2021 Q2 Investment Letter (Inflation)

2021 Q2 Investment Letter (Inflation)

The S&P 500 Index returned 8.55% and the S&P Global Broad Market Index returned 7.22% in the quarter ended June 30, 2021.1 Currently, one of the most dominant concerns among investors is inflation: specifically, whether the recent rapid price increases that we’ve seen in commodities, wages, and asset prices (stocks, housing) are signs of a transitory inflation or a more persistent, pernicious variety. Investors view this question as important since stocks are trading where they are, in part, because most high-grade bonds offer very little yield. Since most portfolios are a mix of stock and bonds, investors have come up with the acronym TINA (“There is no alternative”) to describe this phenomenon of investors paying higher prices than they have historically for stocks since, unlike bonds, they appear to actually offer meaningfully positive long-term nominal and real returns. If a persistent, hard-to-control inflation forces the Fed to materially raise rates, then, suddenly, TINA isn’t true anymore, and some investors may prefer the lower-but-historically-less-volatile returns of bonds, which could create downward pressure on stocks prices. In the remainder of this letter, we’ll explain how we think about inflation and what changes we’re making to the portfolio as a result.   Inflation Inflation occurs when the supply of money and credit increases relative to the supply of goods and services (“too much money chasing too few goods”). Deflation occurs when the supply of money and credit decreases relative to the supply of goods and services (not enough money and too many goods). So, let’s start with a sampling of deflationary pressures, which can occur when the supply of money and credit decreases or when the supply of goods and services increases.  
  • Personal, corporate, and government debt paydown and/or cash buildup – All else equal, when individuals, corporations, and governments, in aggregate, pay down debt or build up cash (in other words, when there are not enough new borrowers to match the savers), the supply of money and credit declines. This decline in money and credit might occur in response to a financial crisis that forces individuals, corporations, and governments to repair their balance sheets, and it also might occur in a benign economic environment if there are not enough attractive consumption and investment opportunities to induce net new borrowing. Since money and credit are the two sources of spending in an economy, when their supply declines, total spending declines. When total spending declines but the supply of goods and services remains the same, the prices of goods and services must, in aggregate, adjust downward. Furthermore, since one person’s spending is another person’s income, this reduction in spending sometimes causes a deflationary spiral where reduced spending leads to reduced income which leads to further reduced spending and so on. (SUPPLY OF MONEY AND CREDIT DECREASES)
  • Globalization – Globalization generally leads to a more optimal division of labor, which brings down the cost to produce goods and services. In a competitive market, a reduction in the costs of goods sold leads at least some companies to be willing to sell their products at a lower price, resulting in lower overall prices for goods and services. However, this deflation does not occur equally across countries. For the countries that have high-cost labor, such as the United States currently, there is more downward pressure on prices of goods and services, especially the labor component. In contrast, if a country has lower-cost labor that also has the infrastructure (education, roads, etc.) to supply desired goods and services, it can actually experience a golden age with a boom in real growth and healthy inflation, as China has recently experienced and as the U.S. did after World War II. (SUPPLY OF GOODS AND SERVICES INCREASES)
  • Technological progress – Innovations such as automation, better communication and transportation networks, cheaper resource extraction techniques, and the invention or discovery of cheaper and/or better substitute products all decrease the price of goods and services. In other words, for the same amount of money, a society can produce and/or purchase more goods and services. (SUPPLY OF GOODS AND SERVICES INCREASES)
  • Reduction in the power of firms and workers to collude and/or collectively bargain – If employees can’t form labor unions and corporations aren’t allowed to collude with competitors, then they all have to compete with each other to earn income and profits, driving down prices. In other words, this competition increases the supply of workers, goods, and services for a given amount of money. (SUPPLY OF GOODS AND SERVICES INCREASES)
