Inflation Is Not Transitory

Picking a fight with both Janet Yellen and Jerome Powell, who are arguing that inflation is transitory and easily contained, is not a great way to start the week, but I feel obligated to try. Before running through why I think they are wrong, it is important to remember that they have a vested interest in spinning that narrative. They may believe what they are saying, but they may well be trying to use their positions to send a message that they want people to believe. For now I am going to bet on an inflation scare. That isn't quite the same as betting on inflation (which I'm also willing to do). I believe that in the coming weeks we will see the following: -- A market that suddenly thinks that whatever inflation expectations have been priced in are not enough and we will see higher inflation for longer. Both the magnitude of inflation and the duration of that higher inflation will be the talking points. -- The market will realize that the Fed doesn't care about inflation and won't change when they hike. Ironically, not hiking will hurt the back end of the yield curve more than hiking. That move to higher yields will be pushed as the incredibly negative real yields in the U.S. hit the headlines again. -- Just because something hasn't happened, doesn't mean it can't. The PCE deflator (Ben Bernanke's favorite measure of inflation) has barely ever gotten above 2% since the financial crisis. It wasn't even above 2% when the economy was humming along right before the pandemic. So, let's point out the things that will take us back to higher inflation, like we had in 2006 until 2008 (Fed Funds and the 10-year Treasury yield, as a point of reference, were 5% then). 1. Jobs. We cannot fill jobs in this country at the current level of wages and this is before infrastructure spending and incentives to manufacture domestically kick in. Yes, much of what is being defined as fiscal stimulus isn't roads and bridges, but the spending is real and the job creation will be real too. 2. China. I am going to stick to my assertion that China is in the midst of shifting from an export-focused economy to a domestic consumption-focused economy. That will entail more demand from Chinese consumers, which will be inflationary (remember, it was the build out of China and ghost cities that helped fuel commodity inflation in the early 2000s). 3. ESG. We are rapidly shifting what we consume and how we produce what we consume. While there has been talk about sustainability, it has accelerated rapidly, partly due to government support, but also because companies have seen the success that sustainability has brought to some companies. My simple working thesis is this: Let's say shifting to a sustainable product and manufacturing base costs 10 cents for every $1 currently made. In 2015, most companies said no thanks because the math didn't work. Now, the math might work quite easily. Let's say that 7 cents of that additional cost can be passed on to the consumer (seems likely right now). That leaves the company with 97 cents instead of the $1 of earnings, but if their P/E ratio can go from 12 to even 13 because of that shift to sustainability and demand from ESG-focused investors, they have more than offset the lower earnings to their shareholders. If my math is remotely right, companies are incentivized to shift rapidly and that will be inflationary. Also, this shift to ESG is changing so much, that it is difficult to know what bottlenecks will occur. We are in the process of creating a new economy and that means that relying on historical data and trends is likely to provide the wrong answers. 4. ESG. ESG is important enough to give it two sections. As investors and consumers start digging into supply chains, I expect that we will also see inflationary pressures. Two obvious questions to ask about supply chains are: Is any part of the reason that the supplier is cheaper because they are polluting or hurting the environment in a way that would not be tolerated domestically? If so, then those suppliers will have to increase costs to meet investor expectations or companies will bring production to more expensive regions. Is any part of the reason that the supplier is cheaper because they treat their employees in a way that would not be tolerated domestically? Again, costs will be incurred at the existing supplier or at the company as they shift their supply. 5. Housing. This isn't a main part of my thesis, but it is difficult to see the rise in home prices and not expect some level of inflation to creep into the data (which is typically based on rent, not home prices, and may be skewed by moratoriums, etc.). 6. India. It is incredibly sad and scary what is occurring in India due to COVID. Having said that, ultimately, they will overcome COVID and this could be the inflationary shock that no one is talking about. To get actual inflation, we will need to hit on several of these points. To hit on an inflation fear, all we really need is a bunch of these subjects to hit the headlines. Bottom Line Expect higher yields. Equity will remain a stock-picker's market as some sectors will respond well to the above analysis and some will lag.

Inflation Is Not Transitory

To get inflation fears, all we really need is a bunch of these subjects to hit the headlines.

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