• Phronimos

the inflation tapeworm and through the looking glass

Updated: Jan 8, 2021

Interest rates are at historic lows across most of the developed world. Even the US Fed Funds rate of 2.25% - 2.50% is remarkably low given a decade of economic growth. Yet inflation remains subdued and markets have concluded that policymakers will cut interest rates again. We appear to be trapped in the “deep freeze” of low growth, low inflation and low interest rates; much as Japan has been since the late 1990s.

A blog that I regularly read and generally respect, said that you had to be an idiot to worry about inflation. Just look at bond yields! They’re not the subtlest of folks (although they are usually right). Well my “looking like an idiot” ratio is pretty high. I won’t venture a number here to prove the point, so let’s go nuts.

There are two reasons to think carefully about inflation. What could cause it to return and what would the consequences be?

Firstly, if growth falters in the major economies central banks will likely respond, as the market seems to now predict. At least they will try. But after a decade of “emergency-lows” in rates, “QE”, “operation twist”, “LTROs”, “yield curve control” and so on and so forth, does anyone still believe that central banks have the power to create inflation? Central bankers themselves seem to have their doubts.

That means the next round of economic stimulus could very well involve coordination of fiscal and monetary policies. Aspiring politicians on the left call for a version of coordinated fiscal and monetary policy named Modern Monetary Theory (“MMT”), which essentially combines a major expansion in social programs financed by freshly printed money from the central bank.

As James Mackintosh quipped, “MMT is neither modern, monetary, nor a theory”.

Yet whether it takes the specific form of MMT or some other more politically centrist program of infrastructure spending or nation-building program, in conjunction with zero rates or financed directly by the central bank, the end result might not be vastly different. More importantly, it could actually succeed in driving up inflation.

Why would this be successful when central banks acting alone were not? One heretical economist by the name of John Cochrane from the University of Chicago believes that inflation is actually a function of fiscal policy, rather than monetary policy. He believes that inflation is driven by how much a government can borrow in its own currency, and the real value of primary budget surpluses necessary to repay that debt. His Fiscal Theory of the Price Level (“FTPL”) says that any increase in nominal borrowing above the present value of real future budget surpluses leads to inflation.

Huh? In English please!

If the government borrows and spends more today than it is likely to be able to pay back through future tax receipts (in real terms) the resulting gap is filled by inflation.

His theory actually helps us understand why central banks failed to create inflation in the aftermath of the financial crisis despite the alphabet soup of programs mentioned above.

It is also worth noting, however, that even without FTPL, by offering interest on excess reserves, the Fed didn't encourage commercial banks to actually lend out the freshly printed deposits they held with the Fed – they merely swapped holdings of government bonds for equally riskless Fed deposits. Very little new broad money actually made it into the system.

But going back to FTPL, governments from the UK to Germany and Japan raised taxes or cut expenditure to get deficits and debt under control, and this fiscal tightening undid whatever broad money growth there actually was.

If this FTPL view of inflation is correct then the large US fiscal deficit since the passage of the 2017 tax cuts could ultimately have a greater inflationary impact than the uber dovish Bernanke/Yellen Fed. If a leftward-shifted Democratic party gains the levers of power in 2020, and manages to strong-arm the Fed into compliance, this could go into overdrive.

And while we are on the topic, there are a few other things worth keeping an eye on with regard to inflation. Tariffs are typically viewed as having a one-off, transitory impact on prices, but does that miss the bigger picture? For example, the Fed estimates that 25% tariffs across all Chinese imports would equate to a 0.4 percentage point increase in the US personal consumption expenditure (PCE) index. With US PCE sitting below 2%, that hardly seems anything to worry about and there could be offsets (a weaker Yuan etc). But the bigger picture is a shake-up of global supply chains. Globalization has been a relentless driver of lower prices for consumer products for decades. A halt, let alone a reversal in that process, would remove a disinflationary constant. Economists are agreed that free trade benefits all, but they have no view on the geopolitical dimensions of great power rivalry. The price of greater American security could well be higher consumer prices.

Also, the underlying US labor market is actually pretty tight. Unemployment in April was 3.6%, the lowest rate since 1969 (ominously just before the 1970s inflation got underway). Wage growth moving into the 4%+ range could suddenly change the psychology of workers, employers and investors.

