MBMG Outlook – 31st January 2022 Past the peak⁉️

Executive Summary

One issue has been bothering us for the last month – inflation. Actually, it’s been bothering us for longer than that but for different reasons.

• The consensus view is that the world has an inflation problem.

            We agree.

• The consensus view is that inflation is too high.

            We’re not so sure.

• The consensus view is that policymakers need to hike interest rates and reduce the injection of government funding into both the economy and capital markets.

            We definitely disagree.

Before you read this section and look at the chart on the following page, ask yourself what you think the annual rate of inflation is in Thailand, Europe, USA and whether this has changed recently.

Definitions of inflation are problematic – no two individuals or households spend in identical patterns, therefore, not everyone is affected in the same way by changes in price of goods and services. This varies hugely within countries (patterns of spend being dictated by personal preferences, availability of disposal income and lifestyle considerations – a family that has high disposable income has different priorities and different capacity for expenditure, than a single individual with no source of income) and also from country to country.

The least unreliable way to capture meaningful inflation trends could be argued to be core inflation, which typically excludes the cost of food and energy.

This is in many ways a nonsensical measure because I don’t know anyone who doesn’t have to spend money on food or energy, but absent any better choices it may be the least bad measure-

How does this compare to what you’d expected?

We suspect that it’s lower in many cases than people perceive from their own experience.

The outliers (major economies where inflation is above 3%) are Canada, USA, and UK – we could have also shown Russia (8.09%), Brazil (7.3%), Mexico (5.5%), Germany (3.7%) & South Africa (3.4%), which along with perennial inflation basket cases Argentina (55.5%) and Turkey (31.9%) are the only G20 nations above 3% (with Netherlands, Spain, France, Indonesia, Italy & Switzerland all falling below 2.5%).

Turkey and Argentina are specifically currency related.

The structure of Brazilian trade has long left the country particularly susceptible to supply chain shocks and Russia’s woes are largely driven by a combination of sanctions and a weaker Ruble.

German inflation reflects a number of technical factors – most notably base effects being exacerbated by the reintroduction of the normal rate of VAT, which was reduced a year ago as a policy to help reduce consumer costs during the lockdowns.

South Africa has suffered extreme supply chain disruptions during COVID, especially during the most recent variant.

The UK appears to have suffered from significant post-Brexit supply chain issues as well as a perceptible recent fall in the Pound.

These might be considered idiosyncratic issues but this leaves, Canada, the USA & Mexico, or what we might call USMCA ( United States–Mexico–Canada Agreement, the successor to NAFTA ushered in by Donald Trump) inflation.

Why are these countries suffering such high inflation?

Although there are many complicated components to any inflation reading (part of what makes them so unreliable), it seems that a number of factors have made USMCA inflation, especially US inflation so severe-

The US is by far the biggest consumption economy – although ‘only’ comprising around 5% of global population, America consumes one-third of the world’s paper and 27% of metals like aluminium (even if Americans can’t pronounce it properly to English ears), as well as other materials, minerals, and resources. America is also largely dependent on imports – so while other countries, such as China are major consumers of timber, none are as reliant on imports.

This has made USA particularly vulnerable to supply shock.

Housing costs have increased significantly for a variety of reasons, but largely due a lack of inventory to meet the post-pandemic demand that may have been partly driven by such low interest rates, but also due to construction constraints because of supply chain issues.

American economic policy during the pandemic has been to support consumption by issuing ‘stimmies payments’ directly to individuals and families. This has disguised some of the demand challenges and also had the reported effect of giving US employees slightly more bargaining power about when to return to the workplace (this may still be very heavily loaded against employees, but inflation merely charts the direction, not the absolute level of employee bargaining power in wage effects).

So, the biggest idiosyncratic factors in the only major instance of global inflation are that a consumer society has managed to keep consuming during a global shutdown but, being a primarily importing economy, has been out of synch with disruptions to global supply. From timber price volatility to microchip shortages to shipping capacity, this theme has been exceptionally well-covered, especially from a US perspective, by the Odd Lots Podcast in the last year or so https://www.bloomberg.com/oddlots-podcast?sref=3ULs2uPI

Sadly, we suspect that US policymakers have not been listening.

A late, but strong contender for the most ill-informed tweet of 2021 was this from Mitch McConnell-

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While there are so many things that are wrong about it, the key point is that the inflation that we’re seeing isn’t a reflection of excessive spending but of disruptions to supply. US consumption in 2021 is expected to be at similar levels to 2019. Admittedly, this is a healthy recovery from the dip of 2020, but still reflects no net increase in spending for 2 years (the rest of the world in comparison managed to increase during that period, nowhere more so than China, where, despite achieving growth close to double digit across the two-year period, inflation remains muted at just over 1% per year.

