Inflation 2.0

Just two years ago, media had zero coverage of inflation as a topic of interest. Now, multiple stories appear every day about how inflation is affecting the global economy, consumers and business.  Recent events are even further accelerating the transition to an inflationary environment. 





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Transcript

Inflation 2.0
Season 1: Episode 7

 Welcome to the Real Spiel with Ryan and Kurt.  This is Ryan Katz with USCF Investments. And this is Kurt Nelson at Summer Haven. 

 KATZ:  Let’s get real about inflation.  Again.  We just spoke about this a few podcasts ago.  Things are changing pretty quick here.  Since we provided our last inflation update inflation is at 7.5% measured by CPI, went up to 7.9% and most recently now 8.5%.  Above what economists had surveyed for their forecasts. What’s going on here Kurt and what should investors be thinking about moving forward?  

 NELSON:   One of the first lessons is that inflation is very hard to predict.  We already knew this.  In 2011, 2010, we had this financial experiment called quantitative easing that the Fed and Treasury undertook to help save the US and global economy from the financial crisis.  And we printed a ton of dollar assets, printing of money, in the neighborhood of over the course of 4-5 years, printed maybe $4 trillion dollars or so.  And I think the foregone conclusion was this has to be expansionary.  If inflation is a monetary phenomenon, we are printing money, this has to cause inflation to go up.  And it didn’t.  And now what we’ve seen is an even faster printing of money through the response to Covid.  What the fiscal policy along with executive policy and Fed policy have been over the last two years, we’ve seen inflation actually go up dramatically higher than expectations.  I think that our ability to forecast that inflation will actually be low, or that inflation will be high is sort of broken.  I think to some degree, maybe, the best forecast for the weather fifteen minutes from now is the weather right now.  And so I think we have to get religion that inflation is very hard to forecast.  We have been told for several years that you don’t need to worry about inflation.  And then starting twelve months ago inflation starting going to go up.  The message was its transitory, ignore it, don’t pay attention to it, just drive by.  And in fact the Fed chair, Jay Powell himself said a few months ago we have to eliminate transitory from our vocabulary.  This is not transitory inflation, this is now just old school inflation.  So, I think what’s been quite dramatic Ryan just over the past few months is how quickly inflation continues to rise.  The other huge shock to the markets going back about six weeks was the Russian invasion of Ukraine.  And we already had an inflation print of 7.9% which is incredibly high, some of the highest we’ve seen in 40 years before the invasion, but this invasion has made things even more complicated across a wide swath of commodities whether its agricultural like wheat or corn or barley, fertilizer, in the metal space things like nickel and zinc and platinum that come out of Russia in high quantities each year.  And of course, the classic oil and gas story that they produce a lot of energy and the ability for Russia to deliver those energy commodities to the marketplace is really challenged right now.  So, it’s kind of hard to underestimate how much things have changed so quickly just in two months based on what we are seeing.  

 KATZ:  That’s really fascinating.  I mean CPI gets a lot of the headlines, the Consumer Price Index, but a lot of folks are not aware of or not making the headlines is the PPI or Producers Price Index.  Which at the same time CPI has gone to 8.5%, we just got a print of North of 11% of the Producers Price Index.  What does that mean and what can we expect?  

