(Don’t) Fear the Reaper.

How inflation can destroy returns

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Nearly 20% of all US Dollars that EXIST were printed last year. 

Let that sink in…

The amount of money being pumped into the system has reached unprecedented levels as JPOW (the FED Chair) has let the money printer go BRRRRR.

I wrote in depth about the FED previously, which you can find here

This has had and WILL HAVE effects we have never seen before. Never before has monetary policy so generously padded the pockets of American citizens.

Fiscal spending is also starting to pile up as President Biden’s new infrastructure package is set to spend trillions of dollars. 

When you have BOTH expansionary fiscal and monetary policy happening at the same time, AKA “Easy Money,” the grim reaper is sure to arrive….INFLATION!

It was a HOT topic this weekend at Berkshire Hathaway’s AGM:

“We are seeing substantial inflation and are raising prices.” -Warren Buffett

In 2016, we saw what happened as Venezuela entered Hyper-Inflation….

Inflation Rates for Venezuela:

2016: 274%

2017: 863%

2018: 130,060%

2019: 9,586%

2016 to April 2019: 53,798,500% 😱 

You had to have a “Walter-White” style stack of money just to buy a chicken… 

But what does this all mean? How does this affect my portfolio?

This week in <5 mins (might be a tad longer, but well worth it), I will cover INFLATION, and how to protect your hard-earned dough:

  1. Inflation 👉 What is it?

  2. Brief History Lessons 👉 We have seen this before

  3. Where are we now? 👉 Current Economy walkthrough 

  4. How Grit’s Playing it 👉 Bull case v. Bear case (and what I am buying!)

1. Inflation 👉 What is it?

I’d like to caveat this newsletter by saying that I’m no PhD in economics, so this walk-through will be a gathering of views from people much smarter than I am. 

So what is inflation?

Simply put, inflation is the decline in purchasing power of a given currency over time. One dollar buys less of a certain good in the future. Put another way - it is a rise in the general price level of goods and services. 

Here’s a dramatic example.

What does $1 TODAY buy you in 1913 - when the FED was founded?

$27.03 worth of goods!

Put another way…what does $1 in 1913 buy you today?

Only $0.03 worth of goods, yikes! 

Why has this happened?

An increase in overall price levels generally occurs when there is a lot of money in the financial system. For example, if Papa Joe and Donald Trump send everyone $1,400 cheques at the same time that new gaming consoles come out during a pandemic - the prices of Xbox and Playstation on the eBay resale market go up (because they’re all sold out). 

There are 3 types of inflation: Demand-pull, Cost-push, or Built-in. 

At the end of the day, inflation all comes down to WHAT forces are tugging at demand and supply. And there are MANY components. We’ll refer to the holy grail of charts from ECON 101 that drove this point home for me…

S= Supply, D = Demand, Q = Quantity, P= Price. Pushing each of the curves out or in will change where the equilibrium price level is (P1). 

High demand and low supply = higher prices 

Low demand and high supply = lower price.

1) Demand-pull inflation occurs when an increase in the supply of money drives demand for goods and services up. Increase in demand is faster than the increase in production (supply), driving prices up (shift from P1 to P2 as shown below).

In our Xbox and PlayStation example, more people are sitting at home with free time, right when a new gaming console comes out. At the same time that Stimmy cheque hits, creating more buyers than sellers, pushing the demand curve out, and the price up. 

2) Cost-push inflation is a result of the increase in prices that work through the entire supply chain system. Following our Xbox example, if the current shortage in semi-conductors persists (lower supply), the big semiconductor companies can charge more per graphics card.

In turn, the Xbox head honchos want to keep their profit margin the same so they pass this cost onto little Justin who is just trying to grip a Dub in Fortnite. The end result is a higher retail price at Walmart for Mr./Mrs. Justin Sr to buy that Xbox. No more V-bucks for you Justin!

3) Built-in inflation which brings in economists’ favorite wild card variable - EXPECTATIONS. 

The idea here is that people expect current inflation rates will continue in the future, so as the price of goods and services rises, workers come to expect that these prices will continue to rise at the same rate, therefore they demand HIGHER WAGES

Higher wages for workers allow them to maintain their standard of living, and not let purchase power erode. But if wages increase more than the price levels increase, workers will have more money to buy more things which then further pushes the price of goods up. Nice little spiral we got going on here!

The reason for busting out these charts is so you can apply this thinking to the overall context of money supply growth, aggregate demand, and GDP. We’ll leave it there but if you want to go down the rabbit hole… here is a great resource.

So how do we measure inflation? 

A common method is the Consumer Price Index (CPI) which simply pools together a basket of goods and looks at the overall increase of these goods over time. While this can be a good start, it tells a good story but not the whole story.

