Inflation's Enabled Escape from the Bottle
As we sit here mid-way through 2022, in a strange way things look somewhat simple, at least from a cause-and-effect standpoint. We have witnessed the turbocharged unwind of a global trade construct that lasted for over two decades, the reckoning of the withdrawal of unprecedented and highly addictive stimulus from Central Banks and mayhem across asset markets from rates to equities. The question of “how did we get here” in most cases doesn’t have a complicated answer despite the ink spilt writing about it. Maybe we think it is complicated because of the political class’s efforts to name numerous real and imagined causes, exclusive of their own actions. The proposed solutions from some politicians are also bewildering and just plain weird. We think the root cause to much of this involves the downfalls of politicization and collectivization of decision making across a number of areas, particularly the economy. Add to this a remarkably consistent inability to risk assess future outcomes and deal with them and the entire process of “managing” the economy has a shaky foundation. In fact, it sort of rhymes with “planning” the economy, which we were hoping was put to rest along with the wall in 1989. Slowing the game down and looking at it from 30,000 feet, we are struck by some blinding flashes of the obvious or said another way, “what were they thinking”?
INFLATION
So, here is the setup. Covid rears its ugly head in early 2020 and the Federal government comes with a fully loaded bazooka of over 3 trillion in stimulus, the biggest chunk enacted in March 2020. A key aspect of this new edition of stimulus is the direct payment feature. Stimulus in the past has relied on the transmission mechanism from the financial sector to consumers and corporates. In 2020, this changed with money directly paid to citizens. Meantime, lockdowns begin to disrupt a global supply chain made efficient to within an inch of its life, exposing its fragility countless times over the next two years.
With the change in administration, we also got a feverishly unfriendly regulatory landscape in the energy business, specifically a demonization of the oil and gas business that spurred a further decrease in capital investment in capacity. This put oil companies further into a box constructed by the explosion in not just ESG strategies but their perceived power to direct fund flows. Ignore the fact that ESG, a close cousin of globalization, has clearly peaked, albeit several years after the one-world framework of nearly everything, including commerce. Quite simply, energy companies learned there would be no rewards in the markets for investing in growth (capacity), so they logically focused on returning capital to those who remained equity holders in their businesses. Meanwhile, oil demand kept increasing as emerging markets continued to develop and developed economies still grew, though at a mature rate. Listening to the “storytellers” predicting a downward inflection in demand remained a surefire way to be wrong about oil markets. Just because one desperately wants something doesn’t make it so. Aside from a brief respite during 2020 and Covid, oil demand continues to grow globally. Obvious to any commodity trader is the idea that supply is most times more critical than demand. Capital expenditures are an important measure of future supply due to the lead times of many large projects and the decline rate feature in drilling. 2021 capex for the oil majors were equal to 2005 levels. Contrast this with the steady rise in global consumption where 2021 global oil demand was 16% higher than 2005. The desire to financially starve oil companies is an effort to reduce the usage of oil amid the switch to lower carbon sources by constraining supply. The problem with this tactic (it’s really not a strategy) is that the if oil demand remains firmer than the availability of crude, the market is imbalanced, and prices rise. And when geopolitics get messy and Russian oil is disrupted, well, then price discipline unravels quickly. So, some can try to blame Russia for the latest price moves in oil, but the reality is the seeds for a higher price deck were planted years ago and watered with today’s counterproductive policies. Now the world is paying the price for a climate agenda that is proving exceptionally adept at missing unintended consequences. What were they thinking?
By late 2020/early 2021, high frequency data had improved dramatically from a year earlier. Manufacturing PMI’s had improved to levels not only higher than early 2020 but to levels matching that of the last peak in the economic cycle. Retail sales exceeded pre-pandemic measures, equity markets were off to new all-time highs and other measures such as employment and industrial production were trending more favorably in convincing fashion. And what of inflation? CPI was rising and comfortably above 1%, so no deflationary concerns present. More importantly, money supply growth was beginning to inflect higher. For the five years 2014 to 2019, M2 grew at an average 5.5% rate, this exploded higher to 19.0% for 2020 (highest rate of growth in our data set going back to 1960). Money supply growth affects prices with a lag, so on top of a fully recovered economy and with a tsunami of money swelling beneath it, what is the move that makes the least sense if one wants to control prices? Add $1.9 trillion in Covid relief part 5 (~7.5% of GDP!) and hold rates at the zero bound. In fact, wait to raise rates until inflation has exceeded 8%. So, into an economic setup where supply was abnormally constrained, the $1.9 trillion package was passed in 2021 and soon after the Fed even attempted to describe inflation as “transitory”. The result is a massive economic and political issue for the party in power and more importantly, devastating for the country in the form of a huge, regressive tax on the citizenry. What were they thinking?
Disclaimer
This newsletter is intended for those interested in economics, financial markets, investing and politics. It does not provide investment advice and must not be used for this purpose. Information presented here is believed to be reliable but cannot be guaranteed. No liability can be accepted for any material contained on this website. Material published here is copyright, but can be quoted, provided that attribution is given. By using this website you agree that you use this information at your own risk. In no event will Dean Ramos, CFA, Arka Kapital, LLC or this website be held liable for any direct or indirect trading or investment losses caused by information on this site. The materials on this site are not an offer to sell or a solicitation of an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the the securities laws of such jurisdiction. Arka Kapital, LLC and Dean Ramos, CFA and this website do not guarantee in any way that there are providing all of the information that may be available. You must do your own due diligence before buying or selling a security. Arkakapital.com, Dean Ramos, CFA and this website must never be relied upon in making investment decisions.
Comments