The inflation era

I’m writing this in the midst of the worst inflation the US has seen in 40 years. When Covid hit in 2020, most people predicted markets would tank. And indeed that is what happened until the money started flowing. Massive financial assistance from governments around the world brought markets back up and roaring to ever new highs. Everything from Housing to Stocks shattered records every day as the pandemic raged. Americans spent their money to cope with the new norms of the pandemic.

The pre-covid era was already booming. Tech stocks saw sky high valuations, it felt like everyday a new unicorn was being minted. Some signs of trouble were already brewing in the form of delayed or lackluster IPOs of said unicorns. As private companies, startups talked up their growth and hid their costs. But as they ran out of private investment money and was forced to go public, the costs were there for all to see, WeWork being the prime example of growth at too much cost.

By the time Covid arrived, the party was almost over. Markets saw the signal and crashed hard as assets converted to cash. But world governments are used to propping up the markets in times like these and stepped in – and the afterparty started.

Almost everyone believed that inflation was a thing of the past. Exuberant money printing by government had not had a single impact on inflation, which is why governments continue to pump money into the financial markets. This time, there were two key differences. Money in the form of stimulus went to people directly, and supply chain problems caused by COVID reduced the supply of goods.

The double whammy of reduced supply and increase in demand caused prices of goods to skyrocket. The result was not obvious at first – oil was still flowing so gas prices remained low, electronics such as PS5 retail price was locked-in but secondary markets showed the true price to be 2-3x retail. Shrinkflation kept prices at grocery stores mostly the same. But in real-estate, it was clear that something was very wrong. Buyers were foregoing standard line-items such as inspections and financial contingencies and bidding 20-30% above asking in addition to prices rising 10-15% per quarter. The fear of being priced out was very real and buyers were flush with cash for the same limited supply of houses. This is how it starts.

Inflation can be caused by increase in money supply (money being worth less), increase in demand (more money in the hands of consumers), or decrease in supply. From 2020-2022, we saw all three. Once it has reached wage inflation (more money in the hands of consumers), inflation is hard to stop because more money is chasing fewer goods, causing prices to increase. In an environment where wages are generally much higher than required for basic living standards, wage inflation does not necessarily follow price inflation as the buffer between living wage and actual wage can absorb the difference. But with median wages stagnant since the 1970s in the US, the lack of buffer meant that wages have to go up as prices go up. This is the feedback loop that makes inflation hard to stop.

The Response

The Federal Reserve’s response of increasing interest rates was predictable but will prove to be ineffective in the short run (1-5 years). The Fed can’t raise interest rates too fast. Almost every business depends on loans and raising loan rates means business can purchase fewer raw materials and produces fewer goods. For consumers that means less supply of goods to buy and thus higher prices for limited goods. So the Fed will raise rates, but not too fast. Raising rates slows inflation by reducing the amount of credit creation. Every loan creates credit which increases the money supply. Raising rates reduces the flow of money into the economy. Less money injection, less inflation. Companies are in a particularly tough spot. Their borrowing rates go up, increasing cost, and their employee salaries go up, increasing cost as well. Price increase on their product is the only thing that can offset the increased costs. Profits will be down and many companies will not survive. The death of companies provides the relief from inflation as the increasing costs that they incur (the feedback loop of inflation) is broken. This is a long process because companies today have huge cash reserves and can cut costs in the meantime while slowly raising prices.

The Fed also has to contend with the very real prospect of stagflation. With current trends, our economy is falling into a recession, the S&P is in a bear market, and general economic outlook is negative with many advisors encouraging companies to hoard cash to survive the next few years (despite the fact that hoarding cash with high inflation is not ideal). The underlying feedback loop of inflation with the upward pressure caused by already low wages coupled with the Fed’s inability to raise rates to where they need to be (~21% in 1980) means we will see high inflation continue for another few years.

