What If Inflation goes to 6%?

[LearningMachine]

You and LongHaul are basically saying the same thing. He's specifically naming sectors while you are talking about lower demand in things that are financed. Well that mean weakness in housing, autos, investment and finance.

 
I said lower price for financed assets not necessarily lower demand.
 
Also, the difference is in timing:

1. 
   First, demand goes back to normal, while minimum wage goes up and stimulus money shows up in people's bank accounts. 
   This causes more dollars to chase limited goods. 
   ]That causes inflation to finally show up. 
   ]That causes market to raise longer-term interest rates, or Mr. Market starts to predict it, and starts raising longer-term interest rates earlier. 
   Fed continues to keep low Fed rate and continues to buy treasuries to try to lower longer-term interest rates.  That causes monetary supply to increase further.  I hear what some say that banks have to hold extra reserves as a result of Fed buying treasuries, but that doesn't stop banks from using those reserves to enable transactions at higher prices. 
   The rise in interest rates causes price of financed assets, i.e. stocks, CRE, etc. to go down, or Mr. Market starts to predict and some financed and effectively-internally-financed assets like stocks start to go down sooner.
   

Prices don't react to interest rates prices react to demand. Rates are the catalyst. So whenever you say lower price you say lower demand.

 

Are you saying you disagree with the numbered points above?  If so, which # do you disagree with so that I can understand your perspective better?

Specifically 5 and 6. If you see sustained inflationary pressure the FED WILL raise rates. In fact the higher LT yields represent an anticipation of this raise down the road. Higher rates of course affect prices of financed assets by influencing demand for them. Higher rates->Lower Demand->Lower prices.

 

An environment where you have 6% inflation without financed assets participating in that is frankly maybe possible in one iteration of a simulation but not one that is plausible.

 

Great, we are making progress in our mutual understanding :-).

 

So, you agree with points #1, #2, #3, and #4.  We don't have to debate them anymore.

 

For #5, sure, I can agree with you that FED might actually raise rates.

 

Regarding #6, looks like you are agreeing that "Higher rates of course affect prices of financed assets by influencing demand for them. Higher rates->Lower Demand->Lower prices".

 

So, looks like we are not too far off from each other here.

[LearningMachine]

- lots of debt is already higher than the fed rate. corporations are borrowing at 2/3-7% depending on credit quality. So inflation would have to start going up to a point where re-rolling future debt will be discounted at a higher rate and affect those asset prices. Plus the market would also assess the revenue side of the equation in valuations.

 

Scorpiancapital, are you agreeing that if treasuries start trading at 6%, and as a result new corporate/CRE debt has to be issued at +600 bps from today's rates, that it will impact financial asset prices, including stocks, CRE, etc.?

 

If cost of borrowing goes from 3% to 9% for a corporation, interest costs will triple.  At the same time, with 6% inflation, revenue would go up only about 6% assuming the company is able to pass the cost of inflation to consumers.

[maplevalue]

If inflation is at 6% for a sustained amount of time central banks will have to decide between

 

1. Keep low rates while letting inflation run at 5-10% for a few years to decrease the real value of debts while the general populace grumbles (much like Canadians have grumbled about higher real estate) but asset owners do well.

2. Raising rates in a meaningful fashion, leading to the collapse of the entire financial system and bankruptcy of the governments that appoint central bank chiefs.

 

My money would be on 1 being the more likely outcome.

[Viking]

Inflation hurting RE is one of the biggest widespread, false narratives I consistently see people peddling. It is my belief, especially in certain areas(Sunbelt) that we're entering a phase not unsimilar in parallels to the mid 2000's. It will also mirror the tech bubble part one(late 90s) and tech bubble part 2(2015-now) in terms of how it plays out. First go around was warranted excitement but also ahead of itself, second go around is all that but with fundamentals to support it, and let it run longer and larger. And during housing bubble part 1.....mortgages where 5-8%......

