Hot on the heels of our new Thematic slot at CitiWire, we were asked to do one of our semi regular pieces this weekend for the highly regarded Australian publication AFR. Below we reproduce the draft sent in as the actual piece is behind a paywall and thus will mainly only be seen in Australia. The central point is that policy makers’ seeming obsessions with Zero – Zero Interest Rate Policy , Zero Carbon and now Zero Covid – are all without any allowance for their ‘unintended’ consequences and are clear drivers of inflationary pressures in the global economy. Whether this remains cyclical and contained or more structural and sustained depends crucially on supply response. While it is still too early to pass judgement, it nevertheless makes sense to invest in the suppliers to the supply chain.
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“To a man with a hammer, everything looks like a nail” is one of the many wry aphorisms that emerged from the former Soviet Union and has become ever more relevant in our current climate of ‘policy based evidence making’. Politicians, central bankers, scientists, activists and lobby groups of all persuasions have evolved a tendency to point to cherry-picked evidence in order to justify their pre-determined solutions. Challenge the solution and you are simply accused of denying the evidence, moreover the policy makers are seemingly no longer required to prove that their policies actually work, instead the challenger has to prove that they don’t. The burden of proof has been flipped. Thus we all are moved to ground zero – Zero Covid has followed Zero Carbon which in turn followed Zero Interest Rate Policy. None of these strategies has been subject to proper scrutiny so far, but that may soon be changing.
All three of these ‘solutions’ feed into what is probably the biggest question for financial markets at the moment; whether the coming inflation is cyclical or structural. By extension this begs the question of whether policy makers are going to alter their pre-determined solution of keeping interest rates as close to zero as possible at the same time as politicians are wishing to keep their pre-determined solution of Modern Monetary Theory (MMT) – or the Magic Money Tree as it is also known – as part of their Zero-Covid response. Meanwhile, the Zero-Carbon strategy is triggering its own round of ‘unforeseen’ consequences in terms of energy prices at the same time as the global economy is trying to emerge from its self-induced Covid coma. Demand is surging as supply is constrained and prices are rising everywhere. The big question therefore is what should be done? Bond investors are always worried less about inflation itself than about the response to fears of inflation, while equity investors are more focussed on who might be winning – and just as importantly losing – from this regime shift.
We suspect it is still too early to tell if this is structural, but a cyclical spike looks pretty certain as we suspect that none of the policy makers will shift their current stance. Politicians won’t give up power over spending, nor will they relax their ‘climate’ policies, while central bankers will not normalise monetary policy. As such demand will continue to recover, leaving the cyclical-reflation versus structural-inflation debate focussed on the supply-side recovery. Many equity investors of course have already placed their bets, in a classic, cyclical versus growth, old economy versus new economy strategy. Commodities have soared, while Mining stocks like BHP have more than doubled over the last six months relative to tech ‘lockdown names’ like Zoom. Similarly, the Global Clean Energy index has fallen almost 50% relative to the traditional energy stocks since January as, not without irony, the activist-driven starvation of capital to ‘old energy’ versus new energy has led to a lack of supply of the former that has now been exposed. This is clearly leading to some pricing pressure that is showing up in industrial input costs (and thus scaring the bond markets) but we should not overlook the way higher input costs can sometimes lead to lower margins rather than to higher output prices. The huge disruption to global supply chains that emerged after the Thailand floods in 2011 for example hit supply of hard drives and auto production in Asia, but that was bad news for companies like Honda and Western Digital rather than their customers. Pricing power is key.
Companies need to be very focussed on their supply chains at the moment – not just their suppliers, but their suppliers’ suppliers as well, especially as demand recovers and the supply damage caused by covid restrictions becomes clearer. Currently there are chip shortages affecting most goods, but particularly autos, which is having the interesting effect of boosting secondhand car prices. Meanwhile, more prosaically, but just as important, is a shortage of plastics. A perfect storm, literally in this case, has hit the industry as the Texas shutdowns in February took out major petrochemical plants and compounded a situation of low inventories due to lockdown as well as Covid related restrictions on ports and logistics. At the same time, the working from home demand for tech hardware that contributed to the chip shortage also contributed to hugely increased demand for packaging. Then there was the ship that got stuck in the Suez Canal.
On balance we think it is too early to call for structural inflation and we also doubt that the central banks will force interest rates higher. As such this looks more of an equity than a bond story and more about input prices than output prices. Those gaining pricing power or those enabling others to do so through supply response will be the winners beyond this short-term supply chain disruption.
AFR MAY 2021
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