May 16, 2021
I recently published a longform research piece on inflation, and an article on some of the dynamics of market capitalization and asset bubbles.
This newsletter extends the topic of inflation by analyzing how it is manifesting this year in particular, examines why the current situation is more comparable to the 1940s than the 1970s, and finishes with some of the investment implications of it.
This past week, the consumer price index came in well above consensus expectations, benefiting from low-base effects and faster-than-expected price increases. The year-over-year figures are coming in rather hot at the moment:
The month-over-month figures filter out the year-ago base effects, but are also very heated:
So, let’s dive under the hood and see where some of this is coming from, and how it is likely to manifest going forward.
The Long-Term Debt Cycle Unfolds
One of my main topics over the past 18-24 months was exploring the long-term debt cycle, popularized years ago by Ray Dalio, which describes a framework for expecting trend-changes in fiscal policy, monetary policy, and inflation/deflation.
I’ll summarize the cycle again for folks who haven’t been following my work, but then also supply some new charts and tie it into some of the current trends we are seeing as of mid-2021 for those who are familiar with it.
Each normal five-to-ten year business cycle in modern US history has ended with higher debt as a percentage of GDP and lower interest rates than the previous cycle. As many of those short term debt cycles string together, debt as a percentage of GDP keeps making higher highs and interest rates keep making lower lows, until debts reach untenable levels and interest rates hit zero.
Rates hit zero and private debts hit extremely high levels in 2008 during the Global Financial Crisis, and the last time this happened was in the early 1930s in the early phases of the Great Depression. In both instances, there was a systemic banking crisis (marked in green), which led fiscal and monetary policymakers to expand the monetary base and take other measures to recapitalize the banking system.
What makes the end of a long-term debt cycle different than the end of a short-term debt cycle, is that the later stages of a long-term debt cycle both in US history and elsewhere, are generally characterized by a significant degree of fiscal dominance and currency devaluation.
This is because at the end of a long-term debt cycle, debt levels get so large relative to the size of the economy that it becomes impossible to deleverage them nominally without crashing the economy, so instead the denominators are increased: the monetary base, the broad money supply, and nominal GDP with a significant inflation component. The mechanism to do this involves large monetized fiscal deficits, accompanied by a central bank willing to hold rates well below the prevailing inflation rate for a while, which effectively inflates portions of the debt away.
The alternative to this process is a deflationary economic collapse, which is a route that the public and policymakers around the world rarely if ever choose. In other words, when push comes to shove and the system is pushed to its limits, policymakers invariably print.
The 80-Year Echo
History can’t tell us everything, but along with analysis of current conditions, it can point us in the right direction.
In terms of fiscal and monetary policy, the 2010s were very similar to the 1930s (disinflationary private debt bubble deleveraging), and the 2020s are shaping up more like the 1940s (inflationary fiscal-driven wartime finance). The previous chart above shows the similarities clearly, but this next section elaborates on the details.
1930s and 2010s
After the debt bubble popped in 1929, the 1930s had a long deflationary private debt bubble deleveraging, resulting in sluggish economic growth and rising political populism. Fiscal stimulus in that decade was large in absolute terms, but small compared to the amount of money destroyed from loan losses. Most of the focus was on recapitalizing the banking system. As such, the decade was disinflationary.
One very basic way to measure financial leverage in the financial system is to look at the monetary base as a percentage of total bank loans. The lower the ratio is, the more leveraged the system is, since there is less base money backing up the total amount of bank loans. This ratio hit a bottom at 12% right at the start of the Great Depression.
Approximately 80 years later, this process began playing out again, as the next long-term private debt bubble popped in 2008 and continued deleveraging into the early 2010s.
Interestingly, the ratio of the monetary base compared to total bank loans hit as low as 12.5% right before the crisis:
Chart Source: St. Louis Fed
There is more data available for the 2008 event since it’s in modern times, which allows us to examine the overleveraged bank situation from more angles.