 

EDIT: to clarify, I wouldn't exactly want to be a highly levered owner of certain RE assets, especially with a lot of short/mid term maturities. But otherwise, most of the higher rates = RE is fucked narrative, is crap.

 

When i post on real estate you probably should stop reading. :-)

 

I think interest rates are very important; if they are driven by inflation expectations then i would expect higher inflation leading to higher interest rates leading to higher mortgage rates to matter (impact real estate  pricing). How much? It depends on the magnitude of the move in rates, the country and which segment you are talking: residential, office, commercial etc.

 

Talking residential, my read is the US has a long runway ahead for higher prices given the big correction in prices after 2008, current lack of supply (after under-building for years) and consumers who are not over levered. The market is poised for a multi year run. Crazy low interest rates will just turbo charge the ST gains. Higher rates will just result in a slower march higher.

 

Residential in Canada is in a very different situation. We had no big correction in prices post 2008 (just a dip), new supply has been coming on the market (Canada was not under building like the US) and consumers are the most levered they have ever been (by far). Especially the big cities like Vancouver and Toronto.

 

The pandemic is also another overlay. Single family homes in Canada are currently in VERY short supply (no one wants to move out of a house with space right now). At the same time there is massive demand as a massive amount of people are desperate to get out of their tiny accommodation and into a house (especially if they have small kids). And the gasoline on the fire the past year has been interest rates. In Canada the most used mortgage is the 5 year fixed rate (with an much amortization of 25 years or longer). People were able to get 5 years mortgage rates as low as 1.5%; i think they are around 2% today. So we have historically low supply, historically high demand and historically low interest rates. I think it is having an impact of housing prices (‘hottest housing market ever’ was a recent headline). Where i live (suburban Vancouver) prices are going up right now about 10% per month.

 

Would a 1.5 or 2% mortgage rate result in a sudden spike higher for single family homes in the US? My guess is yes. (Now i know the mortgage market is different in the US but just image if a 2% mortgage rate was possible and normal).

 

Now what happens when, post covid, the economic recovery takes hold and inflation starts to tick higher and bond yields/mortgage rates start to normalize/increase to the average of the past 5 years? For residential real estate in the US i would expect price increases to slow or perhaps go side ways. For residential real estate in Canada (in the urban centres) i would expect a correction in prices (remember my opening line). Especially if, post covid, supply spikes (people want to cash out) and demand slows (people decide they no longer need to move into a bigger space). Crazy times here in Vancouver.

[COBFInfinity]

I can't believe anyone still subscribes to the Milton Friedman philosophy on inflation. There hasn't been a useful relationship between M2 and CPI in decades, so why would it start now? Seems pretty reasonable that there will be some inflationary pressures as the economy fully re-opens, but to project that as a new long-term trend seems a bit premature.

[scorpioncapital]

People maybe don't see that the manipulated market is a symptom of a kind of controlled communism - yes even in the West. It would not be possible to suppress rates like this without a kind of taking over the most important cost in capitalism - the interest rate and many aspects of a free market. Check out this interview with Jim Grant -

 

Regarding the point about debt costs going up for corporations, yes it's bad for indebted companies with no pricing power. But for superior companies it's just a 'frameshift'. However higher rates will be a headwind even for them because generally making money more expensive closes the pocket books. And while the manipulation and low rates are the first phase, the second phase, the inevitable tightening is also certain. But this may take a decade+ to play out. For those who believed in money and savings it does feel like a rude awakening what is going on. They are being forced to take risks and cannot get a safe return without taking risks. It seems the modern age has adopted the philosophy of do whatever you can do not run out of money before you die and hopefully run out of of road only after, and with the government taking a large chunk of it from your inheritors.

[LongHaul]

Demand for housing can tank quickly if inflation spikes and interest rates spike - In the early 80's builders were sending 2x4's to Volcker because demand for housing was very weak with

very high interest rates.

https://tradingeconomics.com/united-states/housing-starts

 

Essentially heavily financed good - housing, cars, etc can see a very big drop in demand if interest rates spike.

