August 29, 2021
I wrote an overview of how Treasury Inflation-Protected Securities or “TIPS” work in this unusual economic environment, and published a long-form research piece on Bitcoin’s energy consumption.
This newsletter issue focuses on the ongoing supply chain issues, inflation, and commodities. In many ways, the 2020s decade continues to mirror the 1940s in terms of fiscal policy, monetary policy, and de-globalization.
Supply Chains and Inflation
Bloomberg ran a piece several days ago discussing how global supply chain problems continue to grow, leading to price inflation and delivery delays across the board. Here’s an excerpt:
A supply chain crunch that was meant to be temporary now looks like it will last well into next year as the surging delta variant upends factory production in Asia and disrupts shipping, posing more shocks to the world economy.
Manufacturers reeling from shortages of key components and higher raw material and energy costs are being forced into bidding wars to get space on vessels, pushing freight rates to records and prompting some exporters to raise prices or simply cancel shipments altogether.
“We can’t get enough components, we can’t get containers, costs have been driven up tremendously,” said Christopher Tse, chief executive officer of Hong Kong-based Musical Electronics Ltd., which makes consumer products from Bluetooth speakers to Rubik’s Cubes.
The Baltic Dry Index, which measures the price of moving raw materials globally, has more than tripled recently:
Chart Source: Trading Economics
Earlier this year we had the infamous spike in lumber prices, followed by a huge spike in used car prices which was largely a result of semiconductor shortages, and this semiconductor problem remains ongoing to some extent. Toyota, the largest vehicle manufacturer in the world, is cutting production by 40% in September due to semiconductor shortages. Many manufactured goods are very complex, and draw upon supply chains around the world. Just a handful of missing parts out of a thousand can delay a finished product.
But it’s not just manufactured goods. Food and gasoline prices are elevated, house prices have surged, and rents are starting to shift upwards to catch up with housing prices:
Chart Source: St. Louis Fed
Money Supply or Parts Shortages?
Many people are debating to what extent the recent widespread price inflation is the result of supply-chain problems associated with COVID-19 lockdowns, changes in consumer behavior, and broad money supply growth.
That third variable is controversial because it’s political; neither fiscal authorities nor monetary authorities in any country want to take any part of the blame for inflation, so they point heavily towards supply chain issues as being the sole cause of the inflation. Back in the 1970s, they kept saying it was transitory as well, due to one-time factors.
However, it’s important to keep in mind that every major inflationary period is associated with shortages. That’s what inflation is. Price inflation occurs when the money supply goes up a lot more quickly than the supply of products and services. And specifically which products and services get price-constrained depends on where our weaknesses are, meaning where we lack abundance.
The inflationary 1940s decade had major commodity and labor shortages, which also pushed up the prices of most other things. It happened at a time when countries were monetizing massive government deficits to fight a global war, which radically increased the supply of money in the system. Interest rates were held near zero by central banks while inflation soared. Most countries had suspended their gold standards or devalued their currencies relative to gold starting with World War I, through the Great Depression, and into World War II.
The inflationary 1970s decade had major oil shortages, which pushed up the prices of everything else. US domestic oil production peaked and we became increasingly reliant on oil imports, at a time when for geopolitical reasons related to the Yom Kippur War, some of those exporters didn’t want to sell to the US. Importantly, it also happened shortly after the US defaulted on the gold standard and increased its money supply rapidly (as did other countries, who had until that time pegged their currencies to the dollar, which was supposed to be “as good as gold” but was now unbacked and devaluing). Apart from the war, why would oil exporters want to be paid with unbacked pieces of foreign paper, which the dollar had just recently become? It took some convincing, to say the least. Like the Godfather, we offered them some protection, and the petrodollar system was created.
The so-far inflationary 2020s decade has major supply chain shortages, which are pushing up prices across the board as well. And, like the 1940s and 1970s, it is happening at a time when governments are running large monetized deficits, and thus increasing their money supply faster than normal. Interest rates are once again below the prevailing inflation rate, meaning savers are not being compensated for their devaluing money.
This chart shows 5-year cumulative broad money supply growth per capita, and consumer price inflation, for the United States over the past century and a half:
How much inflation we have going forward will depend on the growth of the money supply and how quickly we are able to use our resources to address our supply chain problems.
If the current inflation was purely based on supply chain issues, which are causing issues globally, then we should see similar rates of inflation across the developed world. But we don’t see that. The United States has noticeably higher inflation than our various developed peers. Here’s the US vs the UK vs Japan for example:
Unlike the US, the UK hasn’t rapidly expanded its money supply lately:
And Japan had the slowest money supply growth rate in the world in recent years:
Large fiscal stimulus in the United States, monetized by the Federal Reserve, helped boost demand for goods and services in the US but can’t fix supply shortages, and so our nominal GDP bounced back faster than our peers, along with higher price inflation. People can debate about the various trade-offs for how much fiscal support is useful, what format that fiscal support is best used in, etc. But it does come with costs, in addition to its benefits.
