Most hedge fund analysts and investors working today have never experienced inflation.  It’s trended downwards over the past few decades.

Long term inflation trends

Source: Horizon Kinetics, BLS

Yet the new global rise of populism has led to a dramatic reversal of key factors that kept inflation low for so long. The buildup of new inflationary pressures is being amplified by the policy response to Covid-19 around the world.   Although we are experiencing short term deflation, the greater risk as the world emerges from lockdown will be from inflation and few investors are prepared.  History shows that once inflation starts, it can accelerate quickly and penetrate all parts of an economy.  A sudden increase in inflation would have devastating impacts on financial markets, decimating fixed income, and lowering earnings multiples in equity markets. Earnings derivatives are one tool that investors can use to prepare.

The case for inflation

Inflation or deflation tell me if you can, will we become Zimbabwe or will we be Japan?

-Merle Hazard

The case against inflation focuses on the massive demand destruction occurring as a result of Covid-19.  Core CPI has declined in recent months implying deflation, not inflation. Many sectors of the economy are completely closed and unemployment has spiked.  Many parts of the economy will be permanently changed.  As more people become accustomed to  working from home, for example, there will be less demand for prime office space.  Concerts, sports, and movies will be slow to recover.   Many other consumer habit changes might be permanent.    At the very least we will experience a couple quarters of deflation.

However, certain human tendencies are unlikely to change.  We are social creatures. Even introverts need human interaction.   Its difficult to support the idea that people won’t go out again.  The crowds in the recently reopened Las Vegas indicate that we might be overestimating the permanence of Covid-19 consumer habit changes.  Moreover, aggressive government stimulus has helped alleviate unemployment, and will support consumer demand in the medium to long term.

Demand stimulation

Around the world government responses to the Covid-19 outbreak have been unprecedented in terms of magnitude and creativity.  According to Deutsche Bank, the Fed balance sheet expanded more in the two months following the Covid-19 outbreak than it did in the four years following the financial crisis.  Instead of just buying “safe assets”, the Fed is directly buying junk bond ETFs.  Furthermore, the Fed has used special purpose vehicles which themselves can use leverage when buying assets, so the actual headline dollar figures understate the impact.  After the 2007-2009 global financial crisis government stimulus was primarily targeted at financial markets, not households.  However now policymakers are aggressively targeting household income with direct transfers. In April 2020, American’s total incomes rose by 11% due to emergency support from the Fed, according to The Economist.

The US entered the Covid-19 pandemic with government debt to GDP ratio already near record levels.  The necessary policy response will inevitably drive this figure much higher, probably past the prior record set at the end of World War II.  Inflation is the only way that a country can deal with high national debt while avoiding political unpalatable austerity or default.   In the past monetary and fiscal policy were separate. Now they are becoming increasingly intertwined.  Populism has long threatened central bank independence but it ultimately might be a casualty of Covid-19.

Beyond the initial Covid-19 response,  populist policies will also continue to stimulate the economy.  For example, universal basic income is an increasingly popular idea across the political spectrum.  Although there is a solid social case for UBI in the age of automation, it can have unintended consequences in a populist environment. Once direct household transfers are started, politicians will compete to offer more. The result will be continued money creation, and more direct distributions to consumers long after the pandemic subsides. The idea of increased government support for college, medical care, and other household consumption is increasingly mainstream in US politics.   All these policies more than compensate for Covid-19 demand destruction.

As society reopens, pent up consumer demand enhanced by record fiscal stimulus will enter an economy where supply disruptions have occurred

Supply disruption

Globalization was a key structural force that had kept inflation low for decades but populism has been slowly dismantling it.  The acceleration of globalization from 1990 to around 2016 kept developed world inflation low because it provided access to cheap labor and cheap goods. People immigrated from developing markets to developed markets en-masse, putting downward pressure on wages in certain sectors of the economy. Multinational companies manufactured goods in developing markets. The fall of the Soviet Union  and China’s entrance into the WTO brought large, formerly closed off populations into the global labor force. Chinese exports have been a deflationary mechanism- look at Wal-Mart’s supply chain as an example. Yet today there is no new country the size of China available to enter world markets and drive down costs anytime in the near future.

