Poking The Inflation Monster - The Parts Of The Beast
- We start the discussion on inflation by bringing you the analysis of the tried-and-tested forces of inflation.
- We go over how the three major forces that control inflation are intersecting today.
- This is Part 1 of a series we are writing on risks of inflation.
- We set up Part 2 of our series where we will explore the bigger risks for even higher inflation down the line.
- Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »
Co-produced with Trapping Value
We are currently in a very low inflation environment that is likely to remain with us for the next 24 months. However, following COVID-19, a perfect storm is brewing that would very likely result in higher inflation as soon as the year 2022. This inflation could be very significant and erode your savings. This is Part 1 of a series of articles whereby we explain why inflation is set to go higher (or possibly much higher), and how to hedge against it.
With COVID-19 being firmly the story du jour, you could be forgiven for focusing on little else. We, however, have also been noticing an economic indicator rearing its expensive head, the possibility of inflation. We will tell you why we have started thinking about this in earnest. We will also give investors a brief primer on the forces that are intersecting to create inflation and those that are counteracting it. In a series of articles, we will break down what we think the outcome will be and also stress the time frame over which we expect a resolution.
Where Exactly Is Inflation?
The pandemic has created an extremely sharp pullback in demand for most items. We did see the initial stockpiling effects as stores ran out of essentials, but that was simply a pulling forward of demand. On the whole, demand has cratered, and consumer spending, even assisted by huge government spending, has plunged. Hence, it is no surprise that we are seeing every single aggregate inflation measure collapse. The Consumer Price Index, or CPI, (excluding food and energy) showed its biggest month on month drop.
Based on that, investors must be wondering why we would even touch a topic like inflation when the opposite appears to be the path. That is a key question we need to tackle. For that, though, we need to explain how the economic forces are interacting to change prices at the consumer level.
Inflation Force 1: Demand For Goods
Inflation is created at the apex where three forces intersect. The first is the demand for goods. As we saw clearly during the pandemic, on shorter timescales, prices are firmly set by demand. As demand for oil collapsed with airlines being grounded, some benchmark oil prices briefly went negative.
Source: New York Times
On the other hand, as demand for hand sanitizers and face masks went parabolic, prices went up 1,000% in some cases. Below, we show Governor Gavin Newsom documenting the rather absurd pricing on Purell.
Both events happened rather close to each other, showing that prices don't move homogeneously across all items. Both also show that demand generally rules the day on shorter time frames as supply response times are slower. Today, this is still the primary driver, as overall demand has tanked for a large variety of goods.
Inflation Force 2: Supply Of Goods
In both cases cited above, things reversed rather rapidly as supply responded each time. Negative prices incentivized widespread shutdowns of oil production.
The U.S. oil industry reacted to cratering oil prices by cutting production by 900,000 barrels a day in just a month in what appears to be the biggest one-month decline since the Great Recession. U.S. government data shows that U.S. production fell to 12.2 million barrels a day last week
Alongside that, OPEC cut production by a rather hefty 10 million barrels a day. Hence, just as everyone was making absurd claims about where oil prices would go, the reverse happened.
Oil prices literally bottomed as the whole world bought into the silly notion that producers with large operating costs will produce oil and pay people $100 to take that barrel away.
Just as oil's woes were cured by the supply side response, so were the problems in hand sanitizer prices. Massive markups redirected supply chains to manufacture large amounts of hand sanitizers. The supply of existing and new (with Aloe Vera no less) hand sanitizers exploded. In cases where firms had excess capacity (due to loss of demand of other items), that excess was also directed towards manufacturing items to keep our hands germ free. The results showed.
Prices have normalized to a large degree as demand and supply moved rapidly into balance.
Inflation Force 3: Supply Of Money
According to the Austrian school of thought, inflation is always a monetary phenomenon. In other words, you cannot really have inflation unless the supply of money increases. A simple way to think about it is, if everyone suddenly had twice the money they previously had and the supply of all items remained the same, prices would overall double in order to match supply of money with the supply of goods. So, increasing money supply should theoretically increase prices. Globally, the supply of money has exploded as central banks have created digital dollars at an ever faster pace.
In the U.S., the Federal Reserve has started buying high-yield bonds and treasuries at an unprecedented pace.
Source: Banking Strategist
The Federal Reserve has slowed down this pace recently, but it is still expanding its balance sheet at an annualized rate of $2 trillion. It is this factor that will be key to determining where ultimately prices go.
