The Big Conversation
Episode 72: Is inflation out of control?
This week we look at the rising fear of extreme inflation that is sweeping some parts of the market based on the buildup of income and savings in the US. Could this see a surge of demand that drives prices higher and how permanent could this be? Is copper a legitimate hedge to this outcome? Fiscal policy is extreme by historical standards but most of the inflationary pressure has resulted from supply chain bottlenecks. Until wages start to pick up, inflationary pressures should remain a short-term phenomenon.
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Concerns about inflation are becoming increasingly frenzied. Bank of America noted that the year-on-year change in S&P 500 companies mentioning inflation in their earnings calls has risen 800% this reporting season, nearly eight times higher than the previous peak. Former Fed Chairman and current Treasury Secretary Janet Yellen even suggested that small rate rises might be needed, although she did later qualify those comments. But many measures of inflation, such as the Baltic Freight Index and agricultural commodities, are squeezing significantly higher. The absolute key question for investors is whether this move is transitory or the beginning of a much longer-term menace. For now, the answer is uncertainty. On the one hand, there are concerns about reaching inflation levels that we haven't seen in over 30 years. And on the other hand, there are fears that labor substitution and technology will be the pandemic's legacy, again, capping wages and inflation within a 30-year channel. But there are some commodities that may provide a hedge against both fiscal excess and technological change. In this week's Big Conversation, we'll be looking at the extreme data that's driving the inflation debate and where we might find a longer-term hedge to both an inflationary outcome and one where technology continues to dominate costs.
When we're thinking about inflation, how far and how fast do we expect it to change? The base effect of a spring back in commodity prices is not the same as a long-term squeeze higher in wages, which tend to be far longer lasting. One of the huge areas of uncertainty, especially in the US, is whether we're currently just seeing the impact of extreme dislocations in supply chains, which are struggling to absorb the sudden shift towards aggressive fiscal policy. And year-to-date this has been very much a US-centric story rather than a global one, because the world's largest economy has seen a dramatic shift in its budget balance or net spending as a percentage of GDP, dropping to its lowest postwar level. Budget balances in other parts of the world have also declined, but very few have been as dramatic in terms of their size and scale. And this has led to a massive increase in the savings rate for US households, which have again surged, having remained at extreme levels since last year. This has been mirrored in Europe, but the rate of savings has not been as extreme. US household savings were also starting from a much lower base than their European peers. In the US. Savings have been driven by a huge surge in personal income, which in absolute terms has risen around two trillion dollars over the last year. But this really stands out when viewed as a year-on-year percentage gain, rising 30%, nearly double the largest increase seen over the last 60 years. These increases in fiscal spending by the US government have, along with the drawdown of credit lines by US commercial banks, been a key driver in this startling increase in measures of money supply such as M2. M2 has grown nearly 30% year-on-year, and many people say this is a major reason to expect higher inflation. Although over the years, year-on-year changes in M2 and year-on-year changes in CPI or inflation have had a very weak relationship. And anyway, US commercial banks could decide to hand back their emergency credit lines, whilst households could decide to pay down existing debts or offset future declines in wages rather than spend those savings. But the build-up in income and savings in the US has reached extreme proportions. Cumulative 12-month savings have increased by two trillion dollars in 12 months, representing a potential of upward inflationary pressures. But how transitory will this be? Many of the inflationary pressures have been building within manufacturing supply chains and within the transfer of physical goods. The latest prices paid index of the ISM release is at its highest level since 2008, which itself was the highest level since the 1970s. But the Order Backlog Index gives a clue to the issues that are being faced by US corporates. This index has reached the highest level in nearly 30 years, reflecting a similar surge in delivery components of the Kansas, Dallas and Empire State surveys. Inflationary issues due to a lack of truck drivers or a shortage of vehicles are obviously inflationary, but they can be quickly resolved by higher prices, bringing new employees or capacity into the mix. When there was a shortfall of crude oil storage at the beginning of the pandemic last year, the price of storage shot up even as the price of crude oil fell. But this brought new facilities into the mix and helped stabilize those markets. But for nineteen seventies style inflation to be repeated, we really need to see a consistent upward pressure on wages. And for that to materialize, we first need to see a full recovery in GDP back to the old trajectory, which is about one trillion US dollars above current levels. And one trillion dollars of fiscal stimulus does not equate to one trillion dollars of GDP. In fact, one of the lessons of the last 10 years is it's taken more and more debt and credit globally to create each extra unit of GDP. GDP has been growing because of leverage and not because of organic and sustainable economic growth. Furthermore, the total number of jobs remains well short of pre- pandemic levels. Even when the US economy was close to full employment, inflation remained extremely benign in its broadest sense, with most of the inflation being cornered by asset prices rather than wages. When economies fully reopen, the US and much of Europe will see a demand shift away from finished goods and back towards the services that dominated developed markets for decades. Current commodity inflation may have been brought forward by a surge in demand that was very unique to the lockdown situation itself. And this demand may now rotate back towards expenditure on holidays, leisure and general recreation. The market is currently not pricing aggressive inflation either. US 5-year and 10-year inflation expectations, whilst edging higher, are both around the 2.5 percent mark. Now, this may be the top of the 10-year range, but it's nothing exceptional. US 5-year inflation expectations are, in fact higher than 10-year expectations, and the spread between the 10-year minus the 5-year is close to a 10-year wide. This suggests that the market is not exactly convinced about long-term inflation. Inflation expectations are themselves heavily influenced by the gyrations of oil prices. OPEC is sitting on excess capacity and could easily meet a surge in demand, capping those inflation expectations. So how should people play the likelihood of inflation today versus the risk that this could all simply be a transitory effect of fiscal stimulus, compounding a hangover of supply chain issues from the pandemic? Well, last week we touched on the long-term outlook for copper.
