Ignore Inflation Scaremongers

I often write about the banking and REIT sectors on Seeking Alpha, so when I say inflation is a subject close to my heart, I hope readers believe me.

A recent article about inflation risk by contributor Katchum received much attention and put some of the current inflation issues in the frame.

I'm not sure why the author used the term hyperinflation when he appears to be looking initially for a rise only to above 3%, but it certainly took readers' attention.

In this article I will give a different view of some of the issues raised in the piece.

The Fed

My own view is that, if there was a serious risk of the US economy approaching hyperinflation, Chairman Powell would not have signalled the Fed's intention of allowing the economy to run 'hot' for an extended period in service of strengthening the labour market. The Fed is not always right, of course. But it has a lot of information coming in to form its decisions.

Put simply, the state of labour markets in the US is deflationary.

It was wage driven inflation in the 3-4% bracket over a number of years, in a tight labour market, that lead Powell to raise rates four times before the Covid-19 crisis.

Source: Atlanta Fed

All that's changed. Unemployment has increased sharply, and although it is coming down apace as the economy reopens, the rate of recovery is likely to slow after this bounce. Remember, banks expect high delinquencies to come through, which implies capital destruction in the economy.

Source: Trading Economics

Quite apart from the sudden collapse in demand in the spring of this year as the initial lockdowns in response to the Covid-19 crisis had their effect, the likely stop-start nature of the recovery means there will be a lot of excess labour capacity in the US economy for at least the medium term. This substantially reduces the risk of material levels of wage-driven inflation, when price expectations increase and money starts to "chase" goods.

The importance of this is that current Fed policy is fighting against a powerful deflationary wage/employment impulse. You can see this in inflation expectations (below), which have recovered since the March crash as lockdowns ease, but remain markedly lower than in the 20017-19 period.

Source: St. Louis Fed

And remember, the extent of government support for household income remains uncertain medium term.

In thinking about inflation it's important to understand the real economy situation is one of post shock-recovery, with the shock driven more by a fall in demand (the dead stop of lockdowns), than a drop in supply. This is the reason that scare supply assets (like gold) have inflated. With productive resources mothballed, supply can come roaring back when demand does, which is one of the reasons employment has bounced back fairly well so far. This doesn't suggest inflation will mount rapidly.

The USD is unlikely to collapse

To be fair, Katchum doesn't make the claim that wages will drive hyperinflation. I am just laying that out to give the context for my own thinking. Katchum anticipates a collapse in the dollar.

money doesn't grow on trees. As the Federal Reserve prints more money to buy up assets, the U.S. dollar will plunge and inflation will rise.

The U.S. dollar is correlated to the amount of deficits. As trade deficits and budget deficits rise, the U.S. dollar will need to fall.

Of course, you can make a case that we are seeing in certain asset prices is already a form of hyperinflation, with what Fed liquidity has done to the prices of tech shares and gold or gold linked equities. The dollar is "collapsing" against these assets.

Source: Bloomberg

As tech currently makes little fundamental sense in the framework of likely earnings growth and valuation, recent price moves can be seen as an extension of the same money "needing to go somewhere" that has forced up bond prices, and gold. Equities outside of tech are generally under pressure with the recession hitting the earnings of many sectors hard. Money coming into equities is seeking sectors that can benefit from the current conditions and tech at least offers long term secular growth.

Subdued wage inflation and liquidity fuelled asset prices have been with us since the 2008 financial crisis. What we have now is just another phase of the same thing. It does not add up to generalised high inflation.

The key idea as to why this is the case is that the velocity of money, the speed with which it is changing hands, is not high enough in a low growth environment to generate rapidly rising inflation. Another way of saying this is that it the increase in money supply from the Fed is going into assets, not consumption.

The question opposite Katchum's hyperinflation thesis, though, is whether this money printing and trade and fiscal deficits will drive a collapse in the US Dollar and therefore high imported inflation.

Dollar collapse?

Start with the idea that the US Dollar is going to "collapse" in value. There is no evidence this is happening currently vis a vis the levels it has seen over the last thirty years.

Source: Market Watch

The reason a dollar collapse is unlikely is that deficit spending - and money printing - are in full swing across the globe. Even Germany has abandoned its traditional fiscal austerity with a package of debt driven stimulus measures worth about 10% of its GDP, and the European Union countries have borrowed collectively for the first time, and at scale.

We have already seen large moves between major currencies since 2008. Look at the collapse of the EUR vs US$ shown in the chart below.

Source: XE Trading

Although no central bankers would admit to deliberately weakening their currencies against the dollar, it has at times been a handy 'side effect' of BoJ and ECB rates and QE programs in the last decade.

This move in the EURO, driven by the expectation of a huge QE programme, was not accompanied by upward inflation surprises in the Eurozone, let alone hyper inflation.

