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What sectors will do best in an inflation era?


muscleman
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It seems to me that the FED's 4bn per day QE is way bigger than the prior 3 QEs. I am looking for sectors that will do well in an inflation period. I would think Oil, gas, and gold miners would do well. But I remember seeing some book, probably from Buffet or some other author that asset light business do better in this case because they don't have to spend a bunch of capex to add more hard assets in order to grow earnings, and in an inflation period, the hard assets are more expensive so the capital intensive businesses see their capex sky rocket.

 

What do you guys think?

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It seems to me that the FED's 4bn per day QE is way bigger than the prior 3 QEs.

 

Narrator: "Its not"

 

Federal-Debt-Heldby-Fedvs-Federal-Debt-Heldby-Public.png

 

The Fed's share of total US Treasury Debt is not significantly higher than the past going all the way back to 1970.  There is no "monetization" going on. 

 

wabuffo

 

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One should distinguish between the assets and liabilities side (including capex) during inflation and also the starting phase versus the end phase of the process, as well as the rate of increase (gradual or surprise elements ).. insurance companies do ok if it's gradual but poorly if it's sudden as they can't dispose of long term bonds fast enough and lose out several years of maintaining the purchasing power. Capex intensive business that didn't pre invest in pre inflationary dollars will have higher costs to just maintain their existing business, much less growth. Even those that did pre invest may only have a few years of runway. Hard assets are priced in depreciated dollars so are higher but not necessarily getting ahead. Also probably there is a difference between owning a gold mine and actual physical metal. The miner can be high or low cost producer but either way the cost is higher than gold storage cost .

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Some generalized thoughts below

 

Companies that are massively underfunded on pensions would be huge beneficiaries of a rise in inflation (assuming that it is accompanied by a rise in yields).

 

Real estate does well enough - particularly if you mortgaged the property at lower rates (i.e. the real asset maintains purchasing power while the 30-year bond/liability you're short loses value) so maybe leveraged REITS?

 

Emerging markets with heavy dollar debt would also be beneficiaries of rising inflation in the U.S. - so own local bonds or EM equities

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Any company that makes a percentage revenues - brokers, franchisors, mineral rights. In the seventies money market companies made a lot of money, people forget how popular money market funds were during the 1970s. Farmland? Farmers are also going to be hit with higher input costs so I'm not sure about farmland. I think cash flow real estate will do OK but not if you're buying for capital appreciation.

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I think Edwards Lifesciences will do well in an inflationary environment.

 

Saw this today re: EW's approval in China for Sapien 3 trans-catheter heart valve for the treatment of patients suffering from severe, symptomatic aortic stenosis (AS) at high risk for or unable to undergo open-heart surgery & figured this was as good a place as any to post it.

 

www.edwards.com/ns20200608

 

Not egregiously cheap but not crazy expensive either.

 

They just did a 3:1 split so don't be fooled if a chart shows a big price swing over the past month.

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You could look back at what buffet owned in the early 80s. I recall there was some sort of metals company in his portfolio but it has been awhile.

 

SD there was inflation in the early 80s and there was high unemployment in the same period.

 

Not really. For the few skilled labourers (oil fields, coders, etc), there were multiple offers at higher wages - as there weren't enough of them.

However, there were just a great many MORE people, that lacked the required skills (structural unemployment) - and were out of work as a result. High inflation (that everyone pays for) and high unemployment (that the unskilled pay for) at the same time.

 

It was also a time when the more time it took to build a project, and the more it cost, the better off you were - as a replacement asset couldn't be built for anything close to the current historic cost. As long as the asset worked, it could be sold at a material gain - even if it was an utter POS. And many were!

 

SD

 

 

 

 

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Do you see inflation as a result of current Fed actions? Or future Fed/Treasury actions?

 

I would watch one of the many Lacy Hunt (Hoisington) videos on YouTube. He sees mild deflation in our near future. When debt bubbles go bad the result is deflation. He also says the Treasury, not the Fed, is the key (if we are to see inflation in the future). Fed actions (under current mandate) will not result in inflation.

 

Globally, we have too many workers. And too many plants (capacity). Too much retail space. This suggests deflation is in our future. The rapid move to technology is just getting started and is hitting every industry - and this is highly deflationary (need fewer people, offices).