  • Changes in government policies and societal norms that increase the confidence that a given denomination of a country’s money can be exchanged for a certain level of world output now and in the future – Confidence tends to increase, for example, when a government improves its fiscal discipline and trustworthiness by reducing corruption in government-contract bidding, by cutting projects that have demonstrated little societal return, and by allocating more to projects that have demonstrated strong returns, such as infrastructure and research and development. In these cases, a country’s money is more valued by the international community and, therefore, it can purchase more global goods and services for the same amount of money and credit. (SUPPLY OF GOODS AND SERVICES INCREASES)
  Below is a sampling of inflationary forces, which are mostly the reverse of the above deflationary forces:
  • Personal, corporate, and government debt increases – All else equal, when individuals, corporations, and governments, in aggregate, choose to increase their debt (in other words, when there are more borrowers than savers), the supply of money and credit increases. Since money and credit are the two sources of spending in an economy, when their supply increases, total spending increases. When total spending increases but the supply of goods and services remains the same, the prices of goods and services must, in aggregate, adjust upward. Furthermore, as in the deflationary example, but in reverse, this increase in spending sometimes sets off a virtuous cycle where higher spending leads to higher income which leads to higher spending and so on. (SUPPLY OF MONEY AND CREDIT INCREASES)
  • Deglobalization – When a country closes itself off from rest of the world, it removes workers, resources, factories, and some of its institutional knowledge from the global market, decreasing network effects and division-of-labor efficiencies. This reduces the supply of goods and services available to each country for a given amount of money. (SUPPLY OF GOODS AND SERVICES DECREASES)
  • Technological stasis or reversal as a result of written or unwritten rules that impede innovation such as government price controls, regulatory red tape, and cultural norms that discourage entrepreneurship. (SUPPLY OF GOODS AND SERVICES DECREASES)
  • Increases in the power of firms and workers to collude and/or collectively bargain, reducing the supply of workers or products for a given amount of money. (SUPPLY OF GOODS AND SERVICES DECREASES)
  • Changes in government policies and societal norms that decrease the confidence that a given denomination of a country’s money can be exchanged for a certain level of world output now and in the future. For example, all other things equal, when a government dilutes the value of a country’s money by printing more of it, threatens not to honor existing debt, or institutes rules that weaken the economy to the extent that investors begin to question the long-term capacity of the economy to support its debt, it is contributing to inflationary pressures. Similarly, societal norms moving towards more widespread cheating on taxes and/or refusal to pay debts also create inflationary pressure. In most of these cases, a country’s money is less valued by the international community and so it can purchase fewer global goods and services for the same amount of money and credit. In the case of money printing, the supply of money and credit increases. (SUPPLY OF GOODS AND SERVICES DECREASES AND/OR SUPPLY OF MONEY AND CREDIT INCREASES)
  • Natural disasters – Earthquakes, hurricanes, droughts, and pandemics all tend to decrease the supply of goods and services, either directly or indirectly. Direct impacts include droughts that wipe out crops, earthquakes that destroy factories, and pandemics that result in loss of life (which reduces the supply of labor). Indirect impacts include social distancing and other safety measures that reduce productivity and, therefore, decrease the supply of goods and services that can be produced with a given amount of money. (SUPPLY OF GOODS AND SERVICES DECREASES)
The above list shows that many causal factors need to be measured in order to predict inflation. As you probably noticed, creating accurate measurements for some of these categories is a Herculean task in and of itself. However, two additional considerations show that measurement problems are just the tip of the iceberg. First, each of these factors interacts in complex ways with all the other factors. In other words, in the real world, all is not equal. Changes in technological progress are not independent of globalization which is not independent of society’s aggregate balance sheet choices. Changes in one factor cause changes in other factors which cause changes in other factors and so on. Second, there is a huge and unpredictable psychological component to many of these factors. For instance, changes in government policy such as more money printing or increased government deficits and debt sometimes scare individuals and corporations into reducing their spending by enough that the deflationary pressure of their behaviors outweighs the inflationary pressure of the government’s behavior. Other times, individuals and businesses increase their spending as a result of increased government deficits, accelerating inflationary pressures. A look at the current situation provides a real-world example. Most economists believe the inflation we’re currently experiencing has been caused by both a decrease in the supply of goods and services and an increase in the supply of money and credit: SUPPLY OF GOODS AND SERVICES (NET DECREASE):
