As I consider various potential sources of market volatility over the coming months, the one I believe poses the biggest threat to today’s constructive backdrop for risk assets is so-called “bad inflation.” The costs of intermediate goods and inputs to production are climbing at their fastest pace in decades, which presents a likely headwind to corporate profit margins. Additionally, commodity prices are all rising in unison, be it coffee, corn, lumber, sugar, wheat, or gasoline, further straining corporate and consumer budgets.
Where the Fed may be wrong
The US Federal Reserve (Fed) has repeatedly stated its intention to “look through” the inflationary surge we’re seeing today, which it views as transitory. The Fed seems to assume that supply will quickly come back online as the economy reopens and recovers, allowing pricing pressures to abate. I hold a different view. I suspect that productive capacity for commodities in particular will not bounce back as swiftly as the Fed is forecasting. To be clear, I believe much of today’s bad inflation is being driven, either directly or indirectly, by these rising commodity prices and will therefore prove “stickier” and more stubborn than the Fed expects.
A paradigm shift in the making
As I see it, the public companies that have been rewarded the most over the past decade have behaved more or less like rent-seeking monopolies. Many investors covet steady, predictable cash flows to which they can apply a low discount rate. Conversely, some of the best “short” investments have been commodity producers that greedily expanded their capacity, only to later lose pricing power. The latter cohort likely learned their lesson and will be slow to resume capacity, instead focusing on generating stable, positive free cash flow. If all commodity industries across the board adopt this same stance, it could have profound implications for medium-term commodity pricing.
The “asset-light/intangibles” economy that has dominated for the past 10 years has done so at the expense of investment in the “tangible” goods economy. Many commodity companies seem to have set up their businesses as if they project demand for their products to be flat or negative going forward. That could be a miscalculation. After a decade of underinvestment in real tangible capital, I believe we are in the midst of a paradigm shift:
- The global consumption basket has shifted aggressively toward durable goods like houses, boats, bikes, and cars, away from spending on vacations, dining out, and concerts. While this was largely driven by the pandemic, which delivered an atypical 2020 consumption basket, I suspect a significant portion of the consumption shift will prove to be more enduring.
- The decades-long globalization phenomenon is beginning to reverse, preventing commodity goods from flowing across borders as freely and efficiently as in the past. Again, I view this as structural in nature (trade wars) and as something the Fed has limited ability to control.
Back to the disco era?
The sheer amount of money that has flooded the global financial system over the past year or so is pushing up the prices of goods that most companies and consumers would prefer to stay low. In perverse fashion, the longer today’s stimulative monetary and fiscal policy backdrop persists, the higher the risk that the economic recovery could face stiff headwinds and get choked off by bad inflation.
I also worry about the risk of a “stagflation”-type environment. While not my base case, the probability attached to this scenario is as high as it’s been in decades. Few of today’s investors have experienced stagflation, which last occurred in the US in the 1970s. (It was a great decade for music, but a challenging one for money managers.) There is potentially one neat present-day parallel to that time: Similar to how the US abandoned the gold standard in the 1970s to deal with the cost of the Vietnam War, today’s profligate government spending is largely designed to combat the ongoing impact of a pandemic.
Investment considerations for bad inflation
If the dreaded stagflation outcome has even a 10% – 20% chance of coming to fruition, which is what the Treasury Inflation-Protected Securities (TIPS) market is telling us lately, then interest rates, yield-curve shapes, equities, and various subsectors could exhibit vastly different properties and portfolio correlations than they have for the past 10 years. Said another way, the portfolio that would be likely to succeed amid stagflation looks very different from the one that succeeded over the past decade.
While cyclically tilted, inflation-sensitive assets have performed well since the fall of 2020, I still think having exposure to these areas of the market makes sense for longer-term investors seeking a balanced asset allocation. This would include TIPS and commodity-exposed investments.