Inflation: The elephant in the room?

Inflation and how persistent it is, now fascinates us although we will skip how that relates to US bond yields, as that currently makes no sense. We’re also pondering the recent high performance from non-US markets.

We signaled inflation as a forthcoming problem well over a year ago, and slightly oddly not for either of the two reasons now cited so often. The received wisdom, that it is all about freight rates and used car prices, identifies specific issues we had not spotted.

Freight and used cars – really?

The freight issue seems to be a jumble of factors, dominated by having the ‘wrong’ demand structure, so in any movement of goods (or people), one way traffic is also the worst, if you can get the return route paid for by someone else, you will always halve the cost. Hence the obsession on most mass transport with return tickets. Sudden demand shifts destroy that balanced economy. But clearly there is more to it, so poor port capacity, extra flows created (or existing flows destroyed) by COVID all matter, all that PPE displaced other goods, while grounding airlines eliminated vast amounts of high value hold space.

But all of that, the natural creation of new capacity (that is making more containers), or simply activating more shipping from lay ups, will create new supply, and we therefore recognize that whole process as a fairly short-term spike.

As for used cars, well, I can see from the congested roads that no one is using public transport, but with global over capacity, how long will that surge in demand for cars last? In general shutting car plants due to excess capacity still remains the trend. While flaws in the too tight “just in time” schedules have been apparent for a while, not helped by almost bespoke production, but that too is all probably transient.

After all, a hire car can be any colour, as long as it is black.

So, what did worry us about inflation? Capacity and competition remain the two drivers.

It was capacity, as either the number of viable business units has to decrease, if the costs per unit increase, or the price per unit sale must rise, hence inflation. This is obvious to most, although it seems not to many Central Banks. For a while any business will, it is true, keep going, even if only generating a marginal contribution, but soon it must either cease trading or lift prices. Companies just don’t sit about making losses, in the real economy.

The other part is competition, as the number of operators in a market decrease, the survivors gain greater pricing power to raise prices, while no one builds any new capacity simply to suffer losses. You can easily see these two dynamics play out in the coffee shop sector (or indeed with wine bars and public houses). COVID eliminates 50% of the capacity, by enforced social distancing. Takings must then also fall by 50%. You can prop that business up by furlough, or tax cuts, or eviction bans, but sooner or later the owner will conclude that in a fixed physical space, a 50% revenue cut just can’t work.

With operators in both those sectors and indeed many others deciding they have had enough and don’t want to face mounting debts, the capacity is then lost and the incentive to replace it is weak, so competition inevitably drops.

Looking back at the hire car sector for a moment

We are told it is price inflation caused by a temporary shortage of cars, but that sector famously is full of border line survivors, the margins are wafer thin and often come down to the residual fleet value. Several big firms have also dropped out through insolvency; of the rest many only ever survived on the twin props of residual fleet value and extended manufacturer credit.

Do you think high secondhand values are making them expand their fleets? Not that plausible. More likely they are cashing in. Nor do auto makers need to restock them on vastly extended credit terms, just to keep their own production lines running. New car sales to the sector are always at low margin to bulk buyers. So that’s not likely either.

We think it is quite possibly inflation from capacity cuts and weak competition, and that is nothing like as transitory. That is far more durable, not a brief supply side spike. Turnover is vanity, profit is sanity, as industrialists say.

In short Powell et al want to see no inflation, want to tell their political masters it is all fine, that they can keep running the engine hot, but having skimped on the engine oil, it seems rather more likely that running hot will simply seize the engine. At which point they must either coast to the hard shoulder or apply the handbrake of interest rate rises, before the economy blows a gasket.

 

Currency and the momentum model.

The other note of interest to us is that non-US markets are starting to flash up on momentum boards as exceeding US returns over some time periods, in particular in GBP comparatives.

In dollar terms the momentum is in the S&P 500 and NASDAQ. However, in sterling terms it is moving. We have noticed Europe shifting ahead for a while, but we were surprised to see our GBP momentum model now drawing our attention to Latin America.

From this source – rearranged for ease of reading

Now a lot of these models (ours included) are very sensitive to the recent past (that is the momentum we care about, after all) and that means there are big moves to fall in or out of the sequence, so care is needed. But despite the headline turbulence and distress in the Latin American continent, it has forces in its favour; the index is dominated by big mining operations, closely followed by oil companies, then banks, which are seeing rates rise sooner than in the rest of the world, and then (often Mexican) consumer goods.

They will find the weaker US dollar helpful in some sectors too, but will especially enjoy the vast demand surge (and short supply line to) the US. So, all in an index with some good reasons for outperformance, despite the political noise.

Is Sajid now a factor to note? Rapid reopening will probably also continue.

Talking of politics, I don’t see the renewed ban on French holidays (or rather the absurd elongated quarantine on return, regardless of vaccine status), as anything to do with COVID. Rather it is a shock coming from the always unstable Tory politics, where the return of Sajid has created the first node of a genuine “not Boris” grouping, as a minister now too valuable to be left out in the cold.

Boris can’t bully him twice, without a major loss of face, so some of the other pretenders to the leadership want to take him down, by sabotage to his policy of an overdue full and proper re-opening.

Shapps, who dreamt up the absurd new ban, it seems wants to usurp the health portfolio, and apparently feels put out at being left in a dull and dangerous ministry, hence his attempt to claim territory and undermine a cabinet foe. However, I think his manoeuvre makes little difference to the overall thrust of government policy on rapid reopening.

We also note, that at long last the destructive and stupid attack on UK banks, by enforcing a dividend ban, when they were awash with cash, simply out of political spite, has been ditched. I suspect it is too late to reverse long term damage to the sector, but even if a year late, common sense is welcome, as is evidence that the colossal 2020 state seizure of power, is at last being pushed back, at a few points.

Last April/May I was writing about these kinds of issues, now sitting in this book, if the more regular amongst my readers would like to take a look – one of the measures has to be consistency of approach, after all.  The second volume is under preparation.

Finally, we too will take a summer break, returning to this just before the August Bank Holiday, as summer draws to a close.

We wish you an enjoyable break and a well-earned rest from what has been a crazy year.

Charles Gillams

Monogram Capital Management Ltd

18.07.21