Everything You Need To Know About Central Bank Digital Currencies

In almost any iteration, CBDCs could completely revamp the global financial system as we know it. They have the potential to change the face of finance, and ultimately, change the nature of money itself. Through CBDC’s, fiat money will become truly digitalised and finalise the merger between monetary and fiscal policy.

The development and implementation of digital government money is not necessarily a trend or development one might trade, but rather represents what could be the biggest change to how the financial system is constructed and operates, and is a development everyone must be aware of and would do well to educate themselves on. Should Central Bank Digital Currencies be developed and introduced in a certain permutation, then what money and currency actually are will be reinvented.

Everything from how credit is created, the role of central banks and governments in society, monetary and fiscal policy transmission mechanisms, how the banking system operates, how transactions are processed, the very nature of money itself and how it works, all these things have the potential to be redefined and reengineered entirely.

The problem is however, with these significant changes come even more significant implications. Brought on by temptation, necessity, wealth inequality and rise of populism, Central Bank Digital Currencies “might open a Pandora’s box of unintended consequences, fiscal as well as monetary, overwhelming our would-be masters of money.”

What are Central Bank Digital Currencies?

In their most powerful iteration, Central Bank Digital Currencies will allow individuals, businesses and almost everyone in the private sector to have a digital wallet or bank account directly with their central bank. This in itself is significant, as within our existing financial system it is only commercial banks who are able to account directly with central banks in the form of central bank reserves. In the United States, it is though this channel the Federal Reserve conducts its quantitative easing (QE); they purchase assets from the commercial banks in exchange for central bank reserves.

Without going too much into the dynamic of how QE works, it is via the commercial banking system where true money creation occurs for the real economy. Allowing individuals to have a direct CBDC account with the Fed would allow the central bank to stimulate and interact directly with the individuals, something that cannot be achieved in the present system.

This direct interaction with individuals is being purported as one of the main reasons behind the development of CBDCs. The bypassing of the commercial banking system offers policy makers a completely new toolkit in how they are able to conduct monetary policy. No longer will central bankers’ stimulative measures be constrained by the wills of commercial banks and private sector credit creation.

Rather than relying on bank profitability, regulation and demand for credit to influence the money supply in the real economy, the Fed would be able to inject liquidity directly to individual consumers and businesses themselves. Such a form of a Central Bank Digital Currency would truly transition the central banks from the lenders of last resort to the spenders of last (or first) resort. With such a potentially powerful tool comes great responsibility and equally great consequences, as I will endeavor to detail below.

Almost every central bank in the world has, at the very least, begun preliminary research into the development of their own form of government digital currency.

Source: EY - Tokenization of Assets
Source: EY – Tokenization of Assets

The fact that CBDCs are gaining prominence and entering developmental stages throughout the world at a time where traditional (and “emergency”) monetary policy tools among most developed nations are nearing their usefulness, along with the move of many nations, particularly the United States, to a program of fiscal dominance, Modern Monetary Theory (MMT) coupled with the rise of populism should come as no surprise.

Policy makers have made it clear their intentions are to support asset prices and attempt to generate economic growth at any cost, as they simply cannot afford not too; CBDCs and their inevitability appear to be the culmination of these trends. Debt, demographics and disinflation have put central bankers in a position where they will do anything and everything to avoid Japanification. Central Bank Digital Currencies are the next step down this path of monetary and economic intervention.

Types of CBDCs and how they work

Without going too deep into the potential technologies and infrastructure behind the Central Bank Digital Currencies being in development, it is important to have an understanding of how the various iterations of CBDCs will work and what form they may take. There are numerous different forms of CBDCs being developed, and as such, within this section I will attempt to best summarise these different proposals, along with the potential uses and utility of each.

Retail vs. wholesale

Firstly, CBDCs will either be in a retail or wholesale form. A retail CBDC would be designed for use by the wider population and consumers themselves. This would allow central banks the tools to directly interact with consumers, and thus provide policy makers the greatest amount of stimulative or restrictive measures and data gathering capabilities. A retail iteration of a CBDC represents the most significant change to the monetary system of today and it is through this iteration that money itself will be completely redefined.