The CPI is comprised things like food, shelter, household operations, furnishings & equipment, clothing & footwear, transportation, health & personal care, recreation, education & reading, and alcohol & tobacco. 

As you can see below it’s been rangebound over the last 10 years.

BUT, one thing the CPI doesn’t do a great job of capturing is regional differences in inflation because it uses averages. Check out this article by Anthony Pompliano which talks about how NYC & Los Angeles might be running +11-12% inflation per over the last 5 years.

Another thing the CPI doesn’t capture the rising cost of housing which is hitting record highs in the U.S. Instead it measures the cost of renting. They rationalize this by saying a house is an asset not a consumption item. Which kind of makes sense until you realize there are significantly more homeowners in America than renters.

Let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel and see what he thinks of inflation?

With all this going on, let’s walk through some cases of HYPERINFLATION from the past to better understand the underlying dynamics… 

2. Brief History Lessons 👉 We’ve seen this before…

“History doesn’t repeat itself, but it often rhymes” - Mark Twain

We all know the famous story of Pablo Escobar setting fire to $2MM US dollars to keep his family warm while evading arrest.

Well… you don’t have to be a cocaine baron on the run to rationalize physically lighting money on fire for warmth in the following cases.

Hyperinflation in the Weimar Republic (1921 - 1923)

To pay for the massive costs of the First World War, German Emperor Willhelm suspended the gold standard (convertibility of money to gold) and funded the war entirely by borrowing. 

Their genius idea was that if they won they would impose reparations on the conquered Allies in order to pay for the war. Well that didn’t quite go as planned and left the Weimar Republic saddled with a mountain of debt and no way of paying it. On top of that, Germany had steep reparations of its own to now repay. 

The problem here was that they then printed money to pay off this debt, without the economic growth of the underlying economy to support it. When money supply increases faster than GDP, we have an environment of rapid price increases. 

This mass printing of money was used to then buy foreign currency, which was then used to pay these reparations, but this strategy greatly exacerbated the inflation of the Germany currency, the paper mark. They had to use more and more Marks to buy less and less foreign currency as the relative supply of Marks spiked through the roof.

With the printer going more HAM than Lil’ John in the club, this ultimately led to the collapse of confidence in the currency and hyperinflation. 

A loaf of bread in Berlin that cost 160 Marks at the end of 1922 cost 200,000,000,000 Marks by late 1923.


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Hyperinflation in Zimbabwe 2007-2009

In Zimbabwe from 2008 to 2009, the peak month of inflation was estimated at 79.6 billion percent month-on-month and 89.7 sextillion percent year on year in mid-November 2008.

The foundation for this collapse was laid in the mid 1990s when President Robert Mugabe began his “Economic Structural Adjustment Programme.” The government instituted land reforms that intended to evict foreign landowners to repatriate the land and give it back to domestic farmers. 

However, these farmers had little experience or training in farming. Food output capacity dropped 45%, manufacturing output dropped 30%, life expectancy dropped, and unemployment rose to 80%. As the country experienced an economic collapse, the farmers were not able to obtain loans for development. On top of this, trade restrictions and sanctions were placed on the nation after Mugabe’s gross human rights violations. 

With upheaval in the country, the value of the currency began to depreciate due to loss in confidence of the currency and of the government. The Reserve bank of Zimbabwe responded to this currency depreciation by printing even more money, accelerating the self-perpetuating death spiral. No measure to reinstate a valid currency would have much confidence within this existing system.

Note the logarithmic y-axis scale…

An important framework for this context is the monetarist view:

A general increase in the prices of things is less a commentary on those things than on the worth of money.

When the complete confidence of holding a currency collapses, it loses its ability to retain its value, and full-on loses its very nature of being “money” (store of value, medium of exchange, unit of account).

These are examples of extraordinary measures in extraordinary times. Both in times of extreme conflict. You could argue we’re in a war right now - not one of nations but against a virus.

So how does this shake out?

3. Where are we now 👉 Current situation + Corona

The most prominent charts are of the historic amount of money into the system versus now:

Monetary policy = Controls Money Supply

Fiscal Policy = Controls Government Spending/Taxation

Right now, you will see the term ”transitory” (temporary) dominate headlines in terms of why prices are higher today but may not be in the future. Are the price jumps transitory as we bring the economy back to growth in a post-pandemic world? 

Or have some supply chains and productive capacities been altered for the longer term, leading to a long-term shift in prices? A lot of this has to do with dynamic demand patterns around the Coronavirus. 

We’re feeling the increases across a lot of consumer goods. I see it in cars, copper, semiconductors, wheat, corn, gasoline, and ESPECIALLY houses (shoutout to $1M shacks in Toronto).

