I’m feeling musical today and given it’s still January I thought I’d chill out and think about whether rising oil and commodity prices (and some small firming in bond yields) are a sign of reflation, or breakthrough inflation.

Price rises in oil, energy and building materials including steel, doctor copper and other commodities would suggest a cycle of inflation, and in today’s context the tendency would be to assume that the global economy is reflating. Seems sensible on the surface.

But digging deeper, these price rises are an unlikely signal for global reflation given much of the world is still in physical lockdown, and the economic data prints are not so flash.

Why might this be important to you?

Well, if it is reflation, then U.S. yields are sure to increase, signalling a slow but sure move out of growth stocks. With that comes the knock on effect for value stocks, capital management for businesses (debt becomes more expensive) and investment portfolio positioning for households as equities start to fall to earth and seniors, pensioners and savers start to see interest earnings at some point. For government it might mean less welfare than expected.

But if it is a false dawn and if instead it’s pent-up inflation in response to a low USD (i.e., imported inflation) and the escape from city building trade demand for commodities, and if COVID still has many more months to run before we reach vaccine herd immunity (if we do), then we go sideways, equities remain high and more welfare than expected is required.

Vaccine success and no future lockdowns is the decider between the two, and then trade relations.

And the success of Joe Biden’s first 100 days will have a lot to do with how he balances vaccine supply and welfare programs; at the same time as the treasury and U.S. Federal Reserve share the load between fiscal (welfare followed by stimulus) and monetary policy.

Hey Joe, given lockdowns, new strains, unemployment, retail numbers, dislocated supply chains and other factors, I think what we are seeing is sporadic inflation due to COVID and China supply chain responses. Until we are on the other side of the pandemic and have synchronous openings, there’s probably not a lot to see along the reflationary watchtower.

So, with that theory in mind I thought I’d ponder a few questions.

Hey Joe, what’s the Fed gonna do with that QE in its hands?

Central banks are uber-dovish (accommodative).

Last week, Governor of the Federal Reserve, Lael Brainard explained at the Inaugural Mike McCracken lecture on Full Employment, that price inflation is much less sensitive to labour market tightness than historically, and commenting on the Fed’s new strategy of seeking to run the economy hot, stated:

“The new framework adopts a flexible average inflation-targeting strategy (FAIT) that seeks to achieve inflation that averages 2 percent over time in order to ensure longer-term inflation expectations are well anchored at 2 percent. Under a FAIT strategy, appropriate monetary policy aims to achieve inflation moderately above 2 percent for some time to make up for shortfalls during a period when it has been running persistently below 2 percent.”

And that really means continued bond buying at points on the yield curve that the Fed happens to be targeting at any point in time. In turn, it means lower interest rates for longer in an attempt to overshoot inflation.

As I’ve often discussed, keeping rates at zero is damaging for consumption. Plus, it doesn’t do much because many parts of the population just don’t have the confidence to borrow and the willingness to spend.

Why? Job uncertainty, no confidence, and zero interest rates takes away earnings power.

Away from businesses like banks and insurers that earn net interest margins and get to bank free cash flow until they need to fund claims; and from households that now apply welfare cheques to pay down debt instead of leaving money in the bank because it earns nothing.

It steals from pensioners and seniors, forcing them to stop discretionary spending in addition to physical distancing (both seen in the bad U.S. retail figures released yesterday) because they have lost their riskless interest cash flow.

This is net disinflationary and potentially deflationary. And adding to disinflationary pressure is the decreasing price trend for consumer goods, which continues to crater as a result of the amazon effect which I have been writing about for some time.

Thanks to Bernanke, Powell, Draghi and Lagarde and of course the Trump Administration, there are only two things going up:

Asset prices due to: (a) QE Infinity, Guarantee Infinity and the resultant wall of money and welfare cheques being deployed further out the along the investment risk curve into equities; and (b) increasing commodity prices resulting from the escape from city building (and renovating) trade demand; and
Commodities that have witnessed a rise in prices as a result of choked supply chains during COVID, including oil given rolling lockdowns/openings and heating oil demand for the northern winter, plus the recent voluntary Saudi oil cut.

No Joe. This may not be sustainable, and inflation is not your watchtower for reflation. Also, if Centrals keep rates too low for too long, you get a disinflationary spiral.

It appears to be pent-up spending that could not occur previously due to broken supply chains and the physical distancing response to COVID.

Sporadic relief is inflationary.

But reflation is yet to occur and synchronous global inflation could be many more months, if not a year or so away.