This is a theme I’ve been focusing on for a while. Many countries, especially the US, are backed into a corner due to high levels of debt and basically have to do fiscal stimulus while holding interest rates low, and it is real assets (stocks, real estate, commodities, etc) that benefit from that outcome.
We should also take a step back and look at global supply chains from a high level view.
For the past few centuries, as communication and shipping systems improved, the world became more interconnected. Global trade as a percentage of global GDP grew over time.
This was mostly a good thing because it allowed for more efficient use of labor, specialization, resources, and information. An oil-rich nation could trade with an oil-poor nation that focuses on manufacturing, for example. A country with abundant food resources could trade with a country that specializes in financial services, software, or medical products.
However, the world has gone through occasional periods of de-globalization as well. This chart shows global trade as a percentage of GDP from 1870 through 2017:
Chart Source: PIIE
This chart from the World Bank goes from 1970 through 2019:
Chart Source: World Bank
The world became more interconnected until World War I, which started a de-globalization period. World War I was followed by tariff/trade wars, which were followed by World War II. The end of World War II opened much of the world back up to trade, and much of the world resumed another period of trade growth and interconnectedness.
Globalization briefly stalled after 1980. Fed Chairman Volker had sharply raised interest rates to save the dollar from 1970s inflation, and parts of Latin America suffered financial crises in part because their dollar-denominated debts suddenly surged in value against their local currencies.
China’s economy began opening up to the world in the 1980s under Deng Xiaoping, and the Soviet Union dissolved in 1991, opening eastern Europe and central Asia to the rest of the world as well. From there, along with US trade policies that made use of these new markets, we had a renewed period of globalization, this time with the benefit of information technology. This trade growth peaked in 2008 at the start of the global financial crisis, and since then has gone sideways.
When we look at the chart of US money supply vs inflation again, we can see two big periods of weaker correlation (unlike, say, the UK where it remained far more correlated):
The 1870s-1900s decoupling in the US was characterized by major abundance of land and resources, unlike the UK and elsewhere. American settlers moved across the unsettled continent (often killing and displacing indigenous populations), meaning that land and resources were cheap and abundant. Immigrants flocked to the broadening country as well, providing abundant cheap labor. China, which before then had been one of the world’s biggest economies, was brought to its knees by the Opium War due in large part to aggression from European powers, and many Chinese immigrants came to the US to work, accepting low wages. The American economy went from underbanked to fully-banked. Major oil discoveries were made, the internal combustion engine was invented, and electricity was invented.
The 1990s-2020 decoupling in the US were characterized by similar advancements in information technology and global openness that dramatically improved corporations’ ability to arbitrage labor. They could hire workers in Mexico or China for pennies on the dollar compared to what they would need to pay Americans to do similar work. The United States, with the global reserve currency, hollowed out its industrial base at a far faster pace than our peers, as we shut down domestic factories and opened them up abroad.
Starting in the 1970s and continuing through today, US labor productivity and US wages decoupled:
Chart Source: EPI
The US began running structural trade deficits with the rest of the world (unlike Japan and Germany and many other peers):
Chart Source: Trading Economics
Specifically, the US is a net exporter of services, but a huge importer of goods. When you combine services and goods together we have a net trade deficit, but it’s in the goods area that we are really weak:
Chart Source: St. Louis Fed
This is important, because starting from the initial March 2020 lockdowns and fiscal stimulus, the US and many other places had an explosive difference in goods consumption vs services consumption:
Source: Kelly Evans, Haver, JEF Economics
In other words, people stayed home and bought various goods, rather than travel or eat out or go to concerts and other venues as much. Since the US has de-industrialized and exported our physical goods supply chains to the rest of the world more-so than most other advanced nations, that makes us particularly vulnerable to this type of supply chain disruption in goods. We don’t make many goods, so for us to have goods, China needs to send them to us.
Global trade reached as high as 61% of global GDP in 2008. Maybe we’re at the peak, because globalization has limits. The more interconnected the world becomes, the more efficient it can be, but it also becomes less resilient. China locking down a major port due to COVID-19 policies suddenly impacts dozens of other countries, for example. When highly-engineered devices with thousands of parts get delayed because six parts are unavailable from a foreign supplier, that’s a problem.
Taiwan and South Korea account for a huge portion of the world’s high-end semiconductor production. Nvidia (NVDA), for example, is a fabless semiconductor company that is reliant on Taiwan Semiconductor Manufacturing (TSM) to make their chips.
And just three companies, Samsung, Micron, and Hynix, are responsible for about 95% of computer memory fabrication:
Chart Source: Statista
Your phone and/or computer, essential for your work and/or essential for your interaction with many things you need, likely has parts from Taiwan and Japan and Germany and Switzerland and the US and the UK, with Chinese or Taiwan assembly. It also likely has hydrocarbons from the Middle East or the US or Canada for plastic components.