The most recent poster child for this has been LUMBER!

But will lumber prices stay elevated like this? Complicated question. Right now the bull case for lumber prices is the increase in nesting going on. During COVID, more people are staying home, wanting more space, leading to more renovations. 

Interest rates are also at historic lows, making financing these purchases very cheap (increasing demand even further!). Construction was also one of the few things exempt from COVID restrictions, so it just kept humming along.

All this to say, with tight supply and demand rocking and rolling, prices are parabolic. That’s a good short-term story to tell, but when you look at one good in isolation, you have to know the whole story.

There was an absolutely fascinating podcast out last week on Bloomberg Odd Lots that dove into the price action. The inside story involves supply chain changes post-GFC, trade barriers, cyclicality, and even global warming. Click here to take a listen on your long walk to nowhere.

The podcast highlights that if you were in the lumber industry back in 08/09 during the housing crisis that turned into the Global Financial Crisis you were scarred for life. If you didn’t get completely wiped out, you were very hesitant about building inventory. This led a lot of the builders to keep only 45 days of inventory on hand while making 90 days of commitments. They had to find that 45 day gaps as they went along. 

So when COVID hit in March 2020, people thought:

“no one will be building anything, this is like 08 all over again, and the sky is falling”

So they sold down their inventory, causing the prices to drop. But then recovery started to take hold as nesting was a new concept, and in a tighter supply environment (since they sold down their inventory), prices went higher. 

As they climbed in September 2020, up to $900, no one thought this was sustainable and the price pulled back again. However, if you were looking to buy lumber in the spot market (immediate delievry), no inventory could be found. 

In order to fund the that 45 day gap that I mentioned, you then had to turn to the FUTURES market (contract to buy the good at a later date). That is the chart above which has spiked again. 

This is the setup that you need to grasp when extrapolating longer term price metrics and hints on persistent inflation. This was an inventory cycle issue. A cause of the overall environment, but not sustainable over the longer term.

I walked through this lumber example in such detail to highlight how much expectations and emotions can factor into pricing fluctuations. What economists generally try to do is look at economic factors to try to gauge the overall picture… what they are trying to do is read the tea leaves.

Housing prices, lumber prices, CPI, etc… these are all the tea leaves that we try to read in order to form the overall bigger picture. Here are a couple of other tea leaves that are relevant in today’s inflation debate:

Technological Innovation: The faster the pace of technological advancement, the better we get at making things faster and cheaper. Essentially, the higher the rate of productivity. Further, it also allows for the substitution of labour with automation. By increasing automation, you put a lid on wage inflation.

Andreesen Horowitz, one of the top VCs in the world, does an excellent job at showing how the growth of technology companies plays into housing inflation.

“Take the example of housing prices in the Bay Area. In the last decade, the median home price of $1.3M in Palo Alto has popped to $3.1M. If you look at prices as a function of the “gravity distorting” effects of technology stocks, however, it turns out housing has gotten much cheaper… that is, IF your base unit of currency is an index of tech stocks.”

So basically your best hedge was owning Google stock!

Globalization: The increased ease of shipping and manufacturing across the world shifts capital to its most efficient source on a geographical basis. If I can make a semiconductor in Taiwan for $100, ship it to the US for $5/unit, its cheaper than making a semiconductor in the $US for $300. So globalization also puts a lid on rising price levels (inflation). 

The flip side of that is as countries become more protectionist (America first!), this can INCREASE inflation.

10-yr US Breakeven Rate: This value implies what (bond) market participants expect inflation to be in the next 10 years on average. This figure measures the difference between the 10yr Treasury Bond and Treasury Inflation Protection Securities (TIPS). 

Sentiment: Remember how we talked about how expectations can sometimes be self-fulfilling? You can get a gauge on this in sentiment. A Common measure of this is the consumer confidence index, but also just looking at how often companies are talking about it:

Wageflation: Workers are commonly lobbying for higher wages. In Canada, collective bargaining is now a constitutional right supported by the Charter. It is also a very politically charged subject.

If the entire CPI basket of goods is increasing 2%, I want a 2% wage hike. The government, therefore, has an incentive to keep CPI numbers low, so there is not too much upheaval on the wage front.

Warren Buffett: Berkshire Hathaway is the 8th-largest public company in the world, the 10th-largest conglomerate by revenue and the largest financial services company by revenue in the world. Their vantage point across sectors is extremely valuable and worth paying attention to. This weekend at their AGM:

As a reminder, there is no black and white in this world. There is a lot of grey, and it is more of an art than a science.

SO WHAT DOES THIS ALL MEAN FOR MY INVESTMENTS??