For example, here is a chart of cash levels and Treasury security levels as a percentage of total assets for large US banks:
Chart Source: St. Louis Fed
In 2008, large banks had less than 3% cash and 10% Treasuries, or about 13% combined risk-free assets, as a percentage of their total assets. That’s historically very low. Most of their other assets were loans, including a lot of risky loans that went bad when the overvalued housing market declined. As banks crumbled under the private debt cycle implosion, fiscal and monetary policymakers recapitalized the banking system, keeping the majority of the banking system solvent but mostly letting overleveraged homeowners go bust.
Looking at it another way, this next chart shows total public and private debt as a ratio of broad money supply (M2) in the United States in blue on the left axis. I also added the Federal Funds Rate and the monetary base as a percentage of GDP on the right axis.
Chart Source: St. Louis Fed
Total debt kept increasing faster than money supply for decades (blue line going up), with the total-debt-to-money-supply ratio reaching over 700% at the peak, until the 2008 financial crisis occurred. After that implosion, the money supply began growing faster than debt (blue line going down), and 2020 kicked this deleveraging process into high-gear with another leg down. The ratio is already down to below 450% and heading lower.
Looking at it a third way, here is total private debt in dollar terms in the United States in blue on the left axis, private debt as a ratio of GDP in red on the right axis, and private debt as a ratio of broad money supply in green on the right axis.
Chart Source: St. Louis Fed
When private debt builds for decades up to nearly 300% of GDP and over 600% of broad money supply, there’s no way to deleverage that monster nominally. From 2008 through 2012, the total deleveraging of private debt in absolute terms was only about $3.6 trillion or 8% of the $45 trillion total, and then it began heading up again. Now it’s over $55 trillion.
Instead, the denominator is what mainly changed. Debt started growing at a slower pace, while broad money started growing faster, resulting in a declining ratio of private debt to money supply.
Similarly to the 1930s, the government response after the 2008 crisis and into the early part of the 2010s decade had a relatively large fiscal component, but it only partially offset the loan losses in the economy, rather than stimulate it. The decade was generally disinflationary as this debt bubble rolled over for years.
By the end of the 2010s decade, despite recovery in some areas including a big boom in asset prices, many aspects of the economy, including the industrial sector and overall labor participation rate, failed to fully recover from the 2008 debacle. My January newsletter called The Hindsight Depression covered this topic.
1940s and 2020s
After the 1930s decade of economic stagnation and rising political tensions around the world, World War II broke out in the 1940s.
This war represented an external catalyst that forced an utterly massive fiscal response from the US federal government and other governments, which dwarfed the fiscal stimulus of the 1930s. The US built a ton of domestic industrial production, sent soldiers overseas, and then when they came home, eight million of them were given college education or training on government expense, along with other benefits such as mortgage assistance. Excess industrial production was repurposed for domestic use.
Federal budget deficits were so large, and so many Treasuries were issued to pay for it, that the Federal Reserve had to create a lot of new base money to buy a big chunk of the Treasury bonds on the secondary market to keep yields low, also known as deficit monetization and yield curve control. Unlike the disinflationary 1930s, this amount of fiscal spending and deficit monetization in the 1940s was highly inflationary. Money supply and total demand increased faster than supply could keep up with.
Similarly, as the 2020s began up, private debt was still rather high in the system despite a decade of mild household deleveraging in the 2010s. Plus, with so much wealth concentration, tens of millions of people in the US couldn’t go more than a month without a paycheck. Due to a combination of multiple factors, the economy began to slow by late 2018 and throughout 2019.
When COVID-19 came in early 2020, and countries initiated economic shutdowns to slow the virus, it caused the highly-leveraged global economy to fracture. A global economy with this much debt is fragile, and can’t persist without constant cash flow.
In response to the pandemic and shutdowns, countries everywhere did fiscal stimulus on a scale not seen since World War II, but the US fiscal response in particular was one of the largest as a percentage of GDP, dwarfing the fiscal response to the 2008 crisis. As a result, broad money supply grew at the quickest year-over-year pace since the 1940s.
