You will not find Bitcoin, Ethereum, Dogecoin, or any of the many other cryptocurrencies that occupy the news in a Sutherland Integrated investment portfolio. The truth is that we have little insights into how to value such an asset. Nor could I tell you what a beanie baby, a collector sports car, a Rolex watch, or even an ounce of gold should be worth. I would be speculating, with no basis in my opinion other than maybe a hunch. Sure, it is possible that I could become more informed by studying human behavior, following charts, and consulting the stars but at the end of the day investing in any asset that does not, and will never, produce cash flows is gambling. You are buying something based only upon a hope that someday someone else will pay you more for it. If no one wants to buy it, you’ve lost money, and even worse are stuck holding onto a now useless asset, like Chris Robinson, who went bankrupt buying beanie babies.
Investors who buy these assets like to point to their ability to protect against inflation. While there is little evidence in support of it, the belief is that the assets value will rise with - or ideally above – inflation due to their being a limited supply of them in the world. This argument seems to have gotten louder as recent inflation measures have come in historically high and news outlets publish headlines like the below snippets. This has sparked fears by many investors of an impending market decline, caused by the federal reserve raising interest rates and tapering bond purchases.
While we believe inflation is extremely important to our market outlook, we do not believe that inflation is a cause for concern for investors - right now – and believe that much of current inflation commentary is misguided. Sparing you the pain and suffering of a white paper on macroeconomic principles, the important aspects of inflation in how it relates to present times can be distilled down into two concepts:
Inflation measures the general rise in prices – or weakening of the dollar - for goods and services in an economy over a period of time. The formula is relatively straightforward and is the change in price (price today – minus price at the start of the period) divided by the price at the start of the period. To illustrate the formula, and a flaw within it, lets use the price of a gallon of milk as our example for 12-month inflation measures. For our example, imagine that a little over a year ago President Trump tweeted that drinking milk made you more likely to contract COVID-19. Subsequently, half the country stopped purchasing milk and this lack of demand caused the price to fall. For our example, assume it falls from $4/gallon to $3/gallon. A month later, Trump consults with his advisors and learns that he was mistaken and takes to Twitter once more to clarify that he was wrong. Half the country once again begins to drink milk and the price of milk soon recovers to $4.15/gallon. 12-month inflation measures would be:
[ $4.15 (price today) - $3 (price one year ago) ] / $3 (price one year ago) = 38.33%
Looking solely at the milk inflation number above of 38.33%, it would lead you to believe that the value of a dollar has weakened, or at least in gallons of milk terms. Hidden in the reading, however, is an anomalous occurrence – the president discouraged milk consumption - that occurred at the start of the measurement period. This is called the base affect, where economic comparisons can be distorted by one data point in the denominator of an economic formula. Current inflation readings are similarly experiencing this base affect. One year ago - our base price for many inflation figures – most of us were confined to our homes, unable to travel, go out, had fears about how COVID would impact our financial well beings and as such consumer spending fell. According to the Dallas Fed and supported by economic readings, “inflation rates were deeply negative last spring as demand plunged in many sectors of the economy.” So, it is only natural, like with the milk example, that as the economy begins to re-open and returns to more normal conditions that comparisons to last year will show a rise in inflation.
To account for this, a more accurate portrayal of inflationary trends can be found by extending the time period to before the onset of the pandemic – or January of 2020. By taking this approach it will show the effects of last spring’s price declines and - not only - the subsequent increase as the economy recovered. This would be akin to adjusting our inflationary milk example to include data before Trump’s tweet on milk. The chart shows the adjusted average inflation of between 2.2% and 2.6%, which falls relatively close to the Federal Reserve’s goals and puts inflationary fears into better perspective.
Source of Inflation
As you can see from the chart, average inflation has accelerated in recent months. For this it is important to understand the drivers of inflation. Generally, inflationary pressures can be classified into three types: cost-push, demand-pull, and built-in inflation. We find it useful to separate the different inflationary trends in the economy right now to get a better understanding of where we see it trending long term.
Like it sounds, demand pull inflation occurs when consumer demand increases so much that it rises above current supply. This increased demand then “pulls” up the price of products and creates inflation. American consumers have emerged from the pandemic in arguably the best financial shape in history. During the pandemic they saved more, received increased government support, spent less, invested into a strong bull market, refinanced their homes at lower interest rates and paid down debt.
As restrictions have loosened and vaccination rates have risen, Americans are now once again able to spend. This time from a position of greater financial strength. This is causing strong demand-pull inflationary pressures as buyers competing to purchase the same items “pulls” prices up. However, we believe these pressures to be short lived and not cause for concern. Supporting this belief is that much of the increased financial strength has come directly from the government, whose various programs currently account for over 30% of American personal income. With vaccinations rates rising, the economy re-opening and employment recovering we do not expect these programs and and increased support to continue for much longer, which should ease demand.
Additionally, another portion of this increase in demand-pull inflation can be attributed to pent up demand from consumers. Like government stimulus this should also subside returning prices to more normal trending levels after consumers are finally able to spend the money on things they’ve been dreaming of all pandemic.
Cost-push inflation occurs when prices rise due to a lack of supply or supply shortages. With COVID-19 drastically impacting supply chains and manufacturing capabilities, global supply was cut and has not yet recovered fully. As such the lack of supply for components “pushes” up prices for final products. Most notably, semiconductor - the “brains” inside of every electric device, from computers to cars – shortages alone can be linked to large increases in current inflation measures. For example, most auto manufacturers have been forced to lower production or even close plants without the supply of semiconductors. This has resulted in a limited supply of new cars and a subsequent increase in both new and used car prices. Nearly one third of May’s entire 5% increase in the Consumer price index – most widely used measure of inflation – can be linked to the rise in used car and truck prices, alone. There are countless other examples of supply issues around the world that are inflationary. However, like with demand-pull inflation, we expect these supply chain and manufacturing issues to sort themselves out as workers can return to work and additional capital is invested into manufacturing capabilities. It is even possible, if not likely, that current supply issues could turn from inflationary to deflationary with a likely excess capacity after all current outstanding orders are met.
The last one on our list, and the one that has us saying “right now” after our statement that inflation is not a concern, is built-in inflation. This type of inflation relates to people’s expectations on inflation, which can be a self-fulfilling prophecy. The current bout of inflationary news and transitory inflation we are seeing now could cause an expectation that inflation will continue. If consumers and employees believe that the value of their dollar is being eroded by inflation, they will expect, or more likely demand, that the cost of their own output be raised. Employees will ask for higher wages from companies who will ask consumers to pay more who in turn will ask their own company for higher salaries. This creates a feed back loop that can create structural – or long lasting – inflation. The type that would require actions to be taken by the Federal Reserve that, ceteris paribus, would have negative impacts for equity markets.
This is why we follow consumer inflation expectations closely (chart above.) Especially for the working age population. We would like to see a leveling off in inflation expectation in the coming months. Without it, the possibility of built-in inflation and the Federal Reserve intervening increases.
What this all means for portfolios
In summary, we believe current inflation measures misrepresent the current state of the economy. As such, we are looking past these measures – and the misguided market commentary around them – and focusing on staying committed to long term investment principles. This is with the caveat that we will be playing close attention to consumer inflation expectations, which - if expectations continue to rise - may result in us lowering our overweighting of small cap, and emerging market companies. While these companies, and our overweighting of them, have substantially improved our performance the last three quarters (below chart) we feel that they will underperform if the federal reserve is forced into action sooner than the market expects.
As always, please reach out with any questions, grammatical errors, or just to talk.
Sutherland Integrated Investment Management Group, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.