Between the 70s and 80s (the last period of stagflation in the US), continued supply shocks due to oil embargoes cause prices to spike while unemployment was high. Supply shocks from oil impact every industry, significantly increasing the cost of doing business. At the moment, there is no stagflation since labor markets are tight to an almost unhealthy level (new employee ghosting is now a thing). However, we are seeing oil supply shocks from the Ukraine war causing price increases throughout the economy. As the Fed increases rates and businesses hunker down, labor market will unwind. If supply shock issues (Ukraine war) is not resolved, stagflation is almost certain to follow.

Unwinding of globalization

A shift in the direction of globalization has taken place. From 1979 until a few years ago, China and the United States had been increasingly more economically inter-dependent. US dependence on cheap Chinese electronics allowed it to overlook many morally questionable behavior by the CCP over the years. Trade with China had a significant downward pressure on prices as cheap goods flowed into the US starting in the early 1980s. This trend continued until COVID-induced supply chain issues limited the inflow of Chinese products. With Xi cementing political power, China is increasingly looking inward. China’s GDP goals, set by the central party cannot be met with global trade in the midst of COVID. Instead, it’s being met with infrastructure spending. US policy has exacerbated the situation with increased tariffs on China. China cannot afford to separate itself from the global economic system at the moment, but China and the US are willing to inflict short term pain on each other as trade disparities and power projection in the East China Sea continue to cause friction and occasional alarm.

The invasion of Ukraine by Russia caused immediate supply shocks for wheat, oil, and natural gas. Gas prices in the US have increased 50% as a result and there’s no indication that oil supply will return to previous volume in the near term. Germany relies on Russian for 55% of its natural gas. Germany is attempting to wean itself from Russian natural gas at great costs. Alternatives are unclear and success is unlikely. Prices will remain high as global supply is limited.

With the global economy dependent on two autocratic states China and Russia, these two countries are increasingly willing to project their reality onto the rest of the world, with jarring results. Both China and Russia’s reality distortion media has become a liability for the global system as their nostalgia fueled nationalism bumps up against external reality. The global liberalism belief of “if they trade with us, they become like us” has come to an end. Protectionism and “us vs them” will return to counter risk of economic destabilization by autocratic leaders. The US’s exceptionalism is also coming to an end as the world has suffered through several rounds of economic destabilization caused by the US finance system.

Role of Technology

The deflationary nature of technology is a continuous downward pressure on inflation. Technology increases productivity, driving down costs. This trend is the background of the last century and it the recursively reproducing miracle that has kept inflation down and in places like Japan, creates a deflationary currency. There is no reason to believe the technology party will be over anytime soon as new developments in AI drive down costs for everything from supply-chain/transportation to manufacturing to knowledge work. It appears that AI is poised to transform our entire economy, improving productivity so much, it remains to be seen if humans will be needed in economic production.

The Result

If history is any indication, looking at the period between the 70s and 80s, we should expect that Fed interest rates will oscillate as they walk the line between snuffing out inflation without killing the economy. No one has the political will to bring interest rates to 20% to kill inflation unless that becomes the only path forward. Supply shocks due to war in Ukraine and deliberate unwinding of globalized trade between US/China/Russia will cause prices to continue increasing despite increases to interest rates.

Due to pressures on businesses from raising rates and inflation, stocks will remain stagnant on average. Profit, not growth will be the mantra for the next few years. Costs will be scrutinized and many more businesses will fail than in the last 10 years. VCs and startups will forge ahead under these new conditions and new businesses created during the next few years will become industry leaders of the new normal.

Real-estate will dip short term (1 yr) with average growth matching that of inflation (quite high) in the medium term. Price correction is needed, but wage inflation will create constant upward pressure on price. Commercial real estate will be very interesting to see as companies cut costs in the next few years.

Crypto goes through 3-4 year cycled based on the Bitcoin halvening where supply rate is cut by half. So far, Bitcoin prices seem to be minimally correlated to broader economic trends (10 year scale). Short term economic shocks are pass onto Bitcoin price, but long term price trends follow the Bitcoin cycle rather than the economic cycle. This makes Bitcoin a good bet for the next few years for long-term investors as every halvening is typically associated with a 3-10x jump in price. As USD supply continues to increase, Bitcoin is well positioned to increasing in price at an average rate higher than inflation due to its limited supply.

Athena Capital