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)
- 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)
- 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)
- 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)