Why We Have Not Had Serious Inflation...Yet
It is not uncommon for investors to buy into conspiracy or doomsday scenarios. A cursory glance of the web shows how much attention the Federal Reserve balance sheet gets. However, there are quite a few reasons that the balance sheet expansion has been neutered. First, we have a serious decrease in consumer ability to purchase goods as unemployment has gone vertical. While the lagging official rate is at 14.7%, we may ultimately hit a brutal 25% mark in the United States.
This represents a serious headwind to inflation at least in the short term. Coupled with this, the US consumer decided to save at a rather extraordinary pace to deal with the pandemic.
This again represents a serious loss of demand for goods and the expansion of the monetary base loses its effectiveness as consumers are reluctant to chase goods. Bank credit has also been contracting and loans are harder to come by.
If you're looking to buy a home it might be a little harder to get approved. New JP Morgan Chase customers will have to come with better credit and more cash.
A 700 credit score is the starting point, plus a 20 percent down payment of the home's value is what the bank is looking for in an applicant.
Industry experts say as the economy's future remains unknown lenders are shying away from high risk borrowers.
"Meaning they're going to have to have some money to put into the transaction. Their credit scores are going to have to be at certain levels, they're job will hopefully be restored or they never were laid off," said Diversified Members Credit Union Lending VP J.R. Smith.
Lenders say the shift can be attributed to widespread unemployment and a slump in the housing market.
So, while the M2 Money supply has moved up, the cash is not creating inflationary effects as downstream participatory factors are conspicuously missing.
Ignoring the shorter-term demand and supply factors which generally resolve soon, we have seen the setup for inflation via a very high growth of money supply. On the flip side, consumers don't want to borrow, and financial institutions are reluctant to lend. Until that fact changes, the potential inflationary cycle will remain in hibernation. However, there is definitely a storm brewing under the surface, and the potential for serious inflation is very high. We will look at what could be that spark and how it will likely play out in the next part of this series.
For income investors and retirees, inflation is a major risk as it can erode the value of your hard-earned savings. In the final part of this series, we will highlight the best asset classes to own in order to mitigate against this risk. Inflation is coming back. Higher inflation is not a matter of "if", but rather a matter of "when".
Thanks for reading! If you liked this article and want to be notified when Part 2 is published, please scroll up and click "Follow" next to my name to receive our future updates.
High Dividend Opportunities, #1 On Seeking Alpha
HDO is the largest and most exciting community of income investors and retirees with over +4300 members. Our Immediate Income Method generates strong returns, regardless of market volatility, making retirement investing less stressful, simple and straightforward.
Invest with the Best! Join us to get instant-access to our model portfolio targeting 9-10% yield, our preferred stock and Bond portfolio, and income tracking tools. Don't miss out on the Power of Dividends! Start your free two-week trial today!
This article was written by
I am a former Investment and Commercial Banker with over 35 years of experience in the field. I have been advising both individuals and institutional clients on high-yield investment strategies since 1991. I am the lead analyst at High Dividend Opportunities, the #1 service on Seeking Alpha for 6 years running.
Our unique Income Method fuels our portfolio and generates yields of +9% alongside steady capital gains. We have generated 16% average annual returns for our 7,500+ members, so they see their portfolios grow even while living off of their income! Join us for a 2-week free trial and get access to our model portfolio targeting 9-10% overall yield. Our motto is: No one needs to invest alone!
In addition to being a former Certified Public Accountant ("CPA") from the State of Arizona (License # 8693-E), I hold a BS Degree from Indiana University, Bloomington, and a Masters degree from Thunderbird School of Global Management (Arizona). I currently serve as a CEO of Aiko Capital Ltd, an investment research company incorporated in the UK. My Research and Articles have been featured on Forbes, Yahoo Finance, TheStreet, Investing.com, ETFdailynews, NASDAQ.Com, FXEmpire, and of course, on Seeking Alpha. Follow me on this page to get alerts whenever I publish new articles.
The service is supported by a large team of seasoned income authors who specialize in all sub-sectors of the high-yield space to bring you the best available opportunities. By having 6 experts on your side, each of whom invest in our own recommendations, you can count on the best advice. (We wouldn't follow it ourselves if we didn't truly believe it!)
In addition to myself, our experts include:
3) Philip Mause
We cover all aspects and sectors in the high yield space including dividend stocks, CEFs, baby bonds, preferreds, REITs, and more! To learn more about “High Dividend Opportunities” and see if you qualify for a free trial, please check out our landing page:
High Dividend Opportunities ('HDO') is a service by Aiko Capital Ltd, a limited company - All rights are reserved.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.