There’s a theme rising above the din in financial markets today. Inflation seems to be rearing its ugly head again. Though most dismiss it as trivial or just an energy story, I believe it has the ability to become the pin that pricks the “everything bubble.”
Eric Cinnamond tracks corporate earnings reports as closely as anyone I know of. Recently, in summarizing the great number of this season’s earnings reports he has reviewed, he wrote, “Inflation is showing signs of increasing – the deflation mindset is ending.” This anecdotal assessment is now being confirmed in the broad economic data.
January CPI this week came out at 2.5%. Core CPI (less food and energy) is still running at about 2.25% as it has for over a year now. The sticky version of this measure, that is inflation in prices of goods and services that don’t change very often, is now running at over 2.6%, proving this is more than just an energy story. Almost any way you measure it, inflation is now hotter than the Fed’s 2% target and this presents a serious problem for investors.
Because inflation could quickly kill the golden goose. Until now, global coordinated ZIRP and QE have largely resulted solely in asset inflation with very little consumer inflation. This has allowed central banks to persist in these experimental endeavors in an effort to meet the dual mandate of full employment and tame inflation, however misguided these efforts may have been.
However, if these policies are now resulting in headline inflation, they may be forced to back off if not completely reverse course. Last week Eric wrote, “If one is looking for a QE killer, rising consumer inflation would certainly be on top of my list.” And anything that threatens the perpetuation of those policies is a threat to the elevated prices of financial assets.
Around the world, quantitative easing, along with zero or negative interest rate policy, has been the impetus and inspiration for every other price-insensitive strategy that has pushed asset prices to extreme valuations in recent years. In addition to passive investing I’m referring to stock buybacks, defined benefit pension plans, risk parity, volatility targeting, selling volatility, trend-following and countless other price-insensitive strategies that have all been emboldened one way or another by the “central bank put” that experimental monetary policy represents.
The popularity of these price-insensitive strategies is directly responsible for the incredible valuations across a number of financial assets. The median price-to-sales ratio for the S&P 500 is at an all-time high. Negative real and, in some cases, nominal interest rates on bonds around the world are the fixed income equivalent of these records in equity valuations. Junk bonds are technically in a bubble, according to S&P. Real estate prices are back to bubble territory along with a variety of non-traditional asset classes like art and classic cars. Only during a mania characterized by the widespread adoption of price-insensitive strategies could this be possible.
Global, coordinated quantitative easing was the original price-insensitive strategy which inspired such confidence in all the rest. Thus removing this “central bank put” could be nothing less than the pin to prick the “everything bubble.” And rising inflation may now force the hands of central banks around the world in this regard.
Beyond the markets for risk assets, there are a few other ways rising inflation could be problematic for both the economy and the financial markets. Hyman Minsky did a fabulous job in explaining this dynamic. He identified three stages of an economic and credit expansion characterized by “hedge,” “speculative” and “ponzi” finance:
Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle out of income cash flows. Such units need to “roll over” their liabilities: (e.g. issue new debt to meet commitments on maturing debt). Governments with floating debts, corporations with floating issues of commercial paper, and banks are typically hedge units. For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations.
Moody’s reports that a record $2 trillion of corporate debt will need to be refinanced over the next five years, half of which they rate as “speculative” grade. Considering that corporate leverage is at or near record highs today and covenants on that debt have never been lighter, I believe it’s fair to say that this may be the most “speculative” credit cycle for corporate America we have ever seen.
Minsky continues, “The greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system.” In other words, because of the extreme nature of the current credit cycle, corporate America is now exposed to a uniquely painful credit bust. The bigger they come, the harder they fall.
Minsky also wrote about the trigger for such a crash:
If an economy with a sizable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become ponzi units and the net worth of previously ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.
This is how rising interest rates are so dangerous to a highly-leveraged, finance-based economy. It is also how a virtuous cycle of falling cost of capital sustaining higher prices in risk assets can quickly reverse and become a vicious cycle of rising cost of capital triggering a crash in asset prices.