 NELSON:   So, we kind of think at SummerHaven that the leading indicator are commodity prices for inflation. The very first thing that happens is copper or corn or wheat prices go up.  And then that factors in over a period of time into producer prices.  So, the raw inputs that Kellogg’s or General Mills is using to make Wheaties or Corn Flakes that those higher prices factor into their cost of production.  So that’s the PPI.  And then after another period of time it eventually shows up into the CPI, the consumer price index.  So, this is what you actually have to pay for that box of Wheaties or that box of Corn Flakes when you go to the grocery store.  I think PPI is a leading indicator and I think it suggests that there is going to be continued high levels of inflation for some time.  There are a few other factors that we think here are supportive of inflation being higher for longer.  One of those is the wage labor situation in the US.  Wages are growing, whether its hourly or professional workers and we are seeing unemployment be at record lows.  We’ve probably also seen data that show how many job openings there are unfilled.  And the best way to hire that desired employee in a competitive market is to pay them more money. So, we are probably going to see higher wages for some period of time which gives consumers more money to spend.  Another factor that we think of as a tail wind that’s persistent for months or even more than a year is the high cost of real estate.  Real estate is not a factor in CPI but rent and rent equivalents are.  With the high price of home prices, as measured by Case Shiller, or the benchmarks, these broad-based market benchmarks are going up at levels that we haven’t seen maybe ever.  Going back 30, 40 or 50 years of data.  Real estate prices being elevated won’t show up in inflation but over a period of 12-18 months, that will factor into higher rent costs.  Whether you are renting an apartment in New York or renting a home in Connecticut.  Those inputs are a significant part of CPI and will be part of the Fed’s measured observation for how CPI is changing year over year.  In addition, we have this Russian invasion of Ukraine which has cast a really strange wild card into price discovery in many of these markets.  And it affects all of them, it affects metals, agriculture, energy, even markets that maybe are off the radar for many investors.  And I’ll highlight one Ryan that’s kind of interesting.  If you think about neon, and if I ask where is neon used?  When I was in college, I’d be like that’s the Budweiser sign in the bar.  But it’s not just neon lamps and neon lights.  I think if you tried to buy a car in the last two years you know there has been a microchip shortage because of Covid supply disruptions, etc.  When you make a microchip, whether it be in Taiwan or some of these amazingly advanced Southeast Asian facilities, you use a laser and you inscribe onto a chip of silicon the features the microchip needs.  But for the laser to inscribe onto that silicon wafer you have to be in an environment of neon gas.  That’s a noble gas.  So neon is used heavily in the microchip industry.  It sort of shocked me to discover that maybe 50-60% of the neon comes from Ukraine and that region of Europe.  So, we are worried about shortages of wheat right now, corn, shortages of nickel where we have seen market disruptions, it may be coming in zinc.  Shortages in copper, platinum palladium group metals and maybe the energy complex overall depending on how the global economy and Europe and the West will respond to Russia’s production of this and our interest in continuing to buy Russian oil and gas.  Even beyond that there are these other unintended consequences of the invasion which affect things like microchips for cars.  Because what we know, and we saw this during the Covid crisis, is that you can almost finish a $50,000 car but you are missing the microchip that can controls cruise control or climate control or power windows or GPS. And because you don’t have that $50 or $100 microchip from Taiwan, you can’t deliver your car to the consumer.  It creates a shortage.  So there are a number of things that I think will continue to drive inflation in unexpected ways.  And we are not seeing signs of them clearing in the near term.  

 KATZ:  Inflation can really only fundamentally be controlled by the Fed.  Have their expectations and communications recently changed?  How has the market reacted?

 NELSON:   So, I think those have changed and we’ve seen an initial reaction from the market.  I would say that six months ago you might have had half of the Fed governors hawkish and half of them dovish and looking for more support because we are still in the midst of Covid.  We had a big wave in New England and in the US in January of 2022 and there was a reluctance to withdraw support for the economy to hike rates.  I think what we’ve witnessed in the last three weeks or so is that almost universally the Fed governors are now becoming hawkish and they are saying we want to maintain full employment, we don’t want to hurt workers – people that are just now seeing some wage gains and some positive effects in their bottom line each month.  But we are going to have to hike rates.  We have to because we are behind.  We have inflation north of 8%.  The Fed, has only had one interest rate hike so far I believe, which is a quarter of a basis point.  If you look at 2-year, 5-year, 10-year Treasury rates, they are still significantly below 3% a year while inflation is now north of 8 and we don’t know where it will go.  I think the Fed has indicated that even more dovish members like Lael Brainard the vice chair has historically been not supportive of rate hikes, are all saying we have to do it and we have to do it more aggressively.  I also think we are going to see probably in the next 12-18 months is a number of 50 basis point hikes rather than 25 because there is this catch up the Fed has to do if they want to get their arms around inflation and try to reign it in.  The consequences of that will be significant.  We are seeing interest rates going up mortgage rates going up.  I think 30-year mortgage rates in the US are now above 5% for the first time in a long time.  But it feels to me like we are still in the early innings and I think this is going to continue to develop.  

 KATZ:  Yup and as it develops we are going to continue to update the inflation story as we go on.  Thank you for joining us. This has been the Real Spiel with Ryan and Kurt.  We will talk to you soon.