Inflation Debate 2021.08.15

Updated: Sep 5


The inflation debate appears to be moving in favor of Cathie Wood. We discussed her views last week on value vs growth, but she also touched on inflation. She argues that double and triple spending as we re-opened may have contributed to higher than necessary pressure on goods and commodities. That would suggest recently higher inflation prints are more transitory. Given recent strength in the economy we generally agree with her thesis.


In this article we share some details on why...


  1. Macro Readings

  2. Cathie Wood vs Ray Dalio

  3. Conclusion

1. Macro Readings


Seasonally adjusted unemployment initial claims came in at 375,000, a decrease of 12,000 from the previous week's revised level the week of August 7th. That is below the 4-week moving average of 396,250. The previous week's average was revised up by 500 to 394,500. This does not include the 104,572 initial claims for Pandemic Unemployment Assistance (PUA) that was up about 11% from 94,427 the previous week. The drop in claims is directionally consistent with falling unemployment which fell from 5.9% to 5.4% as the U.S. economy added 943,000 Jobs in July.

Inflation as measured by the Consumer Price Index (CPI) increased 0.5% in July on a seasonally adjusted basis after rising 0.9% in June based on the August 11th report. Before seasonal adjustment that comes to a 5.4% increase over the last 12 months. CPI less food and energy rose 4.3% over the last 12 months...the difference between the 5.4% measure coming primarily from the energy index rising 23.8% over the same period. Housing continues to be a driver of higher inflation.

Year over year figures can be deceptive given the dramatic drop in demand caused by pandemic lockdowns. Looking more closely at the July figures we can see a slow down in the change from recent months. Commodities less food and energy, used cars and trucks, apparel all dropped considerably in July compared to the initial lockdown months of 2020 from April through June. These areas of spending are some of the more concerning in terms of rising prices this year.



Source: https://www.bls.gov/news.release/cpi.nr0.htm


Shelter is the largest component of services and has thus far not been a major contributor to rising prices. However, that could change depending on the impact of rising home prices. Nationwide, the median single-family existing-home sales price rose 22.9% in the 2nd quarter … a record in data going back to 1968 according to the National Association of Realtors (NAR). The jump has been in part driven by higher home construction costs, but the translation into CPI is complex, requiring some assumptions about imputed rents for existing homeowners.


2. Cathie Wood vs Ray Dalio


Cathie Wood is less concerned about inflation getting out of control than Ray Dalio...another deep mind that we pay close attention to. However, both seem to be less concerned than market commentators generally. Larry Summers and Ray Dalio see many parallels to today's environment and those of the late 1960s. We are sympathetic to this view as we have discussed at length on Twitter.


But as of now it seems Cathie and Dalio are both less concerned about immediate CPI inflation and more open to concerns about asset price inflation. Dalio is also particularly concerned about the ability of the bond market being able to consume the large supply of bonds that continued government spending in the Trillions will have on bond yields.


Strong economic reading from falling unemployment and strong economic growth are helping to alleviate some concerns about stagflation. That is probably why bond yields are still well below their peak at the end of March. But it is too early to tell if the decade high yearly readings on inflation are largely transitory or indicative of a more persistent move higher in prices. Coming months will be particularly illuminating given noise in annualized reading from lockdowns a year ago.


Conclusion


Ray Dalio has repeatedly stated that he sees bonds in a bubble. We agree. But without actual persistent CPI inflation there is just so much money sloshing around that some of it is going to see higher yields as attractive. We are at the end of a 40 year bull market in bonds. It is over, but the only way it will reverse is if we see persistently higher inflation. Paradoxically, it is the printing of money that is actually keep yields so low...because that is the source of cash flowing in to buy financial assets at increasingly higher prices.


The tug-of-war between inflationary and deflationary concerns is ongoing. But near term we view the risk of an asset bubble growing as being far more likely than persistently higher CPI inflation bursting that bubble. We think the bubble will grow first. Reason being that much of the CPI driven inflation we have seen does appear to be transitory in our view. As fear of immediate CPI inflation fades then there really isn't much left for investors to worry about...and that tends to lead to a bidding up of asset prices. Our shorts on corporate bonds are a cheap way he can hedge the risk that our timing is off just in case...Correlation Regime changes take time.


Sincerely,

Laozi and Bernard


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