US inflation is clearly, not driven by out-of-control spending.

In fact, it’s a reflection that America is a consumption economy, heavily dependent on imports that rely on global supply chains that have been badly disrupted. Some industries have proven hard to turn back on again after they have been closed down, often because of component supply difficulties (when microchip production resumed, there was demand from all sectors at once as re-opening happened to a substantial extent simultaneously). Other issues have been more specifically pandemic related, with the global merchant marine caught out of position, facing issues like crew quarantine, and denied access to ports (and of course the dodgy driving last year of Ever Given). But these have conspired to have a disproportionate impact on US inflation.

In a sense, this is good news, in that it will largely come to pass, once supply and demand cycles adjust and normalize. Economists and even by policymakers at the Fed, who coined the term ‘transitory inflation’, recognised this. However, the inadequate explanations of transitory inflation left many observers with the impression that transitory mean that we would see a single, short spike in certain goods and normalization. This fails to recognise how supply shocks work, particularly the aspect that they become exaggerated by behavioural effects such as hoarding – when we hear that toilet rolls are in short supply, we rush out and buy more, which makes the supply shock worse. For businesses, this often reflects in changed patterns of purchasing that Tracy Alloway calls the ‘bullwhip effect’ – of businesses “storing up critical components for one year of usage because if we miss one component, we cannot manufacture the products.”

The bullwhip means that supply shocks become less of a single spike shock but more of a series of ever declining peaks and troughs until the wave dissipates into the trend (i.e., a spike followed by a fall, followed by a lower spike, followed by another fall etc.). Provided that the successive spikes are lower each time, then we can see that the supply shock is playing itself out, as is the case in the timber market right now. Lumber futures recently spiked up again, but far less than last year’s peak-

Of course, if the price fails to fully revert to or below the previous bottom or if it spikes to a new high, then we’d have to reconsider our view of inflation, but for now, there’s no reason to diagnose any malady other than the biggest supply shock since World War II.

So, what can policymakers do about it? Well, in the long run, it will fix itself. In the short run, the affected countries should create specific solutions to idiosyncratic inflation issues – subsidies might be one solution although they have a chequered history in government hands.

Despite the factors listed in the box above, the various channels of US policymaking now seem determined to pull the rug from underneath the American economy and American markets in three ways:

1. By cutting back the net spending (also known as deficit) by the government, from $3.1 trillion in 2020 and $2.9 trn last year to less than half of that in 2022 (note that US government fiscal years end on 30th September)

2. By removing the support for capital market prices that the Fed’s asset purchase programme has engendered, in its current phase since 2019. In the past, we’ve used the analogy of addictive drugs and dependencies for this aspect of Fed policy, but at a time when the whole US economic edifice is so brittle, it seems ill advised to just snatch the heroin away from the user.

3. Hiking short term interest rates reduces the disposable income of the most indebted consumers and companies, creating a slowdown of aggregate economic activity, which constrains spending further, and can quickly result in a vicious spiral down.

So, a misdiagnosis seems certain to lead a treatment that is not only painful but genuinely dangerous for the patient.

A common misconception is that the patient in question, the US economy, is in such rude health that it can withstand such bungling ministrations.

In the Technicalities section, we’ll challenge this view but for now, geopolitical ructions in Ukraine aside (and that’s a huge and probably widely understated aside), the key theme for 2022 (and beyond) that we’re watching most closely is policy divergence. 

We worry that that in many economies, policymakers are at risk of invoking serious economic and market consequences through a blind adherence to misguided orthodoxies that in the current environment look and feel like major policy mistakes. 

We hope that in a few economies, the most significant being China, that policymakers will take a different path – and indeed are more easily able to do so because they have managed to continue to grow and at the same time avoid supply shock inflation. 

In the US and UK, despite economies being at or below the size they were a couple of years or so ago, supply shock inflation seems to be spooking policymakers.

This could well prove to be the major theme of 2022.

Ah! as the heart grows older
It will come to such sights colder
By and by, nor spare a sigh
Though worlds of wanwood leafmeal lie – Spring & Fall, Gerard Manley Hopkins

1. MBMG Portfolios based on the average performance of MBMG IA’s private client portfolios of USD 1 million or more, from 1st January 2017 to 27th January 2022 (based on latest actual & estimated data to 27th January 2022)..

2. Average US$ portfolios based on estimated ARC Research Private Client Indices from 1st January 2017 to lasts available data, 27th January 2022) – https://www.suggestus.com/pci.