 

So my guess is mild deflation is more likely in the coming years than inflation. Perhaps 1 or 2 percent. This will not be good for debt holders as the real total value of total debt will grow. So if you have a $400,000 mortgage and deflation is 1% then at the end of a year the real value of your mortgage is now $404,000. Deflation and debt bubbles would be terrible for the economy. This is likely why the Fed is so afraid of deflation getting established, even if it is mild.

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So if you have a $400,000 mortgage and deflation is 1% then at the end of a year the real value of your mortgage is now $404,000

 

True.  However... we have (in my wife's name) a $450,000 mortgage that was taken out early last year and already the rate is down a full 100 bps if we refinance now.

 

In other words, the lower interest payment offsets the deflation.  And that's actual cash flow versus the deflation occurring on paper.

 

 

 

 

 

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Do you see inflation as a result of current Fed actions? Or future Fed/Treasury actions?

 

Definitely tipped to inflation and solely because of the US Treasury because of its net spending -- which creates new private sector deposits.  The Fed controls the price of money but not the supply since it can only do asset swaps (Treasuries in exchange for bank reserves, for example).

 

Here's a long run chart of gold vs deficit-to-gdp ratios.  You can see that the price of gold is a measuring stick that is sensitive to currency debasement when deficits become large vs gdp.

 

Deficitvs-Gold.jpg

 

wabuffo

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It seems to me that the FED's 4bn per day QE is way bigger than the prior 3 QEs.

 

Narrator: "Its not"

 

Federal-Debt-Heldby-Fedvs-Federal-Debt-Heldby-Public.png

 

The Fed's share of total US Treasury Debt is not significantly higher than the past going all the way back to 1970.  There is no "monetization" going on. 

 

wabuffo

 

Is there a reason total US Treasury Debt is the correct denominator for this calculation? It seems to me that if the Fed buys a bunch of bonds and the Treasury puts that money in the economy, it isn't less inflationary because the Treasury borrows a bunch of extra money privately and spends that as well.

 

I could totally be missing something, but wouldn't something like money supply be a better denominator?

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It seems to me that if the Fed buys a bunch of bonds and the Treasury puts that money in the economy,

 

Congress expressly forbids the US Treasury from selling its debt directly to the Federal Reserve - it must always sell its debt to private markets.  The way it works is:

1) The US Treasury sells bills/bonds to the private sector.

2) The Federal Reserve as part of its monetary operations swaps bank reserves for Treasuries.

 

The argument you hear is that the Fed is increasingly "monetizing" the Treasury's debt by buying ever larger amounts. 

 

If debt monetization by the Fed was truly happening, I would expect to see the Fed's share percentage increasing -- but it isn't.  I think people just like to throw around big numbers without context. 

 

Now - one could argue about the size of current US Treasury spending.  But that is a separate issue and doesn't involve the Federal Reserve and its monetary operations/asset-based lending.

 

wabuffo

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^i disagree at the margin and sometimes that can make a huge difference.

 

The cash that the Fed "injects in the economy" when buying government bonds has not been inflationary because it ends back at the Fed as excess reserves. It's somewhat unclear why but there are regulatory reasons (capital rules etc), private participants don't seem to need more money for private constructive and productive endeavors and the Fed started paying big banks for excess reserves held at the Fed.

https://fred.stlouisfed.org/series/EXCSRESNS

https://fred.stlouisfed.org/series/IOER

 

If you look at the evolution of cash in circulation, multiple rounds of QE have had, so far, no direct noticeable effect on the evolution of the curve. As wabuffo says, fiscal authorities are in the driver's seat. However, since the 2007-9 systemic stress test, the slope of the curve has changed (forget what happened since march 2020 for a second). You would then expect either higher growth, higher inflation or both. In fact it's been the opposite(!): lower growth and lower inflation (as well as lower inflation expectations). "Against all odds", the Fed keeps referring to this conundrum while, from a humble perspective, it is a fairly typical scenario when leverage becomes an issue for the ordinary private participant. But the government can print money which may be a pyrrhic advantage.

https://fred.stlouisfed.org/series/WCURCIR

 

i suggest that a better denominator would be GDP. Fred graphs are sometimes slow to integrate recent numbers and this one is a good example. Recently, numbers have indeed been huge as the Fed has been absorbing (indirectly...) what the Treasury has been issuing. The % is now above 20%. What this shows is that the Fed (as the authority that sets the tone or as the coach) has accompanied the Treasury in its debt issue spree and has not (for such a long time) taken the punchbowl away. One could argue, in fact, to the contrary. i guess wabuffo says it's not within their narrow mandates to impose discipline.