Copper, like many other commodities, has had a fantastic run off the lows. But this is a market where the demand dynamics over the next 20 years remain extremely robust while supply is still recovering structural issues. These aren't issues caused by the pandemic, although that didn't help. They've been caused by an underinvestment in the years since the commodity bust of 2015. As a result of this supply issues and are crashing into a host of demand factors such as investments in 5G networks, electricity grids, the growth of electrical vehicle demand and energy technologies which are new such as wind generation. The speed with which China will adopt these technologies will again be breathtaking and could surprise investors. And China is still planning on urbanizing millions of its rural population. The question therefore is can copper have another run like it did in the 2000s? Back then you had China accelerating its urbanization and fixed asset investment. Plus there was a global housing boom on the back of easy credit. Copper prices surged by over 500 percent between late 2001 and mid 2006. Today, copper prices are approaching those all-time highs again. But when we look at them on the logged scale, the current move doesn't look too outlandish. We could soon be entering another supercycle like the one that started nearly 20 years ago. And there are other signs that copper is marching to its own tune. If this was a true reflationary scenario, we would expect reflationary currencies and emerging market equities to keep pace. Although the Australian dollar has had an excellent run, it has been left behind by the performance of copper. Does that mean that the copper price has gone too far in the short term? Or is copper breaking free from some of its old shackles? The performance of copper to the MSCI Emerging Market Index has been remarkably similar over the last five years when re-based to 100. But once again, copper has broken free. Yes, it could be a short-term move, but it could reflect a shift to a new demand regime that breaks it free from the reflation narrative. Of course, some of the copper strength is itself demand that has been brought forward by China, who, as we heard last week, were replenishing their own stocks in 2020 when the price of copper was between five thousand five hundred and six thousand five hundred dollars a tonne. Imports rose by 33 percent year-on-year to a level that was 25 percent higher than the previous record. While China has been quick to take advantage of last year's dislocations, global inventories remain tight. LME warehouse stocks are close to the 20-year lows. With demand picking up in supply currently constrained by the lack of long-term investment, there could be a real scramble for copper. An area that investors are now looking at in this space is new technologies both in extraction industries as well as recycling of old copper products. There is an expectation that recycled copper will command a significant premium to newly mined metal. Investing in mining and recycling technology could therefore be as rewarding as investing in the underlying commodity. But of course, the copper thesis is not without some of the obvious risks. It might just be that pressures impacting supply chains across the whole commodity space are also at play with copper. Therefore, rather than chasing the copper price, it might be better to wait for the all-time highs to be broken. That will bring in a new wave of momentum investors and might convince those that were hoping for a pullback that their waiting game may be in vain. We also have speculative positioning in copper futures, which is close to the all-time high, even if adjusted for an increase in open interest. The copper story is therefore not a new story, and many hedge funds have already loaded up on the idea. Positioning is another reason why it might be preferable to wait for a clean break higher in the price. A further obstacle to copper prices rising could be strength in the US dollar. This is something we've discussed at length before, but the DXY is starting to build the last section of what could be a trend reversing formation. It's still early days and the key level would be a break of around 93. But if that led to general US dollar strength it would impact commodity prices in the short term, including copper, even though copper would remain a strong relative story. In fact, strength in the dollar would be a significant impediment for risk assets in general. It's not the level of the dollar per say, but the speed of the move that matters. Central banks have been determined to prevent the dollar from causing too much damage and rising too rapidly. But given current positioning, this remains one of the biggest risks for the market. However, when it comes to the outlook for copper, any weakness on the back of a stronger dollar could provide some excellent entry points into a longer-term theme that should benefit from reflation. And if reflation becomes a mirage, copper should benefit from a huge shift in our energy and communication networks. Copper has moved a very long way already, but if it breaks the all-time highs, it would suggest that a new super cycle is only just beginning.