April 10, 2016
“Perfect storm: a particularly violent event arising from a rare combination of adverse circumstances.”
Over the last twenty years, most investors have become accustomed to a low inflation world. In the 1980s, and even the first part of 1990s, many investors worried about a return to the high levels of inflation that were experienced in the United States in the 1970s. But those fears were never realized and, as we sit here today, many investors are more worried about deflation than inflation.
But is it possible that we are sitting in the eye of a storm? Is it possible that circumstances are conspiring to create a perfect inflationary storm? And, from a theoretical perspective, what might the lead up to the “perfect inflationary storm” look like?
In this week’s article, we are going to adopt the role of economic meteorologists. The view of The Money Enigma is that one can not predict inflation simply by looking at recent trends in the data, just as one can not predict rain by simply looking out the window. Rather, we need to think about the structural events that are required to create a perfect storm. What are the relatively rare circumstances that, when combined, could create a sudden and violent acceleration in the rate of inflation?
Two Storms Approach
The view of The Money Enigma is that we may be on the verge of a rare event: a moment when two powerful storms meet to create a perfect storm.
From an inflationary perspective, the perfect storm requires two key events to occur simultaneously: a sharp rise in the value of goods, and a sharp fall in the value of money.
The value of goods is approaching a potential inflection point, driven by a lack of investment in new commodity supply over the past few years. While many bemoan the future of commodity demand, the simple fact is that there has been a collapse in capital and exploration spending, particularly in vital commodities such as oil.
Conversely, the value of money is poised for a significant decline. The value of fiat money, particularly the US Dollar, has been well supported over the past ten years, despite the reckless actions of both fiscal and monetary policy makers, but this support could erode quickly if the market begins to doubt the sincerity of policy makers efforts to normalize policy settings.
If the value of goods were to suddenly spike, driven by a tightening of supply, at the same time as a dramatic fall of money were to occur, then this could create a violent surge in the rate of inflation.
But before we dig into too much detail regarding the two approaching storms, let’s take a few moments to discuss a simple question: what drives prices higher?
At the most fundamental level a price is nothing more than a ratio of two quantities exchanged: a quantity of one good for a quantity of another. This ratio of exchange, or the “price” of the trade, is determined by the relative market value of the two goods being exchanged. For example, if a banana is twice as valuable as an apple, then the price of banana in apple terms is “two apples”.
Similarly, the price level is nothing more than a relative measure of the market value of the basket of goods in terms of the market value of money. By measuring market in absolute terms (i.e. in terms of a standard unit for the measurement of market value), we can express the price level as a ratio of two values, as demonstrated in the diagram level. (See “Ratio Theory of the Price Level” and “The Measurement of Market Value: Absolute, Relative and Real” for an extensive discussion of this idea).
What “Ratio Theory” says, in simple terms, is that the price level can rise for one of two basic reasons: either (a) the basket of goods becomes “more valuable”, or (b) money becomes “less valuable”.
Moreover, if the basket of goods becomes “more valuable” at exactly the same time money becomes much “less valuable”, then prices will surge higher. In essence, this is the recipe for the perfect inflationary storm.
If one accepts this basic theory of price level determination, then there are only two questions that need to be answered. First, what could drive a sudden and sharp rise in the value of goods over the next few years? Second, what could drive a dramatic fall in the value of fiat money over that same time period?
Commodities: Demand AND Supply
The basket of goods, by its very nature, contains a large number of goods and these goods are subject to a wide array of market forces. It is impossible to analyze every individual element of the basket of goods. However, it is possible to isolate and discuss a key input into the basket of goods: commodities.
Over the past five years, many market commentators have laboriously discussed the slowing of economic growth in China and the impact of this trend on demand for commodities. While this weakness in demand from China is clearly a big issue, it is also an issue that is well understood by the energy and mining industries.
Not surprisingly, there has been a dramatic supply response.
