Juggling Dynamite

As I detailed last week in Inflation-cycle déjà vu, commodity prices lead inflation expectations, and inflation readings are a lagging economic indicator.   Because commodities and commodity futures are widely stockpiled and traded by speculators, users and producers alike, prices can wildly disconnect from supply and demand factors and, hence, mislead inflation expectations.

As shown below in my partner Cory Venable’s updated chart of the commodity index since 2007 (CRB- a basket of 19 commodities-39% energy contracts, 41% agriculture, 7% precious metals and 13% industrial metals), the 110% rebound in commodity prices over the last year has been greater than the 85% rebound out of the great recession into 2011.

With 80%+ of the economy already open, and consumers having spent record amounts throughout the shutdown on commodity-intensive goods like housing, vehicles and other goods, there are reasons to suspect that the reflation “trade” and inflation expectations are now wildly overdone.

While China has consumed some 50% of all global commodities produced over the last two decades, domestic consumption is just 43% of China’s GDP growth. So, western demand for Chinese exports remains the swing vote on global commodity demand.

After an 8.7% annualized GDP growth rate between 2008 and 2013, China’s growth target over the next 5 years has dropped to 5.3%.  As shown below since 2009 (courtesy of the DailyShot.com), China’s credit impulse in dark blue–a measure of changes in new public and private credit as a percentage of GDP, typically marks turning points in economic activity–appeared to have peaked in March, as commodity prices (light blue) went parabolic.  This suggested commodity prices and inflation expectations had overshot.

As shown on the left, updated through April, China’s credit impulse contracted further over the last month.

Before the COVID-induced spending splurge of the past year dragged forward even more future consumption, aging populations in most countries were already set to want fewer goods over the next decade+, and technological advances are helping us do more with less.

The other major reason we suspect inflationary pressures will recede is that what’s inflated most in the past decade is asset prices. And, as shown throughout history (and today), highly-levered asset inflation, and the over-zealous expectations thereon, are always transitory.

Unlike most, billionaires have more money than they can spend in a lifetime.  Hence they have a higher risk tolerance for losses and tend to hold a lot of assets of all kinds.  This has made them ideally situated to benefit from the $9 trillion of central bank injections into financial markets over the past 14 months.  At the same time, these same forces have increased the correlation between global asset classes as well as social and economic vulnerability to price declines.  Historically, such extreme imbalances have been followed by giveback periods of one kind and another.

“It took nearly 20 years for the wealth of billionaires to double. Then just last year the wealth of billionaires went up more than 50%,” says Morgan Stanley’s Ruchir Sharma. “It’s staggering.” pic.twitter.com/a3DfpwNtnI

— Squawk Box (@SquawkCNBC) May 19, 2021

An insightful article in the FT today courtesy of John Hussman (see The Myths behind the current stock market bubble) considers the belief system widely held today that central bank liquidity can support extreme and irrational asset valuations indefinitely:  “Years of intervention have cast central banks as tools of self-reinforcing speculation. Mere phrases such as “Fed support” now suffice as complete investment strategies.”  While today is certainly not the first time that this misplaced faith has been widely held, the current episode is so extreme that only 2000 and 1929 offer a comparable data set:

In 1934, Graham and David Dodd described the errors that contributed to the 1929 extreme, and the collapse that followed. They observed that investors had abandoned attention to valuations in favour of prevailing trends, while “the rewards offered by the future had become irresistibly alluring”. Moreover, the backward-looking success of passive stock ownership had encouraged investors to ignore price as an investment consideration. Graham and Dodd lamented: “It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic.”

It is widely acknowledged that corporate profits are one of the most reliably mean-reverting financial series (aka capitalism).  With this fact in mind, the chart below offers some illumination.  The lower left shows S&P 500 prices divided by profit margin-adjusted price to earnings since 1928, and the lower right shows US stock prices divided by revenues since 1947.  Suffice to say permanently high plateaus have been non-existent and past episodes of euphoric pricing have brutally punished those who held high.