headlines after its last regular policy meeting  when it unveiled its route map back to what it fondly imagines will be a semblance of normality.

This notional schedule foresees interest rates climbing (!) in widely-spaced 10 basis point nano-steps until they reach the hardly nosebleed heights of one-half of one percent FOUR YEARS HENCE. At that point – “if conditions are broadly in line with projections” the Bank assures us – it will allow some part of its vast £895 billion portfolio of debt securities to mature (some £28 billion of which, incidentally, it still intends to purchase between now and December even as the retail price index rate of change hits its highest pace in one decade and its second highest in three). But it will only actively begin to sell its holdings if and when rates have soared upward thence to one whole percentage point per annum.

The ECB is even more in thrall to its own rhetoric. Even as German consumer prices rise at their fastest pace since our aforementioned “Great Inflation” was finally waning, way back in 1982, its board members are proudly proclaiming their delight at having the €800 billion of Brussels’ “Next Generation EU” slush fund against which to write cheques, on top of the €1.2 trillion previously earmarked for the “Multi-annual Financial Framework” – a planned, top down disbursement which, remember, is additional to the already generous national budgetary outlays in prospect.

And what of the potential impact of this? Well, ECB council member Fabio Panetta told Handelsblatt recently that:

“In the past, impatience led the ECB to raise rates prematurely, keeping excessive downward pressure on inflation and stymying growth. So it’s therefore clear to everyone that in order to guarantee price stability, it may be necessary to, as they say, ‘run the economy hot’, to let it rev up a little.”

As if that were not clear enough, Signor Panetta wants to give the donkeys in the Finance Ministry a good kick in the ribs to get them going, into the bargain:

“Our forward guidance shows how financial conditions will develop in the future, allowing governments to take measures without being afraid that the cost of debt will rise prematurely…”

Children playing with matches spring to mind.

That River in Africa

The Market, for its part, is still largely reluctant to face up to the possibly momentous consequences of what such a regime change would involve and is predominantly willing to accept these blandishments more or less at face value.

By and large, its participants are keeping fingers firmly crossed that the recent blistering pace of price rises will indeed again subside and that this will allow the printing presses to run at full speed for some time to come.

As they do, it is hoped that they will continue suppressing interest rates, filling the pocketbooks of the managerial classes, eroding corporate discipline, confounding capital allocation, postponing the identification of business failure, and so making everyone look like a bonus-worthy genius for some time to come.

What is an investor to do in such a world? Well, if he or she has faith in what the central banks are telling them, they can carry on much as they have done – chasing risk, swinging for the fences, chasing ‘ten-baggers’, ‘buying the dip’. After all, it’s worked out pretty well so far, hasn’t it?

But if they should entertain doubts about the authorities’ continued ability to defy the laws of economics and to wonder what might be the ramifications of continued easy money acting on already tightened supply, badly disrupted logistics, and the prodigious capital wastage to be expected when the enactment of  “infrastructure deals” means inflation goes from “Transitory” to “Mass Transitory” and we switch from “green shoots of recovery” to “Greens shoot down recovery”, what then?

 Well, the first thing to realise is that every inflation is different in detail from its predecessors. Broadly, we must try to identify who is getting the most money the earliest and who is happiest to spend it again and on what, once they do. Is it a consumer-oriented inflation or a producer-driven one? Is it an affair of the private sector or of the state?

As we “rev it up a little”, in Sig. Panetta’s words,  where will the next ‘bottlenecks’ emerge? Will those that do appear encourage those holding the cork readily to increase supply or simply to hike prices? Will they inhibit production – as, for example, the current chip shortage does in preventing the auto industry from reaping the full fruits of the insistent demand for new vehicles – or will they spark innovation and substitution?

These are all complex issues whose resolution is not made any easier by the fact that, by introducing much avoidable noise into the business of price formation, monetary inflation itself is not only a process which  degrades information about the true state of underlying demand and the real degree of relative scarcity in supply, but one which distorts and shortens time horizons and so impairs capital budgeting – whether than undertaken by the entrepreneur or by the investor seeking to participate by proxy in his endeavours.

The Market for Fixed Outgo

One thing we can say is that there is no form of fixed income obligation, no bond, which is priced to cope with any persistence of price rises. Even junk bonds are now trading with yields BELOW the current growth of CPI while German Bunds – which for the half century or so from the Wirtschaftswunder to the launch of the single currency offered their holders a return which was typically 4% above the rate of inflation – are now suffering a 4% shortfall below it.

Even the supposedly impervious index-linked bonds, such as US TIPS, German Bunds, and French OATi’s, guarantee a built-in slippage of up to 1.8% per annum in relation to the currency’s future loss of purchasing power, while UK index-linked gilts will cost you another 1% on top of that.

Thus, rather than seeing them as the steady, income-generating bulwark of a portfolio, it is hard to treat sovereign bonds as anything other than temporary put options which will benefit from inflows if the pace of recovery slackens or the confidence of the Market falters and momentum chasers temporarily lower their risk profile. In all other circumstances, they are essentially toxic waste.