In addition to corporations, consumers have also once again levered up during the current economic expansion. Nowhere is this more evident than in the auto sector. Both leverage (negative equity) and duration (84-month loans) here have soared to record highs. Now deliquencies are starting to become problematic. Credit card debt is also showing similar signs. Rising interest rates along with tightening lending standards could quickly convert these speculative consumer loans into ponzi units, as well.
But there’s one more problem that this dynamic poses beyond the private sector. Imagine the Federal Government as one of these speculative units during a time of rising interest rates. This is something William White has discussed recently.
Suppose a central bank is worried about rising inflation and decides to raise interest rates. But the government has a huge debt with a short maturity. By raising short term interest rates, the central bank raises the debt service burden for the government. At some point, people realize that the government can’t support the debt burden without going back to the central bank to print more money. This is a tipping point. And then you are in hyperinflation.
Hyperinflation is simply the point at which investors have the wool pulled from their eyes and see the truth about the ponzi finance at the government level. The catalyst for just this sort of revelation could be a shift toward a more aggressive fiscal authority. Until now, central banks have had the luxury of managing monetary policy as they see fit without any challenge from governments aggressively pursuing fiscal expansion.
However, this dynamic could be changing, especially here in the U.S. where the new administration has talked a great deal about fiscal stimulus. Donald Trump wants to lower taxes and pursue massive infrastructure projects that would certainly exacerbate the federal deficit and expand the national debt which is now already pushing $20 trillion, not to mention the impacts on inflation.
Under this scenario, in its efforts to control rising inflation the Fed would face, “constraints imposed by the demand for government bonds…. If the fiscal authority’s deficits cannot be financed solely by new bond sales, then the monetary authority is forced to create money and tolerate additional inflation,” in the words of Sargent and Wallace. In other words, the Fed may be forced to expand QE in order to fund the government even if inflation is running above their target.
Central banks themselves have actually proposed this idea of “helicopter money,” the coordination of fiscal and monetary stimulus, as a way to promote inflation. It would be horribly ironic if they were to now have it forced upon them by a populist fiscal agenda only after inflation has already begun to emerge on its own. It could also be horribly destructive.
In a terrific interview for RealVision, Diego Parilla discussed a similar scenario he calls “Lehman².” To flesh out his analogy, “Lehman 1.0” was a bubble in real estate finance enabled by the miracle of securitization. Too much money was lent at the wrong price and the wrong time to far too many people as a direct result of the popularity of products carrying acronyms like CDO’s and CLO’s.
“Lehman²” is a bubble in financial assets, including government debt, enabled by the miracle of monetary policy. Too much money has yet again been lent at the wrong price and the wrong time to far too many people, corporations and governments as a direct result of the popularity of policies carrying acronyms like ZIRP and QE.
When “Lehman 1.0” came crashing down we lost faith in the financial institutions responsible for the bubble. Central banks came to the rescue and restored faith in the the financial system. When “Lehman²” runs into similar trouble, perhaps as a result of rising inflation, and we lose faith in the central banks who will come to the rescue then?
If inflation begins to rise and the fiscal authorities around the world and here at home decide to pursue populist stimulus there’s a good chance central banks will find themselves in a major bind. Either they fight these rising inflationary forces by reversing their experimental policies or they enable these populist policies through quantitative easing at the risk of allowing or even creating hyperinflation… Like choosing between the devil and the deep blue sea.
The bottom line is the unprecedented monetary experiment we have seen around the world over the better part of the past decade was entirely predicated upon a disinflationary backdrop. If the environment is now becoming an inflationary one, whether due to the rise of populism or some other force, it has the power to unwind this process and all of its myriad and exponential effects in the credit markets, equities and in the real economy.
There’s no way of knowing just how any of this will play out. That said, it’s not difficult to understand how best to protect yourself. Financial assets and fiat currencies are most at risk. Real assets, financial hedges and volatility stand to benefit the most. Reducing exposure to the former and adding exposure to the latter seems like a wise course of action.