Chart Source: St. Louis Fed
At this point, the long-term debt cycle in the 2020s entered the second phase; the public debt bubble portion, similar to the 1940s. Rising wealth concentration and populism, along with an external catalyst, changed public and policymaker perception about fiscal deficits, and the floodgates were opened.
In many ways the math was inevitable by this point, with high debts and low interest rates. A number of institutional-scale asset managers were predicting years ago that the next recession would involve these sorts of unusually large fiscally-driven responses, based on how high debt was and how low interest rates were at this point in the long-term debt cycle, which would make monetary policy on its own relatively ineffective.
In other words, the pandemic was a catalyst and an accelerant, but the pieces (high debt, major wealth concentration, and rising populism) were already set. Such a fragile system had no defense against any external shocks, and an external shock we had.
Ray Dalio (co-founder of Bridgewater, the largest hedge fund in the world) described in his 2018 book Big Debt Crises the concept of “monetary policy 3” which involves blending accommodative monetary policy with fiscally-driven cash infusions into the economy, potentially up to and including helicopter money. He popularized the concept of the long-term debt cycle over the past decade, then began saying that the late 2010s were in many ways like the late 1930s, and by 2019 was making the case that the next recession would likely involve these “monetary policy 3” responses not seen since the 1940s.
Similarly, BlackRock published a paper along with Stanley Fisher (former Vice-Chair of the US Federal Reserve Board of Governors) in 2019 that also laid out the concept of having to “go direct” in the next economic downturn. The paper describes aggressive use of fiscal stimulus up to and including helicopter money, due to the ineffectiveness of monetary policy alone at this stage, and then coordinating with monetary policymakers to use financial repression to maintain low interest rates even if there is an inflationary response from the fiscal stimulus. (Hat tip to financial analyst Luke Gromen for bringing that paper to my attention a few months ago.)
Money Supply Growth and Price Increases
Significant increases in consumer prices are generally correlated (after a slight lag) with a sharp and sustained increase in the broad money supply per capita. These charts show the rolling 5-year percent change in broad money supply per capita in blue, and the 5-year rolling percent change in the consumer price index in orange.
The United States:
The United Kingdom:
If the broad money supply goes up quickly while commodities and other resources are abundant, it doesn’t necessarily cause inflation. However, when sharp growth in the money supply occurs alongside some degree of resource scarcity or supply chain limitations, price inflation is quite likely.
There are two causes for broad money supply to go up so quickly during certain periods of time. Either 1) banks do a lot of lending, which creates deposits and expands the money multiplier or 2) the government runs large fiscal deficits and has the central bank and commercial banking system buy a lot of the debt associated with that spending.
This chart shows the annual change as a percentage of GDP in broad money supply, bank loans, and fiscal deficits, to see which levers are driving changes in money supply over time:
The 1940s money supply growth was entirely due to massive fiscal deficits rather than bank lending. Inversely, the 1970s money supply growth was mostly due to high levels of bank lending, which was compounded by gradually rising fiscal deficits.
1940s vs 1970s Monetary Policy Response
The US Federal Reserve responded very differently to the fiscal-driven inflation of the 1940s vs the loan-driven inflation of the 1970s.
This set of charts shows the year-over-year consumer price index in blue, and short-term interest rates in red:
Chart Source: St. Louis Fed
In the 1970s, public and private debt as a percentage of GDP was low. Money supply was increasing more-so due to bank lending than due to fiscal deficits, which means the inflation was mostly in the Fed’s court to stop. Thanks to low debt levels throughout the economy, the Fed was able to raise interest rates all the way up to double-digit levels in order to slow bank lending and reduce inflation. However, they were not very aggressive in doing so until the end of the decade, which resulted in inflation running higher and longer than they anticipated during most of the decade.
On the other hand, public debt as a percentage of GDP was very high in the 1940s. When the government’s debt as a percentage of GDP is over 100%, interest rates of even mid-single-digits would result in monstrous levels of interest relative to GDP and tax receipts, resulting in a fiscal spending spiral. Consumer price inflation was coming in periodic spikes from fiscal spending and changing wage/price controls, but with high public debt levels, the Fed held rates low and even capped long-term Treasury bond rates with quantitative easing, and let inflation burn hot and inflate part of the debt away. Anyone holding physical cash, cash in a bank, T-bills, or T-bonds lost 30-50% of their purchasing power between 1941 and 1951.