Outside of the US, while governments talk about adjusting or even ending some of the support programs engaged over the last months, fiscal retrenchment is unlikely to be easy to undertake politically even if it will have to happen at some point for economic reasons. And a strengthening currency - which fiscal retrenchment might encourage - is rarely seen as an antidote to recession. The ECB and BoJ do not want their currencies to strengthen materially against the US$, so would be likely to respond to its "collapse" with easing action of their own. Although the Bank of China has often in recent years fought to maintain the value of its currency against the US$, it would be unlikely to let the CNY strengthen very materially, due to the importance of its trade surplus with the US given the woes of the Chinese domestic economy, which is visible in the following chart.

Source: Trading Economics

As for the 'general debt and deficits = inflation/hyperinflation' argument, look at Japan. The country has run substantial budget deficits consistently.

Trading Economics

And seen a massive expansion in government debt/GDP

Source: Trading Economics

Yet, Japanese inflation has rarely been above 1% during the last twenty five years.

Source: Trading Economics

While the US debt/GDP ratio, which was 107% at Q1 2020, will have leapt forward over Q2, it is nowhere near the level of Japanese government debt/GDP. It is hard to see this expansion fuelling inflation at a time of very weak demand.

Source: Trading Economics

I would not be playing any strong currency themes off current rate policies. If anything, the dollar might prove defensive if the scaling back of government support programs around the world drives further downside in global demand.

Economic destruction is deflationary

We also need to consider two forms of asset loss in our outlook.

What about economic recovery?

The final part of Katchum's thesis is this:

As small- and medium-sized businesses stay closed, real output will decline. Without real output, efficiency in the economy will deteriorate and inflation will soar.

Two points there:

While the path of Covid-19 is hard to foresee, I do not think it will be politically (or fiscally) sustainable for political leaders in democracies not to allow economies to open up more fully. Of course, that supposition is vulnerable to a number of assumptions, not least that there are no more flare ups of Covid-19 on the scale that we have seen. But there are encouraging recent signs, such as recovery in mall traffic.

This from S&P Global Market Intelligence:

Foot traffic at malls and outlet centers in the U.S. has steadily climbed since May and is now approaching pre-COVID levels, according to an S&P Global Market Intelligence analysis of data from AirSage, which collects and analyzes real-time mobile signals, GPS and other location data to track movement patterns.

Again, this may well depend on lockdowns ending before government support is scaled down. But when thinking about the output question and inflation, you should allow for a happyish ending in the scenarios you consider.

Investment implications

If the economy does keep recovering, then the out and under performers among equity sectors will probably reverse for a time, though a deep sell off of tech stocks won't proportionately benefit value stocks in an absolute sense.

Of the sectors I have recently written about, I would be selective in the banking sector as the Fed's signalling means interest rate increases are a long way off, giving a subdued outlook for interest margins. Additionally, the sector faces the added uncertainty of the non-performing loan wave coming in 3Q numbers. Wells Fargo (WFC) is extremely cheap, has a lot of work to do on its recovery from the 2016 accounts scandal, but offers much upside on even a modest EPS recovery over the medium term if it takes the right management steps from now.

In contrast to banks, lower for longer interest rates are good for REITs. Most REITS are trading at unusually high spreads in terms of their yields vs. the 10-year T-bill. Three I have written on recently are STORE Capital (STOR), Realty Income (O) and WP Carey (WPC). All three seem cheap, with the widened spread vs. the 10-year substantially pricing in risk to their rental income while fundamentals remain solid.

Digital Realty Trust

Another REIT you might consider is Digital Realty Trust (NYSE:DLR). The stock has done much better than its REIT peer group, chiefly because, as a provider of data centres, it is in the right area of the economy in terms of future growth.

Source: Bloomberg

I first wrote about DLR in January 2017, concluding thus:

DLR is off the lows and is in no sense a screaming buy, but the economics of the business are appealing and its growth outlook has decent secular underpinnings. I would be happy adding in small increments to a position here.

The stock has done well since that article, returning 70%, with 56% of that accounted for by stock price appreciation, 14% by dividends.

The yield has fallen from 3.5% to 2.9%. Is this a time to sell?

When I last wrote about this REIT, the 10-year offered a 2.44% yield to maturity. DLR offered a 3.5% yield back then, so the spread between DLR and the 10-year was just over 1%. While DLR's yield is now lower, at 2.9%, the 10-year yield is much lower, at 0.7%.

Source: Google and Market Watch

This has resulted in the spread vs the 10-year widening out to 2.2% (on the right side of the chart above). While DLR's digital status means the stock has gone up this year, it has not fully priced in the fall in risk free rates, so it is discounting macroeconomic risk.

If macroeconomic demand comes back, DLR should do well out of the unwinding of this increased spread while remaining attractive from a growth perspective.

By all means buy some Barrick Gold (GOLD) if the inflation bug tugs at the back of your mind. Bear in mind though that predictions of combinations of inflation, higher rates and currency collapse are, at the least, highly contestable and this should be reflected in your portfolio.

This article was written by

Analyst's Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DLR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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