Getting through the vaccine and COVID should allow Joe Biden to pull on the fiscal spigots and introduce real stimulus, which may or may not start with transitioning to clean energy platforms.

Hey Joe, is welfare reflationary?

Nope.

When governments today talk about stimulus, they’re not really talking about stimulus, rather they’re talking about welfare which is reverse taxation.

Pandemic pay cheques, job keeper, accelerated medical benefits, social security, and other payments that serve to keep the lights on and people fed while the economy is in lockdown, are not stimulatory – other than in the case of asset prices.

Welfare protects families but does not advance the economy, and excess funds while sheltering at home either go into incremental homewares, the secondary market to push up asset prices, or are applied to reducing credit card and loan balances.

And when that money is monetised, that is, when government’s bypass bond, bund and gilt markets and ask their centrals to print/create money so treasuries can drop it directly down household chimneys, it appears on the liability section of the balance sheet, but there is no corresponding asset.

It’s simply reverse taxation from funds although it’s not from funds that the government collected in earlier time periods - it’s new money (or debt).

And there are signs and portents in the real economic data that suggest centrals will continue to beat the same drum for quite some time.

Hey Joe, how about a few numbers?

Looking at the data, there was a near 5% contraction in the global economy last year.

Brazil has run out of oxygen and its hospital system has all but collapsed, the pandemic is trying to return to China, there are 30 million cases in Europe, and the UK has shut its borders with even more contagious as yet unidentified variants disclosed over the past couple of weeks.

In the U.S., there are big numbers in jobless claims with 10.6 million people officially unemployed (18.3 million actually unemployed), December payroll positions lost amounted to net 140,000 (all women) and the CPI only advanced at 1.4%, well below the 10 year average and far from 2%. Retail down.

This has created downward pressure on the dollar and imported inflation. For example, the U.S is a net importer to the tune of ~$870 billion (with China making up 1/3rd) with those imports, e.g., $100 million of oil being paid for with a weaker U.S. dollar.

Further, December U.S. unemployment claims nearly hit 1,000,000 and there are still 45.5 million food stamp recipients. There are continuing appalling numbers associated with COVID infections, hospitalisations, and deaths across the northern hemisphere, not to mention a COVID reprisal in China.

The fact the secondary markets have largely been ignoring this for months is a function of QE/Guarantee infinity which have pushed a massive wall of moral hazard money into investment assets.

And, as you know, asset price increases do not always reflect fundamentals, and there is still no interest from the current Fed to reign them in.

Reflation? Nope, just massive asset inflation backfilling the entire spectrum of asset classes.

Hey Joe, are responses to COVID inflationary for commodities you dig?

Yup, for a time.

In many countries we are seeing increases in prices for steel making bulks and building product commodities. Great for us here in Western Australia, not so great elsewhere.

Home prices and rentals have been lifting in certain pockets. Government incentives have contributed to this in Australia, as one example.

Households have used incentives and welfare to renovate and remodel while they shelter at/work from home, and in the U.S., building contractors and supply companies share price increases reflect demand from families moving out of densely populated cities to build in more COVID friendly locations (and/or to escape taxes, e.g., New York).

With some economies that have reopened/partially reopened, more transport is occurring for people and materials, plus logistics associated with heating oil requirements for the northern winter.

Steel price increases can also be explained by the Brazil (dam disaster/COVID) supply shock and increasing demand from China over the past quarter as a staple for its steel making/construction led recovery stimulus.

Also, with Tesla scaling new heights and Joe Biden’s support of renewable energy and other progressive technologies, lithium is back in demand and graphite and cobalt are showing signs as well as, of course, copper and nickel.

Rare earth companies have rallied but this is a result of shifting reliance from China-based supply chains.

So far, this may still be pent-up demand and a direct response to COVID, and not a reflating global economy.

Hey Joe, is this reflation in your hands?

Nope.

In a lot of cases there are some very good explanations for why we are seeing price increases in oil and energy, but one of those reasons is not synchronous reflation, as evidenced by last year’s GDP numbers.

Global real GDP contracted by 4.9% in 2020. China’s 2.3% GDP growth rate in 2020 was the slowest since Deng’s reforms in the 1970s.

When taken altogether there is little incremental economic growth. As a result, current increase in prices should be put down to sporadic COVID reactionary inflation, which may not be sustainable, and is certainly not reflation at this stage because the money pushing up prices is welfare.

Hey Joe, what you gonna do with those Vaccines in your hands?