 

Great Grant Interview.  Thanks for posting.

[ERICOPOLY]

Seems pretty reasonable that there will be some inflationary pressures as the economy fully re-opens, but to project that as a new long-term trend seems a bit premature.

 

Right.  I don't get it.  We didn't have 6% inflation before covid, so what has changed?

[maplevalue]

Seems pretty reasonable that there will be some inflationary pressures as the economy fully re-opens, but to project that as a new long-term trend seems a bit premature.

 

Right.  I don't get it.  We didn't have 6% inflation before covid, so what has changed?

 

What has clearly changed is the attitude of governments, and the general population, towards running large budget deficits. To take the example of Canada, the Federal Government ran a $400bn deficit in 2020 (16% of GDP vs. 4% in 2009), and has not produced a budget in two years. This government now has a ~50% of winning a majority this spring (if an election is called), and there is very little appetite for austerity.

 

One of the 'classic' causes of inflation is the government printing money since desired spending > taxes. The political dynamics around deficit spending ('build back better') are likely to be very different post-lockdown vs. post GFC so the low inflation experience of the 2010's is unlikely to be repeated.

 

Deficit source: https://tradingeconomics.com/canada/government-budget

[Cigarbutt]

Seems pretty reasonable that there will be some inflationary pressures as the economy fully re-opens, but to project that as a new long-term trend seems a bit premature.

Right.  I don't get it.  We didn't have 6% inflation before covid, so what has changed?

What has clearly changed is the attitude of governments, and the general population, towards running large budget deficits. To take the example of Canada, the Federal Government ran a $400bn deficit in 2020 (16% of GDP vs. 4% in 2009), and has not produced a budget in two years. This government now has a ~50% of winning a majority this spring (if an election is called), and there is very little appetite for austerity.

One of the 'classic' causes of inflation is the government printing money since desired spending > taxes. The political dynamics around deficit spending ('build back better') are likely to be very different post-lockdown vs. post GFC so the low inflation experience of the 2010's is unlikely to be repeated.

Deficit source: https://tradingeconomics.com/canada/government-budget

As far as attitudes and sentiment, we may have entered the reflated roaring 2020s. In Japan (potential leading indicator), in the last 20 years or so, the consensus view is that inflation is coming (there is still some disagreement on timing).

The sky is the limit?

Inflation is coming? (the 2013 'spike' happened as a result of sales tax)

The last reading for Japan (Jan 2021 YOY): -0.6%.

If the idea is to wait for inflation to reach 6% before going through fundamental reforms, this may shape up to be an amazing ride.

 

[ERICOPOLY]

Seems pretty reasonable that there will be some inflationary pressures as the economy fully re-opens, but to project that as a new long-term trend seems a bit premature.

 

Right.  I don't get it.  We didn't have 6% inflation before covid, so what has changed?

 

What has clearly changed is the attitude of governments, and the general population, towards running large budget deficits.

 

During pandemics or GFCs, yes.

[widenthemoat]

Gave this article a quick read and the similarities are alarming. I have no idea when or if it will happen, but inflation is unpredictable and the consequences are severe.

 

https://www.investopedia.com/articles/economics/09/1970s-great-inflation.asp

[Krapdivad]

What kind of companies would you say would benefit from an interest rate increase?

 

Howard Marks writes in his latest memo:

“Because the primary risk lies in the possibility of rising inflation and the higher interest rates that would bring, I think portfolios have to make allowances: even though we can’t predict, we should prepare. This possibility means (a) bonds with maturities much above ten years are obvious candidates for underweighting and (b) inflation beneficiaries should be considered for overweighting, including floating-rate debt, real estate capable of seeing rent increases, and the stocks of companies with the power to pass on price increases and/or the potential for rapid earnings growth.”