https://fred.stlouisfed.org/series/HBFRGDQ188S

 

Still. Recently, i've been looking at Hertz and some posters here wished that public authorities or the bankruptcy judge could intervene to stop the crowd from buying worthless securities. The role of the bankruptcy judge is to apply the estate-value-maximizing rules and be an arbiter between competing interests (secured vs unsecured etc). It's not his or her job to fix the market if it is out of whack, at least if the information is freely flowing. As a judge, it would be possible, even if not a ruling, to include passages that send a message to society. He or she could say here that people should look into the fact that government measures actually sparked (April 2020) the largest monthly household income jump ever and one of the main factors behind the nonsense Chapter 11 share issue is having a large number of people with too much money in their pockets and too much time on their hands with the bonanza mentality.

 

An argument could be made that the US (Canada too etc) has entered the zone of insolvency. When this happens, the fiduciary duties to equity holders start to shift to creditors and one would expect, in a normally functioning market, pressures on the cash balance and higher financing rates. Looking at 2020 Q1 Financial Accounts, the Treasury borrowed $2.734 trillion (i guess soon we'll be talking real money). It did so (absolute and relative record amount by far and by any measures) at record low interest rates and significantly increased its cash balance. IMO, there is something strange going on and i've come to agree that the Fed (and other central banks) don't need to intervene. But they could.

 

For now, i wouldn't worry about inflation (quite the opposite) but matches should be stored in a safe place.

 

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Recently, numbers have indeed been huge as the Fed has been absorbing (indirectly...) what the Treasury has been issuing. The % is now above 20%.

 

It's not really above 20%.  One must net out the intra-governmental asset/liability accounts, IMHO.  It's like intra-company receivable/payable accounts between a holdco/opco structure.  (ie, the Fed is a 'subsidiary' of the US Treasury).  More importantly, both sit on the opposite side of the private sector.

 

As at June 10th, 2020,

....The Treasury owes the Fed $4.15t (because the Fed holds its debt - an asset of the Fed),

....but the Fed also owes the US Treasury $1.5t (because the Treasury has a large deposit in its account at the Fed - this is a liability of the Fed). 

 

In the good ol' days, one could ignore the US Treasury's deposit account which typically maxed out at $5B.  But today it sits at $1.5T (an expansion of 300X!). 

 

Here's an updated chart (vs the FRED chart that I posted that goes til Q3, 2019).  Still way below the historical average despite the Fed owning over $4t of Treasury debt.

Fed-Debt-vs-Tsy-Debt-2020.jpg

 

Again - my point isn't to dismiss what's going with the US Treasury's spending and debt issuance.  It's only to place the Fed properly in its context as a disinterested spectator rather than active participant.  In fact, the very large balance in the Treasury general account is causing havoc with the Fed's balance sheet and future bank reserve forecasts.

 

wabuffo

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So if you have a $400,000 mortgage and deflation is 1% then at the end of a year the real value of your mortgage is now $404,000

 

True.  However... we have (in my wife's name) a $450,000 mortgage that was taken out early last year and already the rate is down a full 100 bps if we refinance now.

 

In other words, the lower interest payment offsets the deflation.  And that's actual cash flow versus the deflation occurring on paper.

 

I thought you divorced last year.....

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Laacz at roughly a 10% cap rate which consist of mostly valuable Los Angeles and San Diego self storage facilities.  They own facilities in Houston, Vegas, and Arizona.  But the California assets are about 60-65% of the overall value.  If we get inflation, they can increase self storage rates on a quarterly or semi-annual basis.  If we get deflation, you bought it at 10% cap rate, they have only $45mm of debt on it.  So it is very safe.  Self storage facilities do not require much cap ex once they are built and running.  I can't imagine a better real asset that protects you in an inflationary environment and not suffer much in a deflationary environment.   

 

Multi-family apartments tend to do well in an inflationary environment. 

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...