Visually, the most stunning collapse in spending has occurred in the US oil industry. The chart below (source: Baker Hughes, Business Insider) demonstrates how quickly and dramatically, oil-drilling activity in the United States has collapsed. This collapse in activity will lead to lower US oil production volumes in the short-to-medium term, particularly given the high production decline rates experienced by non-traditional (shale) oil fields.
In the mining industry, the supply response has been slightly less dramatic, but nonetheless is still remarkable. While the decline in capital expenditure by the global mining industry at a headline level may not seem that dramatic, the decline in spending is remarkable if you dig into the numbers a little. The chart below (source: CSFB) demonstrates that while maintenance capital spending has remained steady, expansion capital spending has been slashed by nearly two thirds since 2012 and is expected to decline further in 2016.
Moreover, both the energy and mining industries face the same basic problem: major discoveries are becoming less frequent, the quality of discoveries is falling and, consequently, capital intensity is rising. For example, copper head ore grades have declined sharply over the past twenty years, and this is a phenomenon shared by most major industrial metals.
The key point is that while demand for commodities may be tepid at present, there has been a strong supply response, one that threatens to lead to a sudden rise in commodity prices at some point in the near future. A sudden rise in the value of commodities, particularly crude oil, could trigger input price inflation across a wide range of industries, thereby leading to a marked increase in the value of the basket of goods, the numerator in our price level equation.
The Value of Money: Policy Expectations Meet Reality
While a significant rise in the value of goods may trigger higher prices, the view of The Money Enigma is that the key risk to the inflationary outlook is a sudden and violent decline in the value of the major fiat currencies.
Over the past ten years, the major fiat currencies have largely maintained their value based on the (erroneous) belief that the current cycle of extraordinary monetary policy would be “normalized in due course”. But just in the last few months, it seems that markets have begun to doubt the notion that policy will be normalized in the next few years.
The view of The Money Enigma remains that if the markets lose faith in the Fed’s commitment to normalization, then it is highly likely that the US Dollar, and other major fiat currencies, will experience a significant loss in value. If this loss in the value of money occurs at the same time as a squeeze in commodities in experienced, then a repeat of 1970s-style stagflation is a real possibility.
Why will the value of money fall if the Fed fails to normalize policy? Well, this is a question that we have discussed many times over the past six months. In essence, the answer is this: the value of fiat money at any point in time is primarily determined by expectations regarding the long-term expected growth of real output relative to the long-term expected path of the monetary base.
Fiat money is a financial instrument and represents a proportional claim on the future output of society. In some ways, fiat money is very similar to a share of common stock. Each share of common stock represents a long-term proportional claim on the future cash flows of a business. Similarly, each unit of the monetary base represents a long-term proportional claim on the future output of society.
The value of a share of common stock depends upon (a) the expected path of future cash flows, and (b) the expected issuance of equity that is required to support that growth in cash flows. More cash, higher stock prices: more shares out, lower stock price.
The value of fiat money depends upon (a) the expected path of future real output, and (b) the expected issuance of money by the central bank (the expected path of the monetary base). More output, the higher the value of fiat money: the more money that is issued, the lower the value of each unit of money.
Currently, the market exists in a strange fairytale state. Despite the incredible growth in the global monetary base over the past ten years and despite the very poor real output growth this has engendered, the market still believes that at some point, the major central banks will “normalize” policy, i.e. raises interest rates and reduce the size of the global monetary base back towards previous pre-QE levels.
However, if the markets realize that normalization has, in effect, become an impossible goal for the Fed, then confidence in the major currencies will quickly erode.
As discussed in “The Markets Go to Rehab”, the view of The Money Enigma is that the markets are addicted to monetary base expansion and the Fed, despite its best intentions, doesn’t have the intellectual or political strength to wean the markets from this powerful drug.
In conclusion, it is possible that the conditions have been created for a perfect inflationary storm. Most investors are very complacent regarding the risk of inflation and have dismissed the early signs that inflation could be rearing its ugly head. However, should a sudden collapse in faith in central banks occur at the same time as the commodities cycle begins to turn, then the unthinkable could happen and inflation could sharply accelerate.