2020s Policy Response
With public and private debt levels very high relative to GDP again, the 2020s are shaping up directionally similar (not necessarily in terms of magnitude) to the 1940s in terms of how the Fed is likely to respond to bursts of inflation.
We’re in the middle of an inflationary spike, while the Fed commits itself to holding rates at zero and monetizing US deficits, for lack of other alternatives.
Chart Source: St. Louis Fed
With their new policy of Average Inflation Targeting, the Fed is purposely targeting above 2% inflation levels for a period of time, while holding rates at zero for a while.
In addition, because the inflation is fiscally-driven rather than loan-driven, the Fed would see little reason to slam on the brakes immediately by raising rates if there is an inflationary spike. They’re sticking with the narrative that the inflation is transitory due to the fiscal response and supply chain shortages, and thus not requiring an immediate policy response.
Plus, with such high government debt levels, high interest rates are untenable. By the end of this year, the US government will have around $30 trillion in federal debt and rising. For every 1% average interest rate on that debt, they would owe over $300 billion in annual interest. So, policymakers have a strong incentive to keep rates low despite periodic inflationary events that may occur.
Transitory Inflation and Supply Shocks
You’ll often hear from policymakers or the media that inflation is transitory.
Many types of inflation occur rapidly and then suddenly cool off. Indeed, here’s a model of what price inflation might look like this year:
Chart Source: Steno Larsen, Enlund, Sarwe, at Nordea
However, as I described in my recent article on inflation, there’s a big difference between inflation that is only transitory in rate of change terms, and inflation that is truly transitory in absolute terms.
Inflation that is truly transitory in absolute terms would mean that a lot of prices go up due to a temporary supply shock of some sort, and then come back down when the supply shock is over.
On the other hand, inflation that is only transitory in rate of change terms would mean that a broad set of prices jump quickly and then stop going up quickly, but never actually come back down. Instead, they go through a permanent step-wise increase in price levels and reach a new equilibrium at a higher level.
This first chart here shows the year-over-year consumer price index change (aka price inflation) in the 1940s. Indeed, each inflationary spike was transitory. However, the second chart shows the absolute level of the consumer price index. After each inflationary spike, prices remained at that permanently higher plateau. In other words, inflation was transitory in rate of change terms, but not absolute terms.
Chart Source: St. Louis Fed
The current inflationary spike that we’re seeing in 2021 is being dismissed as being caused by supply shocks. But of course, all inflationary events involve supply shocks. That’s one of the inherent catalysts of why inflation happens, every time.
The 1940s had all sorts of war-related commodity and labor shortages. The 1970s had the oil embargo. The 2020s have semiconductor shortages, various commodity shortages, and shipping constraints.
External/accidental supply shocks on their own eventually result in prices returning to normal, when the anomalous supply shock is resolved. They involve specific goods/services.
On the other hand, rapid increases in the broad money supply that boost demand for goods and services without boosting the supply of goods and services, result in supply shocks and cause price inflation. As the market adjusts over time, this price inflation becomes transitory in rate of change terms, but with prices that ultimately settle at a higher level, due to more money permanently being in the system. This second type of inflation is likely what we’re experiencing at this time.
Some specific parabolic price levels will almost certainly come back down pretty far. Lumber’s extreme price behavior, for example, is due to an acute sawmill bottleneck.
However, many prices are unlikely to revert back to where they were pre-2021. Many companies including Procter and Gamble (PG) and Coca Cola (KO) are raising prices due to higher input costs. Many commodities such as copper are unlikely to fully retrace their 2020/2021 gains. Chipotle (CMG) is unlikely to reverse the shift towards $15 average wages once it implements them. These are higher equilibrium levels, with a lot more money in the system.
