The Breakdown - Inflation Is the Cruelest Tax

Episode Date: October 4, 2020

Today’s Long Reads Sunday selection is “How To Avoid Paying the Cruelest Tax: Inflation” from the Wall Street Journal. NLW argues the piece reflects a changing conversation in mainstream financial circles about the possibility of inflation on the other side of new Federal Reserve policy.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by crypto.com, nexo.io, an elliptic, and produced and distributed by CoinDes. What's going on, guys? It is Sunday, October 4th, and that means it's time for Long Reads Sunday. You guys know that I spend a lot of time paying attention to narratives. And one of the areas that I pay most close attention to is when the mainstream finance and economic narratives start to reflect things that we've been saying in the Bitcoin and Crypto space.

For that reason, I want to read a selection from the Wall Street Journal, which instead of just a single author actually has six separate contributors. Spencer Jacob, Aaron Back, Justin Layhart, Nathaniel Taplin, Jinju Lee, and Telos. The piece is in the herd on the street section, which is effectively like the Wall Street Journal's narrative watch. The piece is called How to Avoid Paying the Cruelest Tax Inflation. And the lead is investors worried that record budget deficits and massive fed bond buying will stoke a big rise in inflation have places to hide aside from hoarding gold coins, some of them surprising. This is not an article about Bitcoin, although it probably should be, but I do think it's important

to recognize again when the things that we've been saying over here and the narratives that best benefit Bitcoin all of a sudden start to make their way into the mainstream. With their portfolios gyrating and an election looming, investors are spending more time than usual pondering what their taxes will look like in the future. But they haven't given much thought lately to, quote, the cruelest tax, inflation. Maybe they should. Rising prices can do funny things to a portfolio, most of them bad. Stock prices might rise without really being worth anymore, or stay steady and lose buying power. Bonds become certificate of confiscation. Broadly speaking, inflation shrinks private savings and bails out people and governments that have borrowed heavily. But not everything withers.

Some investments could do quite well. Right now, neither Wall Street nor Main Street expects rapid inflation, and that is a good thing. It is good because they may well be right, but also because investors can protect themselves at a reasonable price. Investments that offer protection look reasonable while more vulnerable ones have racked up nice gains recently. You don't buy insurance or sell your beachfront home when the hurricane's already coming. One reason many pros aren't alarmed is that some of Wall Street's best and brightest got egg on their faces predicting runaway inflation after the financial crisis. But some smart money remains wary. A surge in gold buying this summer was one sign of concern. Investing legend Stanley Drucken Miller said last month that the Federal Reserve's statement

that it would let prices run above their target could mean that they lose control and that inflation could reach 10%. Even a far milder rate of 3% to 5% would make some investments big losers and others' relative winners. Professional investors express their views on inflation through the bond market. Based on something called the 10-year break-even rate, they think it will average just 1.6% over the next decade. That rate was about a percentage point higher back in the spring of 2011 when the Federal Reserve was in the midst of its second big bond buying program dubbed QE2. Trillions of dollars later, we are in QE4, with record budget deficit deficit. microscopic interest rates, and trade frictions to boot.

All textbook causes of higher prices. Yet mom and pop are also relaxed. The University of Michigan's monthly survey of consumers shows that Americans expect prices to rise by 2.6% annually over the next five years, identical to their average prediction since the recession ended in 2009. If the textbooks are right this time, then the worst victims of about of inflation would be bonds. The 10-year Treasury note yielding just 0.68% is already an invitation to lose money. money. Treasuries could fare even worse this time than in past inflationary episodes. How much

investors lose and how fast their money disappears depends in part on the Fed. The main reason yields are so low is that the Fed has promised that it won't raise its target range for overnight rates, which now sits near zero, until the Commerce Department's gauge of consumer inflation has been moderately above 2% for some time. For the more widely followed consumer price index from the Labor Department, which runs warmer than the Fed's preferred price measure, that could translate into central bank in action until inflation was near 3% for a while. A spike in interest rates could cause sudden, steep losses for investors who bought bonds through mutual funds.