So far, most media across the political spectrum suggest the vaccine rollout has been underwhelming. It is going much slower than anticipated and various logistical issues may continue for some time.

While the secondary markets are looking through the pandemic to the other side, vaccinations are slow and behind schedule and some hospitality and leisure businesses with large infrastructure requirements may never reopen.

Biden was partially elected on his promise to bring the virus under control, and he’s targeting this over his first 100 days by asking everyone to wear a mask and proposing funding in his relief package (more on that below) to assist in the vaccine roll out, as well as for hospitals and healthcare.

And now we have mysterious new virus waves threatening the UK and 22 million people recently locked down in China as a result of a small but what appears to be growing outbreak, again.

We are hoping that governments can effectively deal with these new waves quickly, without having to resort to shutting down supply chains yet again.

While global supply chains are dislocated by COVID and continuing trade wars and tensions with China, it will be difficult to even think about synchronous reflation.

Hey Joe, when you gonna get reflation?

Sustainably firing up the global economy, or reflation, feels like a post-pandemic story.

The productivity heart of the global economy and money velocity will need to be defibrillated with real fiscal spending, and heaps of it.

Since the eve of the GFC (2008, Q3) M1 velocity (speed to spend) has fallen by 63%, while M2 (speed to save) has not fallen by as much, i.e., 40%, indicating the economy is way quicker to save then to spend.

And while the broadest form of money velocity (money with zero maturity which includes M1 and M2 and all money market funds) has ticked up by o.o5, it still only sits at 1, indicating that financial assets are turning over very slowly.

But as I’ve written before, many governments have forgotten what real fiscal stimulants look like and have instead been relying on monetary pump priming, particularly in the U.S.

And with current deficit spending and bond issuance levels and chimney money that’s already been deployed, how far will interest rates need to go to enable more government fundraising? And who or what will buy the paper?

There are no answers as its not been done before, except in Japan. But bond demand in Japan is almost closed circuit in nature (i.e., domestic).

Joe says he will give it a go and we’re all hoping he, VP and Senate tie-breaker Kamala Harris, and most likely Secretary of the Treasury Janet Yellen, plus what looks to be an able team being built, will succeed, quickly.

Hey Joe, doesn’t another $1.9T chimney money make $5.4T?

Yup.

Last Thursday, Joe Biden announced a $1.9 trillion rescue plan.

It’s not yet approved. It’s still a proposal. It’s all welfare.

It’s all directed at funding schools to reopen, vaccine roll outs, loans and grants to help struggling businesses and $2,000 stimulus cheques.

It’s not reflationary, it’s ‘keeping the lights on’ spending, or reverse taxation.

How much will find its way back into equities markets? Who knows, but why will it be any different to April?

If it passes, it will be the first part of a two-part initiative, the second part will apparently be outlined in February before a joint session of Congress.

Putting aside the question of control associated with marginal control of the Senate and outright control of the House, here are the other items Joe inherits:

Welfare, $1.9 trillion on top of $3.5 trillion already - that’s $5.4 trillion
Vaccinations, $? billions, potentially ongoing like the flu jab
US national debt, $27 trillion versus US GDP, $23 trillion
Interest servicing costs of debt, $0.4 trillion
Federal Government deficit $3.2 trillion (remember when Pelosi told Trump that the Dems would not accept a deficit of over $1 trillion at the time of the Trump free kick tax cuts? It has now tripled)
Trade deficit with China, $0.3 trillion
Total trade deficit $0.9 trillion
Government unfunded liabilities of $159 trillion and rising
Growth stimulus requirement? Many more trillions yet to be created

And the more money that is created to sort this out and the more interest rates are managed down to keep a lid on debt servicing; the more net disinflationary.

Reflation, let alone monetary normalisation, seems to be too far out along the watchtower at this juncture, given the pre-vaccine response to COVID and soured trade relations that so far have not allowed a return to pre-COVID and pre-Trump days.

But sporadic COVID-response induced inflation in commodities? Yup. Asset inflation? Yup. You got them both in abundance!

If you agree, that gives you a big clue as to how long liquidity will last and what that means for the accessibility to and cost of finance and growth.

It also suggests that there’s still plenty of economic risk before we reach reflation.

So don’t pull the reflation trigger too early in your business or investment strategy because it might just be breakthrough inflation.

But if the vaccines do the job, the back end of the year should start to get interesting again!

Time to calibrate your 2021 strategy to take inflation/reflation optionality into account.

Later,

Mike

Hey Joe, is commodities inflation the watchtower for global reflation?