Again - my point isn't to dismiss what's going with the US Treasury's spending and debt issuance.  It's only to place the Fed properly in its context as a disinterested spectator rather than active participant.  In fact, the very large balance in the Treasury general account is causing havoc with the Fed's balance sheet and future bank reserve forecasts.

wabuffo

"as a disinterested spectator"

Thanks for the real numbers; it's always helpful to complete the picture drawn by random and largely irrelevant history buff type of comments.

Paul Warburg, who was a quiet driving force behind the 1913 Federal Reserve formation used to support the real bills doctrine (open market operations of the Fed directed to productive use) and worried about the slippery slope leading to monetization. He also suggested to put the brakes on at times but he became irrelevant AND eventually despised when his contrarian opinion became too contrarian. There is little to gain from this line of discussion and will only add two additional items that the "disinterested spectator" quote triggered when i read your post.

1-Socrates was reported (he was not a writer; he was more into oral dialogues) to be a disinterested spectator when he was ordered to drink a deadly poison. i guess not everybody is so detached.

2-Recently, my three older children (all full-time students) submitted a plan for the oncoming summer: given various government programs, they were planning to carpe diem. I objected, giving rise to constructive tensions. They responded that i was no longer really productive anymore, to which i acquiesced AND that i should be a "disinterested spectator" (not exactly those words, but close) to which i offered some resistance. Their fifth amended plan involved finding a remunerative job and reversing engaged procedures to obtain free money. i may focus too much on governance issues.

 

@muscleman

Apologies for clogging your thread.

If you think inflation is coming, you should consider shorting long-term Bunds (they are still positive) but many buyers expect negative developments and don't intend to hold until maturity.

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I find it fascinating that every time we have a big crisis, people start worrying about inflation and deflation at the same time.  During normal times, people tend to use the recent rates.  The inflation/deflation debate was quite fierce in 2008/2009 as well. 

 

I am a little surprised that people are a lot more intellectually interested in papers and theory.  I have mentioned Laacz and levering up your own real estate assets.  If we do have significant inflation, owning multi-family will likely be a very good hedge that has a 30 year fixed rate mortgage on it.  For some reason people like to postulate about commodities, TIPs etc.  Aside from the early 2000s, when has commodities really made money for people?  It seems the base rate of success for commodities is pretty bad.  No research, but I have personally lost money everytime I touch commodities.  But people seem to make money owning real estate, especially in hard to build places.

 

It is weird that when people are handed very valid solutions to their problems, Laacz, they kind of ignore it and instead try to go on some sort of philosophical search.  It almost seems like the intellectual quest to understand inflation is more important than looking at a very solid and easy to execute solution.  Is it because it seems too easy? 

 

I have noticed this kind of indifference both on this message board and elsewhere.  It's puzzling to me. 

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I agree on LAACZ. Owning nice productive assets with little leverage run by a good operator should beat non-productive assets like Gold or Bitcoin over the long run, or at least offers a better risk adjusted return.

For a large cap investor PSA may offer a similar purpose (same asset class, low leverage and well managed) but it is not as cheap.

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I find it fascinating that every time we have a big crisis, people start worrying about inflation and deflation at the same time.  During normal times, people tend to use the recent rates.  The inflation/deflation debate was quite fierce in 2008/2009 as well. 

 

I am a little surprised that people are a lot more intellectually interested in papers and theory.  I have mentioned Laacz and levering up your own real estate assets.  If we do have significant inflation, owning multi-family will likely be a very good hedge that has a 30 year fixed rate mortgage on it.  For some reason people like to postulate about commodities, TIPs etc.  Aside from the early 2000s, when has commodities really made money for people?  It seems the base rate of success for commodities is pretty bad.  No research, but I have personally lost money everytime I touch commodities.  But people seem to make money owning real estate, especially in hard to build places.

 

It is weird that when people are handed very valid solutions to their problems, Laacz, they kind of ignore it and instead try to go on some sort of philosophical search.  It almost seems like the intellectual quest to understand inflation is more important than looking at a very solid and easy to execute solution.  Is it because it seems too easy? 

 

I have noticed this kind of indifference both on this message board and elsewhere.  It's puzzling to me.

 

I think it's the same reason why the short threads on here often outperform- something is simple and works, what else is there to say?

 

Something like the underlying causes of inflation/deflation is complex and fundamentally can't be proven. So it can be fodder for a never ending discussion. But buy decently located RE with reasonable leverage, let the tenants pay it off, end up rich, isn't very complicated, so there isnt much to discuss.

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