4. How Grit’s Playing it 👉 Bull case vs Bear case 

Given what we know, let’s highlight two scenarios, what to invest in each case, and how I’m approaching the issue of inflation in my portfolio.

The Doomsday Scenario

On one side is the doomsday crowd who think we’re going to hell in a handbasket. They are saying that the government’s current aggressive spending is not dissimilar to a Weimar Republic Germany, and we’re trying to inflate our way out of debt. 

When inflation balloons to 8%, then to 10%, then 20%, we will have a central bank-induced recession as they print money and the death spiral is engaged.

The Goldilock Scenario

Rates come up slowly, but the economy comes back to full production and grows alongside it. Increased capital investment deals with bottlenecks so you have a little rather than a lot of inflation. 

For example, a couple of million automobiles can’t be built right now because of the chip shortage. This gets solved, pricing comes back down. 

COVID also gets dealt with, as it is (for the most part) now in the States. This brings the service economy back to life – which is 85% of the U.S economy.

In this scenario, you get mild inflation running above CPI but not crazy scary. Still, I am a prudent investor and I can tell you one thing I won’t be doing…letting my money gather dust in a savings account!

Because with inflation SAVERS are punished and INVESTORS are rewarded!

The biggest difference between Doomsday & Goldilocks is timing. Get the economy jump started but take away the punch bowl when the party gets roaring!

4. How Grit’s Playing it 👉  What I own !

Call me an optimist and a believer in human ingenuity, because I’m all in on the Goldilocks approach. In this case, I own things that are not easily replaceable such as: land, hard assets like real estate and infrastructure, and high quality (value) equities - oh and some bitcoin too ; )

Last week, I announced I bought an interest in a Blueberry farm. This ticks the box of “hard to replace” and REAL assets

The reason you want to own real assets like blueberry farms and real estate is that the value of the property will rise with inflation, therefore retaining the general purchase power. If your real estate is income-generating you can also raise these rents over time.

That is the general idea, but again - we need to understand the dynamics within the market. For example, the pandemic altered where people work and what they consume. So if you’re an office building - your tenants will likely be drastically reducing their footprint as work-flex becomes much more prevalent.

That’s why I favour residential, industrial real estate and farmland that is yield producing and more resilient when thinking about inflation.

With bond yields at historic lows, another area that is getting a lot of focus is alternative investments and private equity. The 60/40 portfolio of equities/bonds doesn’t work anymore, what works is 60/20/20 with the introduction of alternative assets. I personally don’t own bonds because I am not a boomer but I understand some can’t live without them.

But I do own alternative assets where a lot of the big pensions and smart money are piling into (infrastructure, farmland & timberland). FOLLOW THE SMART GUYS.

HARVARD:

BILL GATES:

The wealthy are also diversifying into alternative assets like high end art (hello NFTs!), wine and sneaker collectibles. I have written extensively about it HERE.

The other reason why I like infrastructure and also commodities like copper is the recently announced fiscal plan that Biden released that has trillions geared towards antiquating updated infrastructure.

Copper is a mere twenty cents away from a 50-year high!

Oh and I have also been buying bitcoin since November 2020 when it was only US$13k!

To summarize I own these inflation-protected assets:

For my high value stocks you can check out my portfolio HERE.

For specifics on my private investments, you will have to wait until I launch my paid newsletter (though this free version will remain)!

Wrapping up…

It’s important to look back in history in order to understand which events triggered massive economic shifts and get in front of them. If you think back to the 80s - interest rates on mortgages were around 17-20% which sounds crazy! Now they’re closer to 2%… So you need to look what happens in an environment like that.

However,

“No [wo]man ever steps in the same river twice, for it's not the same river and [s]he's not the same [wo]man” - Heraclitus, Greek philosopher

Which is why we need to put on an additional set of lens to really build out the context over that period.

Until next time. Always Yours. Incessantly Chasing ROI,

-Genevieve Roch-Decter, CFA

P.S At the Berkshire Hathaway AGM this weekend Charlie Munger called bitcoin 'disgusting and contrary to the interests of civilization' but Jimmy who’s 11 years old and owns bitcoin hasn’t learned about civilization in history class yet.


What else we Grittin’ On?

Stocks R’ Us. Households increased stockholdings to 41% of their total financial assets in April, the highest level on record. Owning stocks is the new American dream!

Tech Beats. At $7.5T, the combined market cap of Apple, Microsoft, Amazon, and Google is higher than the GDP of every country in the world with the exception of the US and China. Who doesn’t want to own trillion dollar companies that grow earnings 30-50% YoY?

Revenge Spend. The U.S consumer has paid down debt, refinanced their home at lower rates, made substantial gains in home and stock equity & their personal income is soaring. Things are about to get wild with: REVENGE SHOP & TRAVEL!


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