Inflation, not Recession, the Big Risk for Investors
Some US homebuilders’ share prices are down more than 50% this year. A large cohort of the global auto sector is trading at 6 to 8 times earnings. These sectors are highly sensitive to economic growth — cyclical rather than defensive in the industry lingo — so the share price movements tell you the market thinks there is a US recession coming.
It’s a situation that presents something of a conundrum for investors. History suggests you make your money paying high multiples of low earnings in cyclical industries, not low multiples of high earnings like we are seeing now. But, while markets seem to be pricing it as a fact, I’m not sure there is a recession around the corner, particularly in the US.
In any case, the world’s financial markets might have a far bigger issue to deal with than a potential recession.
Inflation finally starts to show
At a recent equities conference in Germany, Gareth Brown and I watched more than 30 company presentations. In previous years, every presentation contained a slide on electric vehicles and artificial intelligence. Even a boring office property trust managed to throw AI into the mix. This year, the theme was much simpler.Across a wide range of industries, managers were talking about cost pressures and price rises. Commodity prices and input costs are up. Labour is hard to find and asking for pay rises. And companies are increasing prices for the first time in decades.
Many of these companies are integral parts of the global supply chain. Krones AG sells bottling systems to consumer goods companies the world over (it estimates a market share in excess of 30%). Steel prices are up. Oil-linked plastic prices are up and wages across the company will rise more than 3% this year. At the conference, the company announced they will raise their own prices more than 4%.
Long time coming, long time going
Have we reached an inflection point? Is all of that cheap money and quantitative easing finally turning up in consumer inflation?
It wouldn’t be the first time inflation has been mysteriously absent for a long period of time. In an August version of Grant’s Interest Rate Observer, monetary historian and perennial gold bug Jim Grant talked about the missing inflation of the 1960s:
“It’s worth remembering that the great inflation seemed to come out of nowhere. From 1959 through mid-1965, the CPI showed an annual rate of rise no greater than 1.7% … the Keynesian fine tuners could seem to do no wrong”.
“By the late 1960s, the CPI was increasing by 5.5%. A decade’s worth of anti-inflation bromides and ineffectual monetary policy produced a measured rise of consumer prices — this was 1980 — of 13.6%.
“Maybe it can’t happen again in just that way. But is there no meaningful risk today that 10 years of monetary activism, now paired with hugely pro-cyclical fiscal policy, might tilt the inflation rate higher?”
When it finally turned up, inflation proved stubbornly difficult to erase.
Assets priced for a low rate world
From Australian residential housing to commercial property, long term bonds and equity markets, assets are priced as if low interest rates are here forever. How else do you justify a 4% cap rate on a Sydney office property (that’s before depreciation, remember)?
My university training in economics certainly didn’t give me any insight into the consequences of a long period of quantitative easing. I’m not sure those with a lot more training are any better off.
But inflation, and consequentially higher interest rates, are surely one potential scenario for which the anecdotal evidence seems to be mounting. And this, far more than a recession, is the one big risk for financial markets.
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Steve began Forager Funds in 2009, and now manages approximately $470m across two funds. Offering a listed Australian Shares Fund (FOR) and an unlisted International Shares Fund, Steve focuses on long-term investing in undervalued companies.