Even tips, Treasury's index to inflation would lose value. But not all government bonds would do so badly. Consider China. The Treasury of the world's second largest economy has been relatively restrained in terms of stimulus. Nominal 10-year Chinese yields, currently at 3.15%, according to FACCet, are around 2.4 percentage points higher than U.S. Treasuries. And the gap in real terms is even higher. If U.S. inflation accelerates, and especially if the Fed keeps rates low anyway, then the return could get an extra boost from the impact of a falling dollar relative to the yuan. No wonder foreign investors

bought nearly $300 billion yuan or $44 billion of Chinese government debt in the first eight months of 2020, triple the amount during the same period last year. For those who prefer investing closer to home, American stocks don't do all that badly when inflation rises. That might come as a surprise to people who remember the 1970s. In 1979, Businessweek ran a famous cover story, The Death of Equities, how inflation is destroying the stock market. From 1973 to 1979, the core consumer price index, which excludes food and energy, rose at an average pace of 7.3%, while the S&P 500 fell 8.5% over the same period. But periods of milder inflation have been kinder to stocks. From 1990 to 90s, 1995, for instance, the core consumer price index rose an average of 3.8% a year, and the S&P 500

rallied 74%. In theory, stocks offer a natural hedge against inflation, at least compared with bonds. Businesses that can raise their own prices should be able to grow their earnings more quickly, helping shareholders keep pace. Since 1880, equities have risen by more than inflation 88% of the time on a rolling 10-year basis, according to a study by Goldman Sachs. But Goldman found the highest real or inflation adjustment. adjusted returns for equities, came when inflation was low. In 10-year periods where the consumer price index rose by between 0 and 1.5% on average, the S&P 500 posted a real return of 10.6%. That return fell to 8.7% when inflation is between 1.5 and 2% and to 6.5% when inflation is

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I.O. Inflation can boost companies' revenue, but it boost costs too, and not all businesses have the pricing power to keep up. One sector that does, and could provide a good hedge this time, is natural resources. Skeptics might say that this impression is skewed by the experience of the 1970s, which was marked by three events that juiced returns for metals and energy. The Nixon shock of 1971, when the U.S. dollars linked to gold was severed, the 1973 Arab oil embargo, when crude prices quadrupled, and the 1979. Iranian Revolution when they surged again. But the stretch between 1973 and 1982 actually was one of the least impressive periods for metals and energy stocks in real terms, according to data from

fund manager GMO. The combined sector's real return was just 0.6%, though that still beat the S&P 500's overall performance by more than 5 percentage points. Looking at all eight stretches since 1930 that saw high inflation as defined by GMO, energy stocks had a real return of 6.2% while the overall market fell by 1.6%. Despite being remembered for gas lines, the stagflation of the 1970s in early 1980s hurt demand and resource stock valuations. Owning gold was a famously good bet during the 1970s. The yellow metal hit its all-time high adjusted for inflation of 8.50 an ounce in 1980. But as GMO's Matt Cadnar points out, the historical return of gold adjusted for inflation over many centuries has been about 0%. It pays no dividend and is really only attracted to those who fear that

paper assets like stocks will somehow fail to be honored. And while gold prices are already close to all-time highs, energy and material stocks have lagged behind the market sharply. The two sectors combined now make up less than 5% of the benchmark S&P 500, about half their share from five years ago and a quarter of what they made up 30 years ago. Retailers might be another good place to ride out an inflationary wave, though it matters what the company sells and how flush consumers feel when prices start rising. Sellers of consumable goods such as grocery stores Kroger and Albertsons, big box retailers like Walmart and Target, and even dollar stores are likely to fare well no matter what the unemployment levels are because they sell essentials. The same goes for auto parts and home improvement retailers. Broken cars and homes need to be fixed,

even if doing so becomes more expensive. On average, even a milder inflation rate of 2% helps most companies selling consumables, notes Scott Mushkin, equity analyst at R5 Capital. Volume growth is minimal for consumables, which means anything that moves revenue incrementally higher, such as inflation, will benefit those companies. Food retailers with successful private label brands, which yield higher margins, might see an advantage over those who don't. Supermarket branded soup, for example, will look more appealing than Campbells at a time when everything becomes more expensive.

