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"Transitory"

The year is 2025.

Pints costs £2,000.

The trillion dollar coin has just been minted.

Anyone suggesting inflation is not transitory is sent to the “friendship gulag” for re-education.


Remember the good old days of caveatception? The time when the Fed put a caveat within a contingency within a caveat? First they were contemplating a future in which they might consider talking about talking about tapering, then they considered said future, then they were talking about talking about tapering, before actually talking about tapering, and now I’m told we can expect actual tapering (!) in the next few months.

But this isn’t a post about tapering, it’s a post about inflation.


At the most basic level, inflation is the relationship between a pile of money and a pile of goods and services. If both grow at the same rate, prices stay the same (I.e. inflation is 0%). If the pile of money grows faster than the pile of goods and services, you get inflation. It’s measured using the Consumer Price Index (CPI) which is a basket of goods and services that the average consumer purchases each month.


So what is this pile of money? It's all the US dollars in circulation, and it's called M2: the sum of physical cash, all bank deposits and anything that can be readily converted into one of the former two without loss of principal. Of all the US dollars in circulation, just over 25% have been created in the past two years. Which sounds like a terrifying stat, as the pile of goods and services certainly hasn’t grown that fast.


But there’s a bit more to inflation than two metaphorical piles. There are actually a couple of flavours of inflation. Which flavour you get depends on who gets the new dollars. If it goes to relatively less wealthy individuals, they tend to spend it on things they want or need - this tends to drive prices of goods and services higher, creating inflationary pressure as measured by CPI. However, if the dollars flow to wealthier individuals, who want for little, they tend to save or invest the additional funds - which inflates asset prices and does not directly affect CPI. This goes part of the way to explaining why, with the money printer permanently set to brrrrrr, we don’t have hyperinflation and £2,000 pints, but we do have high equity valuations and studio flats unfit to house livestock that cost £1m.


Like most simplifications, the CPI has its flaws. So what actually goes into September’s staggering 5.4% CPI number? Here are the relative weights of each good/service that goes into the CPI calculation:




Here is how much each category grew vs September 2020 (note the broad-based, large numbers):

And finally, their contribution to September’s 5.4% CPI number (i.e. the product of the previous two charts):

Now we’ve covered the components of inflation, let’s talk about why it may not be transitory. And why, with just about every dwelling priced >£1m, shelter is only up ~3%.


I’ll take a moment to comment on “shelter”. Just about every dwelling cost >£1m and seems to have charged ahead in the past 18 months – so why is the shelter component not higher? Because the CPI doesn’t concern itself with house prices (because they’re assets), it concerns itself with the price of “shelter” which is what you pay in rent… or, if you own your property, the Bureau of Labour Statistics calls you and asks “What do you reckon you could rent your house out for?” No further evidence necessary. Clearly, that's not a particularly scientific measure.


The problem with inflation is it can be a self-fulfilling prophecy. Prices rise, then wages rise so workers can afford their lifestyles, which creates more demand, pushing prices up and around we go. If it really takes off, we end up needing a wheelbarrow full of £100 notes for a night out - which apart from being ludicrous (where would we park them?) - is also highly inconvenient.


While we don’t have hyperinflation (and I think it’s highly unlikely we’ll get there), we do have inflation. Quite a lot of it, in fact - and I believe more than people think. And at the risk of re-education, it might not be transitory.


The issue we face, is that while “reopening supply chain bottlenecks” have pushed the price of certain goods and services higher, they’re staying there for extended periods of time. The bottlenecks aren’t clearing fast enough. Oil costs a lot. Transport costs a lot. You cannot get a semiconductor for love nor money (I’ve tried both). All this means that just about every physical good becomes more expensive because it costs a lot of money to make it, or to get it from A to B. Everything from vapes (check out Philip Morris’ results a few weeks ago) to PlayStations are either expensive or unavailable due to the semiconductor shortage. This will start to bite the average consumer, who will need higher wages to compensate.


So what does this mean for investing and net exposure? I'm being careful and keeping it low respectively.


Central banks want some inflation, otherwise what’s the point of buying something today if it’ll be 5% cheaper in the near future? Which has disastrous economic consequences. So they’ll probably try to tame inflation by raising interest rates - which is not news to anyone. While I don’t think rates are going to the moon (for a number of reasons) they are highly likely to rise - perhaps above 3% in time. The problem is, market valuations don’t reflect this scenario, they demand low rates forever, and that, is cause for concern.


The way I express this concern is with a net exposure of ~30% (i.e. long exposure – short exposure). This means that if the market moves up 20%, my portfolio should rise by 6% - which is annoying, but not the end of the world. On the other hand, if the market falls 20%, my portfolio should fall by only 6%. Sure, I’m risking short-term underperformance in the pursuit of long-term outperformance, but I’m happy to do that. It’s not possible to outperform all the time, but it is possible to outperform over time. In the scenario where the market falls, I’ve the firepower to hoover up any stock whose price doesn’t reflect its prospects. And that is when investment managers add serious value to their investors.



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