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Contrarian Deflation!?

Updated: Oct 31, 2023



As I read headlines like this and look around me in real life hard to see where the deflation is!! “Producer prices jumped .5% in Sept, bringing the YOY rise to 8.6%. We haven't experienced inflation this bad since the stagflation of the 1970s. The difference is the numbers didn't get this bad until the end that decade. The current stagflation decade is just getting started”!

So after some back and forth his week with some exceedingly smart macro players and with

BarryB... As everyone piles into the inflation trade, the contrarian in me has me wanting to think about heading the other way and this whole market set up does worry me.

Not only may inflation be transitory, it may be forewarning of accelerating disinflation or worse. I’m hugely long energy Nat gas, coal, tankers & shippers and nuclear and happily so and have been for last 12-18mths and am long banks and Underweight big index tech. This has given me and excellent 2021 following a stellar 2020,

BUT...its all about what next! Where the Puc is going and where the machines are NOT!

The following is linear/simplistic and clearly ignores the friction (i.e. inflation) of shattered

supply chains, tensions with China, resiliency overtaking efficiency and so on. Nevertheless, I

don’t see much consideration of these types of arguments out there, albeit reductive.

When I look at positioning its still just NOT there yet on Oils and so the delayed trend following late to the party thematic should repeat itself here! The seeds of deflation/depression germinate with inflation (history wrongly focuses on Weimar

for inflation.

The deflation that followed, however, had worse outcomes i.e. the NAZIs). Current inflation mostly due to supply shock – so, if inflation runs at 5 percent and wage growth under 4 = demand drag. Buying conditions deteriorate...This means central banks risk responding to supply shock generated inflation with tighter monetary policy. This will curb demand further. More worryingly, rising rates and wealth effects inversely correlate, ref housing. Recession follows.

And then we might get clubbed with a supply revival (which lags demand) = DEFLATION, DEPRESSION....

Separately, there can be no inflation without a rise in until labour costs (a function of wages and productivity). Wages are increasing, but if productivity increases commensurately, unit labour costs remain constant. Add investment in new technology, more favourable economics in terms of STP/automaton over cheap labour (autonomous driving, battery tech, digitalisation, renewables) and productivity could rise, wages could stagnate (in aggregate) and unit labour costs could fall.

Karl Marx was right; we are too clever. Innovation will lead to deflation. At the same time, the industries seeing the most wage inflation are the hardest to automate, e.g., Leisure & Hospitality. They are inherently less productive industries as a result of their structure.

So, well established and now rising wage & price Services inflation will be joined by the step-up from decades of Goods deflation to sustained Goods inflation (likely amid protectionism, de- coupling and China demographics) and voila, you have sustained 3% inflation. Fed has no excuse not to raise rates (soon).

Not terrible for P/E ratio (though the current P/E on full-cycle, trailing 10 year inflation-adjusted operating EPS is 15% too high and I see a P/E compression and moderate negative EPS revision correction this quarter), but we can surely agree that -1% TIPS reflecting current central bank policy settings and a 1.5% 10Y yield are wholly unjustified if that is the case.

On bigger picture: The debt and demographics drivers of deflation have only got worse. We are all Japan now to varying degrees. However, if repatriation of manufacturing is indeed a trend then production costs will rise. If cost pressures can be passed on sustainably,

perhaps inflation takes hold for a time.

If they can’t, it is deflationary and contra growth. Regardless, it feels to me like we we are perched on a peak with macroeconomic instability all around us. Asset prices are high because we are in a negative real yield environment, which is entirely the making of monetary policy. But such an environment is required because any normalisation of real yields would result in debt deflation.

So, I guess that tells us all we need to know about deflation vs inflation. You only get prospect of inflation if monetary policy stays abnormal, any normalisation will result in deflation. Credit still has to grow at a multiple of income in order for their to be aggregate growth.

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