[thowed]

companies with the power to pass on price increases and/or the potential for rapid earnings growth.”

 

Any thoughts on this?  My starting point would be Consumer goods companies e.g. Mondelez, Unilever etc. for price increases.

 

I'm sure Buffett says something about this in his 70s feature on inflation - will have to dig it out.

[maplevalue]

What kind of companies would you say would benefit from an interest rate increase?

 

One obvious one is banks/insurers.

 

The KBW Bank Index only recently exceeded its pre-GFC high (chart below https://finance.yahoo.com/quote/%5Ebkx/)

[wabuffo]

what if rates fall even as inflation hits 6%?  What's the playbook say then?

 

wabuffo

[Spekulatius]

what if rates fall even as inflation hits 6%?  What's the playbook say then?

 

wabuffo

 

[LearningMachine]

What kind of companies would you say would benefit from an interest rate increase?

 

One obvious one is banks/insurers.

 

The KBW Bank Index only recently exceeded its pre-GFC high (chart below https://finance.yahoo.com/quote/%5Ebkx/)

 

Not all banks are equal.  Some have exposure to low-FICO customers, CRE debt, long-term bonds, etc.

 

I'd recommend listening to BAC earnings calls.  Almost looks like Brian Moynihan has been getting trained by the GOAT over years.  Sometimes, both Moynihan and GOAT let little anecdotes slip through of them talking with each other. 

 

BAC is soaking in the money supply, while keeping it with Fed or short-term govt guaranteed securities, while waiting to deploy in higher interest rate environment.

 

Because your equity in bank is leveraged about 10x, its wise to go with highest quality as little mistakes can make 10x the impact, and so can some wise decisions.

[LearningMachine]

Things that are scarce that are necessary for people or almost necessary for people, and can cashflow at higher prices.  Even better if you can buy it in today's dollars and pay back in deflated dollars in the future, while locking in low long-term rates.  Ability to lock in long-term rates is key - a lot of companies either don't have that ability or don't care enough about shareholders to use that ability because they would rather show higher income now and hide the risk under the rug.  Price you pay matters too!

 

Companies holding such scarce things.  Even better if they have price-insensitive customers where they don't have to have a praying session before increasing prices by a cent, and where they have the ability to lock in long-term debt at low rates.

 

Just do the analysis assuming what would happen to the company if inflation hit 10%. 

 

No matter what anyone says, don't miss doing the analysis what would happen to the company if interest rates also hit 10%.  You want to be covered for that risk even if some say it is low risk or will never happen.  It is your money.  Vast majority of companies will fail this test.

 

Also, look at what went up in 1970s to consider.  Also, figure out why they went up in 1970s.  Same things may not go up this time - also matters what entity that thing is held in this time.

 

Also, consider that impact of 10% inflation in higher earnings will show over years & decades, while impact of 10% interest rates will show immediately, creating buying opportunities.

 

So, have cash ready to pounce like 1974 if it happens again this time because you will find that vast majority of companies won't meet the bar above currently.  They are probably still good businesses but have to priced fairly much lower in 10% interest rate and/or 10% inflation rate environment.

 

[CorpRaider]

If you told me you would wipe over half a million people off the population balance, I would think it would be deflationary, but I guess most of those people were economically productive.

[TwoCitiesCapital]

If you told me you would wipe over half a million people off the population balance, I would think it would be deflationary, but I guess most of those people were economically productive.

 

Nothing trillions in direct payments can't fix- at least temporarily

[ERICOPOLY]

If you told me you would wipe over half a million people off the population balance, I would think it would be deflationary, but I guess most of those people were economically productive.

 

I'm sort of curious about that effect.  If Grandma dies of covid-19 her house is sold and her heirs remodel their kitchens, spending more money in a short period than Grandma would have.

[CorpRaider]

Yeah, good points.  Maybe it also drops the future healthcare cost/drag on productivity.