With the United States and China entering a period of global competition, even a Cold War type of environment, the United States in particular as well as other countries have to think about their global supply chain exposure more than they used to. There is also a big political push to address the trade deficit and wealth concentration, which are both bigger issues in the United States than other advanced nations.
In other words, after multiple decades of extreme globalization, we seem to be on a longer run towards re-shoring portions of our supply chains, which takes a very long time. This can improve resiliency, but can also increase prices, because the reshuffling of those interconnected supply chains isn’t cheap.
In this sense, the 2010s and 2020s are shaping up to be directionally similar to the 1930s and 1940s in terms of de-globalization, which mirrors the fact that the fiscal and monetary policies are similar to that period as well.
Tech vs Oil (Disinflation vs Inflation)
The commodities market tends to move in huge bull/bear cycles.
Periods of oversupply result in low prices, which leads to less investment/development, which leads to periods of undersupply, which eventually results in high prices, which leads to more investment/development, which leads to periods of oversupply.
Chart Source: 2021 IGWT Report
Oil is the biggest commodity by far in terms of annual commodity revenue. Here’s the 5-year cumulative price change for oil vs price inflation:
Decades with low inflation tend to be characterized by periods of commodity abundance, and decades of high inflation tend to be characterized by periods of commodity scarcity. For nearly a decade, commodities have been pretty cheap, and this has dis-incentivized companies from spending money to bring new supplies online.
As we look out deeper into the decade, it’s not hard to imagine higher energy prices across the board.
Here’s a fun chart I like to track. It’s the Nasdaq 100, but priced in barrels of oil instead of dollars:
Data Source: Macrotrends
The Nasdaq 100 is very tech/internet/growth oriented. Whenever the line is going up, it basically means tech stocks are outperforming oil, and vice versa. Over the long run, we should indeed see tech companies outperform oil, because they are able to compound value. But it goes in massive cycles, with some long periods of oil outperformance as well.
Tech stocks outperform in one of two main ways. Firstly, they create structural real underlying value. Secondly, investors can pay cyclically higher prices during periods of time, per unit of value (in other words, the average price/sales or price/earnings ratios change over time, in bubbles or troughs). Investors tend to overpay for tech stocks during times of commodity oversupply/cheapness.
Here’s a log version of the chart:
Data Source: Macrotrends
The 1970s were very inflationary as previously discussed, as the dollar became unbacked and the US ran into oil shortages. Oil outperformed the Nasdaq.
After the petrodollar system was established and Fed Chairman Volker raised interest rates extraordinarily high in 1979 to finally quell inflation, the world entered two decades of disinflation during the 1980s and 1990s. The Nasdaq outperformed oil.
Then, in the 2000s, the sharp economic rise of China and other emerging markets resulted in more commodity demand, following the two-decade commodity bear market. Oil outperformed the Nasdaq.
After the global financial crisis in 2008, however, the world entered another disinflationary trend in the 2010s, as global growth slowed and oil/commodities were in a period of oversupply. The Nasdaq outperformed oil.
At the peak of the economic lockdowns in spring 2020, WTI crude futures briefly went negative, and have since rebounded.
We’ll see how this plays out. My base case is that as we head deeper into the 2020s, with various supply chain problems, de-globalization, and less new oil supply coming online, that another longer-run commodity bull market is setting itself up. It won’t be a straight line, of course, and we’ll need to monitor developments over time. And this comes at a time when tech/growth stocks are very highly-valued by historical standards.
Plus, the rate of margin growth may have peaked for the cycle:
Chart Source: Yardeni
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Changes since the previous issue:
Since the latest newsletter, I haven’t made many changes, other than swapping out Exxon Mobil (XOM) for EOG Resources (EOG).
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Final Thoughts: Ongoing Devaluation
This continues to be an environment where inflation is running higher than the prevailing interest rate that you can get on bank accounts or Treasuries.
If you bought a 5-year Treasury note a year ago, for example, the official level of inflation over the past year alone has already exceeded all five years of interest payments the Treasury holder will receive until maturity in 2025.
As this chart shows, Treasury rates are still lower than forward inflation expectations (as measured by the Treasury TIPS market), and lower than current consumer price inflation:
This means that people’s cash money is gradually losing purchasing power. Inflation-adjusted interest rates haven’t been this negative since the 1970s.
A consequence of this is that it pushes people further out on the risk spectrum, including people who don’t have a very long time horizon and can’t afford to have much volatility in their portfolio. People are historically quite overweight equity exposure at this time, for example.
Basically, devaluing money encourages the formation of asset bubbles, but policymakers find themselves with little other choice due to the high debt levels that, in part due to prior fiscal and monetary policy, have built up in the system.
I continue to prefer good stocks and hard assets in this environment with a long-term view, but investors should be prepared for volatility along the way.