Commodities then? Well, yes, these are generally negatively correlated with bonds – which is to say they tend to go up when the latter go down and vice versa – and if we loosely say inflation is too much money chasing too few things, among the things which tend to run fastest during that chase are commodities, especially those an increase in whose production requires long lead times and significant capital investment to achieve.

As early as the spring of 2020, we wondered whether the Corona Crash which had so depressed their prices should be seen as a brief anomaly of which the bold should seek to take advantage. By this time last summer, we were pushing the theme that one should buy ‘neutrons and protons’ – hard, physical inputs to production – as well, if not instead, of ‘electrons’ – the disembodied Tech names which everyone had just to such empyrean heights.

Having halved in relative price as the crisis hit, commodities then recouped two-thirds of their losses vis-à-vis FAANG stocks over the next six months, before once more losing ground as the tide of monetary inflation and its interpretation by those attempting to navigate it changed direction over the course of the next three months, before reversing yet again in the early weeks of September.

Such vicissitudes are very much part and parcel of these environments being due to the inevitable turbulence which accompanies every inflation as well as to the waxing and waning of the speculative positions accumulated amidst its eddies.

The fact that such surges and dissipations are common not only sows much confusion but inevitably tests not just the investor’s fortitude, but also the limits of his pocketbook since commodity holders typically incur their own costs of ownership, as encapsulated in the concept of ‘contango’. This is a technical phrase which describes the fact that the price of the futures by means of which most people gain their exposure to commodities are often priced higher than the immediately available ‘spot’ physical commodity; a phenomenon which means the buyer is continually paying a premium as he replaces each now more lowly valued contract in turn, as it approaches its expiry, with a new, longer-dated one at a higher price.

Additionally, the technicalities of this form of investing meant that some of this drain used to be offset by the interest to be earned on the margin cash balance or eligible security which needs to be posted to the futures exchange, But, alas, this is yet another longstanding feature of the market largely eradicated, if not actively reversed, by the practice of Quantitative Easing and the suppression of interest rates to – and even below – zero.

 So, if not commodities per se, what about those firms involved in their extraction and refining?

 Well, while it is true that these generally offer worthwhile operational leverage (meaning their income will escalate more rapidly than their fixed costs, at least), it is also a sad fact that this is a highly capital intensive business plagued with long lead times whose investment cycles tend both to exhaust free cash flow and end up being horribly counter-cyclical.

 While it may be too harsh to imply that, as Mark Twain pithily observed, “a mine is a hole in the ground with a crook at the entrance”, all too many miners have proven to be poor stewards of others’ capital.

To give but one illustration of this, US extractive industries, taken collectively to include oil and gas as well as mining, have spent the last seven years frittering away all the accumulated profits built up over the preceding forty, as the so-called ‘Supercycle’ of this millennium’s first decade turned to shale bust and Covid Crisis.

Too Much of Good Thing

Thus, if bonds are not to be had at any price and commodities suffer an erosion which can limit their appeal to the buy-and-hold investor, that must mean equities – with or without miners, refiners, drillers, and millers – are the key to beating inflation, aren’t they? After all, companies’ aggregate revenues will be inflated along with everything else and so should at least expand in inverse proportion to the loss of value of the money in which they are reckoned, no?

Well, not so fast.

For one thing, from revenues must be subtracted costs and those too will be inflating, meaning each company faces a constant battle to keep its head above the waters of a rising river of easy money.

Secondly, the randomising nature of inflation sows discord up and down the supply chain – and the leads and lags between having to buy in raw materials and components and then churning out (and getting paid for!) products can dangerously stretch a firm’s financial resources.

Further to this, the similar stresses which one’s customers are feeling may force them to prioritise the purchase of what may suddenly have become more pressing for them to acquire than what it is you are trying to sell. In essence, the suddenly higher price of those needs they now consider more urgent leaves them short of the funds with which to buy your offering of goods or services as well.

As things spiral further out of control, the increasing variability of price rises across the whole range of marketable products will progressively make accurate accounting more and more problematical and may mean that what at first seems like a monetary gain actually represents a debilitating capital loss.

Finally, if the disease becomes still more acute, interest rates will not only rise – to which published cost a host of informal and case-specific surcharges may be added as the market mechanism begins to fragment – but lending horizons will inevitably shorten to the point that everyone ends by living day to day and hand to mouth.

One thing that is sure is that this increase in uncertainty, coupled with a climb in nominal (if not always in real) interest rates, tends to reduce the multiples attached to earnings. The unfortunate implication of this is that even though revenues might rise, earnings might not, and even if earnings do rise, the stock price might not wholly follow.

The great test of this came in the US in the 20 years ending in 1982. As the rate of price increases crested ever higher and relapsed less deeply with each successive turn of the cycle, even the generation born of the Great Depression gradually learned to get rid of their money at an ever faster pace before prices ran away with them – a course of action which, when followed by a growing fraction of the population, inevitably ensured that they did.