And as Warren Buffett said at Berkshire Hathaway’s (BRK.B) annual shareholder meeting in early May:
We are seeing very substantial inflation. We are raising prices. People are raising prices to us and it’s being accepted.
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I put new money in regularly. Currently I put in $1,000 per month.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
I chose M1 Finance because their platform is commission-free and allows for a combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people. (See my disclosure policy here regarding my affiliation with M1.)
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
I made very few changes since the April newsletter, since the portfolio has generally been well-positioned for this environment.
I’ve been emphasizing gold stocks a bit more recently as they showed signs of bottoming in recent months, while trimming some of the high-flying commodity producers like Nucor Steel (NUE), and buying more stocks in the healthcare sector. The energy sector looks good going forward as well, from a long-term perspective.
M1 Finance doesn’t have an option to hold bitcoin; I hold bitcoin in cold storage.
Primary Retirement Portfolio
My retirement portfolio consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 through 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017, in order to preserve capital, I dialed my equity allocation down to 60% (40% domestic, 20% foreign) and increased allocations to short-term bonds and cash to 40%. This was due to higher stock valuations and being later in the market cycle more generally.
After equities took a big hit in Q1 2020, I shifted some of the bonds back to equities, and it is now 71% equities (46% domestic, 25% foreign), and short-term bonds and cash is now down to 29%. For my TSP readers, this is equivalent to the 2040 Lifecycle Fund.
This is an example of a portfolio strategy that takes a rather hands-off approach but that still makes a tactical adjustment every few years if needed, based on market conditions, which reduces volatility and makes the retirement account feel less like a casino than many indices these days.
This employer-based retirement account is limited to a very small number of funds to invest in, so my flexibility is limited compared to my other accounts. I would, for example, have more exposure to precious metals, commodities, and digital assets in that account if it were an option.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus I have larger personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts: Navigating the 2020s
In this environment, I’m generally more bullish on stocks that traditionally fall in the “value” side of the spectrum. Energy producers and transporters, financial institutions, industrial companies, gold miners, and pharmaceutical companies all look reasonably-valued and are benefitting from a pro-inflationary environment. I like certain growth stocks as well, but selectively.
Indeed, there has been somewhat of a growth-to-value rotation, similar to the early 2000s. This chart is the ratio of the Russell 1000 Value index to the Russell 1000 Growth index. Whenever it’s going up, it means value is outperforming, and whenever it is going down, it means growth is outperforming.
The late 2010s look a lot like the late 1990s, in terms of equity sector performance and macro factors.
Both environments had a strengthening dollar, low commodity prices, and major tech/growth sector outperformance. When the reversal occurred in the early 2000s, it led to over half a decade of a weakening dollar, strengthening commodities, value equity outperformance, and international stock outperformance. My base case is to see a similar outcome in the 2020s.
However, I expect the 2020s to be a bumpy ride. Fluctuating periods of aggressive or nonexistent fiscal policy will likely play the leading role in inflationary spikes and inflationary cool-off periods. The Fed mostly has to keep rates low regardless of what inflation does, dismissing it as transitory and supply-chain related, but they could have periods of time where they briefly try to tighten and slow things down, before reverting course and turning dovish again when something breaks.
So, we need to stay on our toes, monitor economic indicators in rate of change terms, and focus on quality-businesses at good valuations.
Two years ago near the end of the past business cycle, a number of magazines started to run covers about inflation being a thing of the past. Here in mid-2021, inflation is becoming a popular theme on magazine covers.
Like most things, I expect this will get overplayed for periods of time. I’d suggest fading headlines and parabolic commodity price spikes. Lumber prices, for example, already hit extremely high levels and in recent days have been turning back down. That’s not a commodity I’m particularly bullish on from current elevated levels.
However, I think it’s worth keeping an eye on things that haven’t truly broken out yet, like the energy sector and the gold industry. Some of these areas have long runways of ahead of them in my view. Within the past month, parts of the world are still undergoing rolling lockdowns and virus case spikes, so some aspects of the global economy like the energy market aren’t even fully recovered yet.