As the inflation debate continues to rage on, many market gurus like Paul Tudor Jones, Stanley Druckenmiller, and Bill Gross think the Fed is behind the curve. They point to supply constraints, exploding commodity prices, and extreme labor shortages as precursors to a new protracted inflation cycle. Paul Jones, whom I admire for his long-term macro track record, described the current economic climate as a certain kind of crazy, and made it clear that if the Fed doesn’t take a hawkish stance on inflation soon, he is going all-in on commodities.
We have a more tempered, or should I say short-term versus long-term, view. While we agree inflationary pressures are real, we think they may only last two to three years as they did during the last commodity super cycles of 2006-2008 and post-Great Recession. This is important because commodity investments look fairly priced under this scenario; unless you invested early in those other recent cycles, you missed the boat and witnessed your investments roll over and take out new lows as the cycle dissipated.
We feel a more accurate way to look at the economic landscape is to start the deflationary conversation. Current consumer demand is extremely abnormal. So much was constrained during the lockdown that we are now experiencing a sort of mania. A significant amount of pent-up demand is flooding the economy, whether in home furnishings, used cars, travel, or almost any other consumer durable or discretionary purchase. Underlying this consumer mania is unsustainable direct fiscal support.
In addition, corporations are taking advantage of this abnormal demand. They have pricing power not seen in decades, gross margins are exploding even in the face of increased input costs, all fueling a one-time profit surge. Add to that very easy year-over-year earnings comparisons, buybacks driven by robust cash flow, and record corporate debt issuance at historically low rates and, surprise, you have the highest Price-to-Earnings (PE) ratio multiples seen in years. A high PE ratio is always an indication of very robust future profit expectations so, case in point, we are pulling forward a significant amount of optimism.
Lurking behind the scenes of this surge-driven inflation is the strong potential for anti-growth policies, including increased regulation, higher individual, corporate, and capital gains tax rates, cost pressures from the transition to green energy, and the inevitable reduction in monetary and fiscal stimulus. While some of these measures may not materialize, the cumulative impact has to translate into slower growth in the out years. When combined with the tapering of pent-up demand, we have a recipe called malaise. We have seen it twice in the last 12 years, post-recovery, and it’s coming again.
The dilemma facing asset allocators then is, do you chase the inflation trade or start to prepare for the deflation trade? We think it’s a little bit of both and, more importantly, this is where diversification becomes the most critical component to portfolio success. Never has there been a time where broad portfolio construction is essential. That’s our focus, and having all the tools at your disposal is paramount. The cross currents are real and impactful, and with valuations at extremes, caution, diversification, and remaining disciplined will win the day.
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