To My Clients, Friends & Observers:
The first principle of Brae Head, Inc. is to build and protect purchasing power over time. A growing challenge going forward will be to immunize portfolios from inflation. It's been so long since inflation was a problem that a little history is in order. Let's review.
"Inflation is always and everywhere a monetary phenomenon." - Milton Friedman, 1979
"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." - John Maynard Keynes, 1916
"Inflation is a disease, a dangerous and sometimes fatal disease, that if not checked in time can destroy a society. Examples abound. Hyperinflations in Russia and Germany after WWI...prepared the ground for communism in one country and nazism (national socialism) in the other. The hyperinflation in China...eased Mao's defeat of Chiang Kai-shek. Inflation in Brazil in 1954...brought military government. A more extreme inflation contributed to the overthrow of Allende in Chile in 1973 and Peron in Argentina in 1976, followed in both countries by military junta." - Milton Friedman, 1979
The best contemporary illustration of hyperinflation is Venezuela, where estimated inflation exceeded 65,000% in 2018 and 9,900% in 2019. It is incalculable now because the economy has completely collapsed. The government is dominated and controlled by Cuban communist thugs masquerading as benign socialists.
Inflation is caused by excessive monetary growth. "Excessive monetary growth" is a rate greater than the rate of economic output. One illustration of the excess is the ratio of U.S. debt to Gross Domestic Product. U.S. Federal debt has grown steadily from 55% of GDP in 2000 to 98% in 2020. The Fed predicts that it will be 104% in 2021 and 195% by 2050. As Milton Friedman explained in 1980, there were three reasons for accelerated monetary growth at that time: 1) rapid growth of government spending; 2) government's full employment policy; 3) mistaken policy by the Federal Reserve.
There are powerful beneficiaries of increased government spending. There are too few forces at work to limit the endless growth of government or to collect the taxes to finance its sprawl. Our government finances its increased spending by increasing the quantity of money. The U.S. Treasury sells bonds to the Federal Reserve System which pays for the bonds by printing Federal Reserve Notes (cash) or by issuing a credit to the Treasury which can then pay its bills by cash or check drawn on its account at the Fed. The global market for U.S. Treasury bonds is saturated. Understand, the bonds must be sold. There is only one reliable purchaser: the Federal Reserve Bank.
There will be no warnings broadcast of inflationary dangers. The public will not be alarmed. In fact for years the Federal Reserve Chairs have campaigned for inflation, setting an annual target rate around 2%. Treasury Secretary Yellen said recently that "there is no inflation." Fed Chairman Powell said recently that "money supply doesn't matter anymore." (Because it can't? Because the die is cast?) Money supply (M2) is up 20% year over year. To be clear: inflation is always and everywhere accompanied by monetary expansion and monetary expansion is always and everywhere accompanied by inflation. Hyperinflation has always been accompanied by some form of authoritarian control whether communism, socialism, or fascism.
The rationale for a 2% annual inflation target was ostensibly to fight a deflation caused by: globalization and cheap labor; cheap energy caused by a superabundance of carbon fuels; and galloping technology which is reducing and replacing labor costs. But there are other beneficiaries of inflation. Governments realize increased taxes as citizens are inflated into higher brackets. Printing money enables the farce of paying people not to seek work, people who are therefore not counted as unemployed, thus lowering the reported unemployment rate.
Those who can raise prices for their goods and services don't object to inflation but those who can't are powerless and desperate as their income buys less and less. Inflation is cruelest to the poor. How cynical are wealthy politicians promising social programs to aid the poor when it is their monetary and fiscal policies which impoverish?
Inflation enables debtors to repay in cheaper, devalued dollars over time. A person with a million dollar mortgage at a 3% rate, whose income increases 3% a year, is paying interest and principal with ever cheaper dollars. The debt service is effectively free. Who has million dollar mortgages? Not poor people.
The enormous U.S. debt can only be repaid in cheaper, devalued dollars. The evidence is that this nascent inflation is deliberate and by design.
Whither The Dollar?
It withers. America gets away with its financing because its debt is priced in U.S. dollars. It is what enables the fantasy of Modern Monetary Theory. It can sell its debt internationally because the dollar is the world's reserve currency. Approximately 60% of global economic transactions and 88% of international foreign exchange trades are executed in dollars. U.S. sanctions on bad actors like Iran and Russia are only as effective as they restrict their uses and transmissions of dollars. Oddly enough it is U.S. Treasury securities and cash that underpin the Chinese yuan. China is working diligently on replacing the dollar.
The Wall Street Journal reported on April 6 that China has created a digital currency, the first for a major economy. Though similar to other cryptocurrencies, the digital yuan is controlled by the China central bank and does not allow anonymity to the holder. If China, the biggest merchandise trading nation, managed to succeed in toppling the dollar as the reserve currency, it would plummet like Monopoly money. China is unlikely to succeed but the dollar is already weakening. There are alternatives being tried: cryptocurrencies with blockchain accounting systems. Although bitcoin and the other cryptos have no sovereign backing, all it takes is for a buyer and a seller to agree to use it and bypass central banks. India is the first sovereign to outright ban cryptocurrencies. The digital yuan will give the Chinese communist party vast new power over its citizens. More and more companies - if not all - have initiated bitcoin and blockchain exploration to some extent. (See the February 7th issue of Forbes). It will likely take a long time to unwind the dollar as the reserve currency but it will not take that long for its devaluation. We might not see it in our lifetimes, I hope not, but the younger generations are in for some very challenging times.
Meanwhile all this excess money is going into real estate and the stock market, making the rich richer and leaving the middle and lower classes to suffer the punishment of inflation. And that's the social aggravation that brings to mind that uprising in France in 1789. The new progressive buzzword lately is "Equity," which sounds to me a lot like "Egalite." The markets have been great for investors. It's the potential upset of the whole system that gives one pause.
Our biggest challenge is preserving purchasing power. Securities selection therefore emphasizes companies that have pricing power and companies least affected by interest rate hikes in the event. The Fed has persuaded me that it will leave rates unchanged and that this inflation will be unchecked for some time.
What could mitigate wage pressures and boost profit margins is increasing productivity, driven by continuing breakthroughs in technology. The tech revolution is still in its infancy.
Finally, corporate earnings for the first quarter are 85% reported and they have been exceptionally strong. Most have exceeded analysts' expectations. They have to in order to justify their prices. The S&P 500 Index trades at 44.92 its trailing 12 months "as reported" earnings (P/E). It has only been higher once: in May 2009 when it reached 123. Historically the mean is 15.94 and the median is 14.85.
Dennis M. O’Connor