In aggregate terms, over the first part of this period, relative additions to the money supply were dampened in their impact on prices as people, in good part still unaware that their savings were being ‘diluted’, held some of the excess in reserve. But, as the grim realization dawned that this entailed a loss of real purchasing power, a nationwide game of pass-the-parcel ensured that prices rose faster than the stock of money grew – a combination which paradoxically meant that it was perceived as being too hard, rather than too easy to come by.

As Andrew Dickson White wrote, a century earlier, in his seminal examination of Revolutionary France’s hyperinflationary ‘Assignats’, “money is never seen to be so scarce as when there is too much of it”.

Wars, price and wage controls, currency upheaval, budget deficits, the actions of hapless central banks, harvest failure, oil shocks, banking crises, civil unrest, and repeated industrial conflict – all were blights which afflicted the Western economies in an economic version of Pharaoh’s plagues during this unhappy period.

Some were a direct result of inflation; others resulted either from it or from the ham-fisted response to it of floundering governments.

As the economic and social malaise deepened, even equities could not offer a total defence for investors. Indeed, the S&P 500 ended this two decade stretch no further ahead in terms of total return than at the start, once the loss of value of the money in which it was reckoned was taken into account.

Within that period, bear markets in 1968-70, 1973-4, 1977-78, and 1980-82 – each comprising drawdowns of between 20% and 50% – brought repeated heartbreak before the clouds finally dispersed, the worst of the inflationary storm abated, and the subsequent Great Bull Market in stocks AND bonds finally found its legs.

The Fog of MOAR

What lessons from this can we draw for today?

The crucial observation is that inflation is a disruptor. It disrupts pricing, planning, economic calculation, capital allocation. It scrambles information and shortens time horizons. As arbitrary losses accrue and old certainties crumble, the fingers of the Invisible Hand of unconscious social co-operation become dislocated.

As the medium of exchange becomes a mechanism of short-change, the higher virtues of thrift and prudence are progressively elbowed aside in favour of dissipation and febrile speculation. In a world where everyone is in constant danger of being cheated, everyone, nolens volens, becomes himself a cheat.

In their earlier stages, inflations seem to most favour those who can borrow the most money with which to buy control over the flow of future goods and services whose prices are expected to outstrip the diminishing real cost of servicing that debt.

But even here, the risks are that the thickening fog of miscalculation and the spreading snarl of disputes and disruptions leaves customers unable to pay, suppliers unable to deliver, bankers unable to refinance, and governments unable to desist from heavy-handed interventions.

Such unwieldy empires of debt are thus not only more susceptible to loss than they appear during the inevitable fluctuations of the inflation itself, but they are uniquely vulnerable to the stringency which must accompany its end.

The key, then, would seem to be to acquire part or full ownership of well-run firms which readily generate free cash flow, preferably over short intervals and without too much call upon working capital. Of course, like everything else in this crazy world of ours, such gems are likely to be priced very richly by comparison with traditional norms, so even here the dilemma is that the attempt to acquire a measure of protection from the ravages of inflation needs one’s fears to become realised fairly rapidly in order to justify those prospective safeguards’ purchase.

Lord Arjuna’s Charioteer

In summary, inflation works its malign magic not just by raising prices, but by corrupting prices; through the seemingly arbitrary variation in price changes it effects between input and output; by precluding the possibility of making rational comparisons between one set of goods, one means of production, one use of capital and another.

Such confusion leads to incoherence in decision making and to entrepreneurial blindness. The links in every supply chain became both stretched and then broken. The time consistency of commercial processes decays ever more rapidly until every one ends by being conducted in a hand-to-mouth manner.

As the threads in the subtle tissue of exchange successively fray and snap, the whole rich tapestry of largely anonymous and barely perceived economic co-operation tears and crumbles into dust. The steady, ordered hum of Adam Smith’s pin factory dissolves into a shrieking Bedlam of urgent, self-aggravating atomism. His Invisible Hand becomes manacled, if not amputated.

We regress from being contributors to a vast, enriching network of skill-sharing, want-satisfaction, and wealth building to being isolated scavengers, picking over the refuse heap of civilisation, snarling at each other over the bones we find there, and each implicitly trying to cheat his fellow out of his malodorous sustenance by trying to gull him into taking our rotten money before its value shrivels into nothingness.

Inflation is the real ‘Graveyard of Empires’, the real Plague of Egypt, those seeding it the real ‘Greeks bearing gifts’ whom we are earnestly enjoined to beware. In a manner only slightly more metaphorical than was Oppenheimer’s allusion to the atomic bomb does an inflated currency ‘become Death, the Destroyer of Worlds’.

It is a peril which clearly confronts us today: a peril made all the more pressing by the fact that some seek to engineer it, many seem to welcome it, and many more – dulled by long years of happenstance and diversion – cannot bring themselves to admit that it is a credible prospect.

It is a very real peril, nonetheless.