  • Business closures during lockdowns (DECREASE)
  • New business start-ups, many of them online (INCREASE)
  • Protocols to prevent the spread of COVID that limited the number of people who could be in the same room or that made it harder for each person to do their job, both of which impacted output, especially at factories that produce and warehouses that ship durable goods. These issues are ongoing with COVID still wreaking havoc in key countries such as Brazil, India, and Indonesia. (DECREASE)
  • COVID protocols limiting international travel, even for business reasons, which disrupted global supply chains, either preventing or delaying movement of goods through the supply chain. These issues are ongoing with COVID still wreaking havoc in key countries such as Brazil, India, and Indonesia. (DECREASE)
  • With enhanced unemployment benefits that replaced or enhanced incomes as well as the return of day trading combined with an ebullient stock market, many workers are reluctant to return to the workforce, causing labor shortages and rising wages. (DECREASE)
  SUPPLY OF MONEY AND CREDIT (NET INCREASE)
  • Enhanced unemployment benefits, stimulus checks, and a whole host of other unprecedented deficit-driven government spending initiatives have increased society’s aggregate debt and, when combined with ebullient housing and stock markets, have increased the current incomes and the perceived wealth of many people (INCREASE)
  • Loan and rent forbearance programs (INCREASE)
  • Virus fears reduced discretionary spending, increased cash buildup, and improved debt pay down, putting many individuals in the position to splurge as the economy opens back up. (DECREASE THEN POTENTIALLY NET INCREASE)
  • COVID forced people to confront their mortality, couped them up, and shut down many of their favorite activities. This combination has created a strong emotional desire in many to spend regardless of budget. The surging popularity of the acronym YOLO, which stands for “You only live once,” demonstrates the ubiquity of these feelings. (DECREASE THEN INCREASE)
  • COVID suddenly and unexpectedly drove a major mix shift in spending, away from experiences and towards durable goods, including housing. It takes time to build the capacity to meet this unexpected stairstep up in demand.2 (MIXED: DECREASE IN EXPERIENCES AND INCREASE IN DURABLE GOODS)
In our view, the above rationale seems to explain the inflation we’re currently experiencing. However, it unfortunately doesn’t help us to answer the question that really matters: Is this a transitory inflation, or is it the start of a more secular, sustained inflation? In order to answer this question, we need to answer a whole host of questions, including but not limited to: Is the housing market strength (and the willingness of many millennials to take on new debt to fund housing investment and consumption) sustainable, and, if so, how long will it take for supply to catch up to this newfound demand? Did recent COVID experiences cause individuals and corporations to be more averse to debt in the future, or have government actions bolstered confidence to continue borrowing? If there is increased borrowing demand, will banks actually lend and thereby the money multiplier increase, or will there continue to be a decrease in the velocity of money? Is the government willing to continue huge government deficits, and, if so, will they be used to fund high-return projects such as investments in research and development and infrastructure, or will they be used to fund stimulus payments that are perhaps less likely to produce durable increases in productivity and growth? Will enhanced unemployment benefits expire, turning today’s labor shortage into a labor glut? Will COVID and the continuing China-U.S. tensions result in a long-term move away from globalization, in which supply chains are optimized not for speed and cost but for resilience, or will the global supply chain be repaired and relubricated in short order? Will productivity dramatically increase, due to the pandemic supercharging innovation and capital spending, thereby reinforcing the persistent and decades-long deflationary pressure on wages for many workers in the U.S? Unfortunately, there are too many unknowable factors interacting in ways that are too complex and unpredictable to model future inflation with any degree of accuracy. So, if we can’t predict future inflation (or any other macroeconomic factors, for that matter), what can we do? Well, we can prepare. And, to us, that means owning a portfolio that can deal reasonably well with both inflation and deflation. In our view, our portfolio full of a diverse collection of global champions with enduring pricing power, ownership-minded management teams, and conservative