But the bigger reason to actually spend some time worrying about inflation is the enormous damage it could do to financial asset prices. It might not be a likely outcome, but it is a very bad one from today's starting point of elevated equity and bond prices.

For the decade of the 1970s, bonds and cash generated negative real returns and equities generated a real return of just above zero. That is, after adjusting for inflation, you lost money in cash and bonds and went essentially nowhere owning stocks.

If inflation did return in a major way, how should our investment strategy respond?

Conventional wisdom is that between cash, bonds and stocks, the latter is the least-worst option as companies are able to raise prices during inflationary periods. The reality is a little more nuanced. Luckily for us, one of the greatest investors of all time lived through such a period and left us his notes.

In the early 1980s, Warren Buffet noted that “The average tax-paying investor is running up a down escalator whose pace has accelerated to the point where his upward progress is nil”.

Inflation raises the hurdle rate for the return on equity that must be achieved by a company in order to produce a real return for its individual owners. Take the following example: in a world of 12% inflation a business earning an 18% return on equity and distributing 100% of that return to its owners in the 40% tax bracket is actually eroding their real capital, not enhancing it (18% minus 12% inflation = a 6% real return, while a 40% tax on the nominal 18% distribution = 7.2%, therefore the after tax real return is -1.2%).

Inflation acts like a tax; and one that is not actually capped at the level of reported income. At the extreme, a sufficiently high inflation rate can turn a positive return at the company level into a negative one for its individual owners, even if they aren’t required to pay explicit income taxes.

If inflation today jumped to 13%, the half of the S&P500 earning below this average 13% return on equity would be returning a negative real return even if income taxes on dividends and capital gains were zero.


Furthermore, with the long-term “risk-free” government bond currently yielding 2.1%, a business that utilizes equity capital at 13% is clearly worth a premium to investors over the equity capital employed, i.e. it is a reasonably “good” business in which a dollar reinvested should be valued by the market at more than one hundred cents. That remains true even though taxes on dividends and capital gains reduce that to perhaps 8-10% in the hands of the individual investor. But at a 10% inflation rate, that is no longer true. It generates no value added for the individual investor.

To keep up with that hurdle companies need to increase their nominal return on equity. That means generating higher sales on existing assets, increasing profit margins, or both, while at the same time NOT having to employ significantly greater amounts of new capital. While most investors are probably aware of the first two levers, there is probably much less focus on the impact of inflation on the latter.

As Buffet notes: inflation “takes us through the looking glass in the upside-down world of Alice in Wonderland… inflation is a tax on capital that makes much corporate investment unwise, at least if measured by the criterion of a positive real investment return to owners”!  

In a normal, stable world, companies with high returns on equity capital are logically expected to retain much or all of their earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns suggest a very high dividend payout so that owners can direct capital toward a more attractive area.

With high inflation “bad” businesses have to retain as much capital as possible simply to remain a going concern – not because they are so attractive as businesses, but precisely because they are so unattractive. Why?  Because the gigantic corporate tapeworm of inflation, “which preemptively consumes its daily diet of investment dollars regardless of the health of the host organism”.  More dollars are required for receivables, inventory and fixed assets in order just to maintain the same unit volume as the previous year, and the less profitable the business, the greater the proportion of profits consumed by the tapeworm. In other words, the impact of inflation on the amount of capital invested in the business also works to the disadvantage of low return businesses.

These businesses are forced to retain as much capital as possible, so expect to see dividends curtailed or paid out of contributions to capital from other sources. Of course there will be those strong businesses that retain capital because they genuinely see better investment alternatives, but those companies will be harder to find.

So what should we do if inflation accelerates? Well, cash and bonds are definitely out. While they may appear stable in the short-term, their real value is rapidly eroded.

Within equities we should be looking for businesses that: (1) are able to increase prices easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.

In short: pricing power, plenty of capacity and a low requirement for new capital.

While we currently focus on businesses with strong pricing power and high returns on capital, we are generally happy for significant capital to be invested as long as the returns earned on that capital are appropriately high. With inflation this emphasis will shift. Our focus should turn laser-like toward those few businesses that have significant pricing power and very limited need for new capital at all.

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