In fact, now globalization is reversing, or at least rearranging. The US and other developed markets have been getting stricter on immigration for years. Then Covid-19 hit and immigration flows basically stopped. This might make it difficult to harvest certain crops in the US and in the UK- potentially driving food price inflation. It will also make it harder for other labor intensive sectors with domestic operations to find workers- driving higher wages across the economy as things open up.

More importantly, the global trading system is becoming less open. The US-China conflict gets a lot of press coverage, but the bigger story is more widespread.  The WTO’s multilateral dispute settlement mechanism has ceased functioning because new judges can’t get approved to the Appellate Court.  WTO most favored nation rules are becoming less relevant than regional agreements, many of which are between emerging markets.  When  Covid-19 hit, many nations put export restrictions on essential items.  Companies across the economy found their production impacted by shortages of parts and delays in shipping during as the pandemic spread.   The idea of incentivizing companies to bring more production closer to home is now common in developed nations.

In the post Covid-19 world, businesses will need to focus more on resilience and less on cost efficiency. As trade policy changes they will need to spend more time and money dealing with tariffs and nontariff barriers in optimizing their supply chains.  While its true that modern technology facilitates easy price comparison, making it harder for companies to raise prices, it won’t prevent production costs from going up for everyone at the same time.   Price comparison in an inflationary environment will simply be a matter of seeing which supplier increased prices the least.  Higher cost structures will impact consumer prices across the entire economy.

Inflation and financial markets

Today, a financial system that is structurally intolerant of inflation faces a changing political-economy regime that makes inflation inevitable.

Ruffer Review

An inflationary environment changes the value proposition for all asset classes. The impact on fixed income is obvious. If inflation is higher than the rate on a bond, investors lose money in real terms. A large allocation to bonds during an inflationary period can result in large loss of wealth. During the 1970s and 1980s bonds were known as certificates of confiscation. With yields on bonds currently so low, it won’t take much inflation to decimate fixed income in the 2020s.

The impact of inflation on equities is more subtle and counter-intuitive, yet still potentially devastating. During inflationary periods, revenue will grow across the entire economy. Some companies will have pricing power and low variable costs, and therefore be able to grow revenue faster than inflation, leading to much higher earnings. Other companies will lose money as their input costs rapidly rise. Yet even investing in companies that can grow profits in an inflationary environment might not be enough. One forgotten feature of inflation is the impact on earnings multiples.

A look at financial history shows that price/earnings ratios tend to be lower during times of high inflation.

Inflation and Earnings Derivatives

Source: Crestmont Research 

Why inflation leads to lower PE ratios

Warren Buffett first wrote about inflation’s implications for equity investors in a 1977 Fortune article: How Inflation Swindles The Equity Investor.  Buffett’s analysis argues that return on equity typically does not increase along with inflation.   Hedge fund manager Lyall Taylor also wrote a detailed analysis on the interaction between PE ratios and inflation that is essential for understanding today’s market.  PE ratios are based on multiples of nominal, not real earnings. A high nominal return on equity is low in real terms in an inflationary environment. Since PE ratios are based on multiples of nominal earnings they are justifiably lower when inflation is high in order to compensate. Lower PE ratios also reflect a higher cost of capital in an inflationary environment.

In recent years, price stability has been an important factor justifying record high PE ratios.  When this reverses, even investors that focus exclusively on the quality companies could experience losses.  

The role of earnings derivatives

Using earnings derivatives investors can invest directly in company and sector earnings streams.   There is no better way to invest in growth while hedging against falling PE ratios that could accompany inflation.  

The FAANG Revenue and FAANG Earnings Indexes are an especially useful tool for growth investors that are concerned with high valuations.  Although there is a defensible case that FAANG companies will continue to thrive post Covid-19,  there is no guarantee that their earnings multiples will stay high.   Licensing BLX Global’s FAANG indexes for a structured note or option product could be a better choice for long term investors with a broad mandate.  Similar opportunities are available for other sectors.    Contact us if you’re interested.