balance sheets is such a portfolio. If the economy experiences future inflation, we think our businesses have such strong pricing power that they will be able to raise prices at least as fast as any cost increases that they experience and probably even faster. When combined with our companies’ attractive volume growth opportunities, we believe these price increases will drive persistent, high-return-on-invested-capital earnings growth that will, over the long-term, mostly offset any valuation multiple contraction that they experience from higher interest rates. If the economy experiences deflation, we believe our companies’ pricing power will enable them to keep their prices from falling as fast as their costs and that their dominant market positions and conservative balance sheets will enable them to grow their market share through aggressive investments in customer acquisition and through the purchase of distressed competitors. Furthermore, because we believe investors tend to overly penalize businesses that they fear will be negatively impacted by the dominant macroeconomic narratives of the moment, we’ve used the recent inflation fears and excitement over the post-pandemic recovery as an opportunity to rebalance the portfolio. Therefore, we added to or introduced new stocks in our portfolio that sold off because they have more stable cash flows and thus benefit less from inflation and economic strength, including our Big Tech, software, and information services holdings. Conversely, we trimmed some of the more cyclical positions we own such as our bank, commercial real estate brokerage, and luxury holdings, all of which benefit from the inflation and economic recovery narrative and thus have experienced strong recent stock price performance. Concluding Thoughts The level of future inflation is undoubtedly an important component of future returns for both individual stocks and the market as a whole. As a result, it’s understandable that investors spend a lot of time thinking about it. Unfortunately, there are many things about that future that are impossible to predict, and inflation is one of them. Therefore, as with all other macroeconomic factors, we try to prepare rather than predict. By concentrating our portfolio dollars on a diverse collection of global champions that possess enduring pricing power, ownership-minded management teams, and conservative balance sheets, we believe we’re prepared to both survive and thrive through a wide range of future economic scenarios. By adding portfolio dollars to stocks that underperform as a result of inflation fears and by trimming our exposure to stocks that outperform as a result of these fears, we believe we can capitalize on investors’ chronic short-termism and enhance the long-term, risk-adjusted return of our portfolio. In our view, the key to successful long-term investing is to adopt a sensible game plan and then to execute this game plan in a disciplined way. We can adopt a sensible game plan on our own but we can only execute it in a disciplined way if you, our client, understand the process and allow us to do so. This fact explains why we spend so much time on our thought process in these quarterly letters. And it also explains why we continue to be so grateful to you for the trust and grace you display by allowing us to steward your hard-earned savings through both good times and bad. Know that we take this responsibility incredibly seriously and that we are invested right alongside you. Finally, we hope you have a great remainder of the summer, and please reach out to us with any questions or concerns you may have. We are here to help! Sincerely, The YCG Team Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security nor were they selected based on profitability. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not necessarily reflect current recommendations nor do they represent an account’s entire portfolio and, in the aggregate, may represent only a small percentage of an account’s portfolio holdings. A complete list of all securities recommended for the immediately preceding year is available upon request. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. S&P stands for Standard & Poor’s. All S&P data is provided “as is.” In no event, shall S&P, its affiliates or any S&P data provider have any liability of any kind in connection with the S&P data. MSCI stands for Morgan Stanley Capital International. All MSCI data is provided “as is.” In no event, shall MSCI, its affiliates or any MSCI data provider have any liability of any kind in connection with the MSCI data. Past performance is no guarantee of future results.   1 For information on the performance of our separate account composite strategies, please visit www.ycginvestments.com/performance. For information about your specific account performance, please contact us at (512) 505-2347 or email [email protected].  All returns are in USD unless otherwise stated. 2 See https://www.vox.com/the-goods/22445613/behavioral-economics-budget-post-pandemic.
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