Sellers of discretionary items might suffer, though, if wages don't keep up with inflation. Sales of appliances and full-priced apparel could shift to off-price retailers. In an inflationary environment, retailers have incentive to stock up on inventory before prices rise even higher, according to Professor Gerard Cashan of the University of Pennsylvania's Wharton School. That means companies with strong balance sheets and vendor relationships should have an advantage. That will be even more important if the higher inflation comes with higher interest rates pushing up borrowing costs. Cash-rich retailers like Walmart and Costco would be better positioned than Target in BJ's wholesale, while Dollar General would have an

edge over Dollar Tree. Technology and health care stock stocks, both recent market darlings, look iffy if inflation hits. While parts of the tech sector, such as software as a service, might be nimbler at passing on rising costs, tech valuations are high and have proven to be very sensitive to rising long-term interest rates. Meanwhile, health care inflation has already been high, and any attempt by the government to cool price gains could target drugs and medical care. Utilities in real estate could face a double whammy. Many investors own them for their yield. If bond yields rise, they would look worse by comparison. And both regulator-controlled utility rates as well as long-term commercial leases could be slow to adjust to an uptick in prices

even as borrowing costs rise. Even worse than those industries would be financials, though how bad depends on the Fed. Banks are both borrowers and lenders, but they also must fund themselves with a base of equity, and a relatively small share of their assets are hard assets like real estate. Historically, therefore, banks experience more of the downside of inflation as creditors. Past periods of high inflation have been marked by declines in book value multiples, according to a compilation of historical data by autonomous research. High U.S. inflation in the 1940s and 1970s saw Nader's for bank price-to-book ratios. By contrast, the most recent peak ratio was hit during the low and stable years of the 1990s. However, in a return to a period of somewhat higher but overall

steady inflation, not unlike the 1990s, inflation itself might not be a major determinant of bank's performance. Much more important would be the degree to which the Federal Reserve was willing to let long-term rates rise. The steepness of the curve is a big factor in bank's profitability. It is tempting to trust that inflation went the way of disco and bell bottoms, but hope isn't a strategy. Investors concerned about protecting the buying power of their savings don't need to take refuge in precious metals or cryptocurrency. There are some plain vanilla options that could hold up well. So there you have it. You get a little shout out for crypto at the very end, but I want to point out, I guess, one more article that I'll just read an excerpt of, just to see if maybe we get a

different sense of where people actually are hedging their money based on a concern about inflation. This one comes from CoinDesk and is titled Bitwise Bitcoin Fund doubles to $9 million as investor fears grow over runaway inflation. An amended filing with the SEC last week showed that the asset manager Bitwise had raised in total just under $8.9 million for its Bitcoin fund, which provides accredited U.S. investors with exposure to Bitcoin through a traditional product. This marks the single largest increase in assets raised in the fund's two-year history. A filing from 2019 shows that the Bitcoin fund had attracted $4.1 million in investment, meaning the fund has more than doubled in size in the past year. While Bitcoin has come on in leaps and bounds in its acceptance among the traditional

investment community, Bitwise's head of research Matthew Hogan told CoinDest the more immediate cause for the surge in the fund's size came from concerns over runaway inflation. Quote, with the unprecedented expansion of the Federal Reserve's balance sheet, the radical amounts of fiscal stimulus, and the Fed's new and significantly more dovish policy, Bitwise clients are looking for a hedge. Bitcoin is the most efficient hedge for inflation that exists in today's market. So obviously we will see how this all plays out over time. There are plenty of forces that are extremely pointed in the other direction of deflation. But I think it's relevant to notice when the narratives in the Bitcoin space and the crypto space start to show up in the Wall Street

Journal and other outlets like it as well. So hope you enjoyed that conversation today, guys. And until tomorrow, be safe and take care of each other. Peace.