A wholesale CBDC on the other hand would be introduced for use within the commercial bank interbank market and other selected institutional and shadow-bank participants. The goal of a wholesale CBDC would be to increase the efficiency and ease of transaction within these wholesale markets. However, compared to a retail CBDC where direct interaction with consumers provides the mechanisms of stimulus and intervention the central banks truly desire, the benefits of a wholesale CBDC do not appear overly significant.

Indeed, from a payments infrastructure perspective in the United States, “there appears to be no need for a CBDC in wholesale payments in the United States”, as the existing wholesale payments infrastructure allows efficient wholesale transactions to be processed with “infinitesimal operational costs and zero demands for collateral or liquidity”.

Direct vs. indirect

A direct model represents the likely iteration of a retail CBDC described above. A direct model would allow consumers to have a direct relationship with their central bank, who would then need to provide many, if not all, the banking and payment services whose responsibility currently falls to the commercial banking system.

For a CBDC to have any meaningful stimulative ability by central bankers, a direct model would be required as this would eliminate the need for intermediaries in the money creation process. Simply, a direct model would allow consumers to have a bank account directly with the Fed, in which they hold their Central Bank Digital Currencies. The central bank would then have complete autonomy over every CBDC held by the private sector within their CBDC account.

There are both significant benefits and consequences associated with a direct iteration of a CBDC. Most notably and meaningful is the role of commercial banks in a world of direct central bank money. Such an environment would completely alter the responsibilities and requirements of the central banks as well as the commercial banks.

Whilst costly for central banks and significant in scope, some permutations of CBDCs could result in the central bank completely intermediating the commercial banking system and taking complete control over the roles and responsibilities commercial banks provide. Everything from banking to lending. This is a significant development in which I go into further detail later.

An indirect (or two-tier model) of a CBDC would allow consumers to hold their CBDCs directly with a commercial bank, similar to how deposits are used today, with the commercial banks continuing to act as the intermediary between the central bank and consumers. The commercial banks would be required and obliged to provide the CBDC to consumers on demand, of which the commercial banks themselves will hold on reserve with the central banks. This is similar to how central bank reserves work today, and may not necessarily be a meaningful change to the financial plumbing currently in place.

Indeed, the central bankers utility of the two-tier model largely depends on the restrictions and regulations commercial banks are offered in relation to their ability to use their CBDC reserves. Whilst this model would remove the central banks from the significant operational requirements of a direct CDBC model, if the goal of a CBDC is to allow central banks to bypass the commercial banking sector and provide direct stimulus, a two-tier model may not necessarily provide any meaningful additions to how central banks can stimulate.

Token-based vs. account-based

A token-based CBDC would be akin to digital cash in a similar manner to the currencies of today, the difference being cash would be completely digital and a physical alternative redundant. A token-based CBDC would make all units of the CBDC fungible and would be a bearer instrument, fully transactable by the holder.

An account-based CBDC differs on the other hand, as it is through this version of a CBDC whereby the policy maker’s toolkit becomes immense. In an account-based CBDC system, ownership of a CBDC is demonstrated through ownership of an individual account that holds the CBDC. One would demonstrate ownership of a CBDC account and all of the currency within. The individual CBDCs themselves would not be fungible nor would they be a bearer instrument.

An account-based form of a CBDC is perhaps better categorised as an identity-based form of money. One’s identity would be imbed in their CBDC account, and thus their identify embedded within their money itself. By embedding ones identify within ones currency, an account-based or identify-based CBDC could be manipulated for both good and bad based on the individuals status in society or their spending habits as a means to implement monetary “stimulus”.

Associating an individual’s money with their identity is one of the most important and impactful considerations associated with Central Bank Digital Currencies; herein lies the association with money as digital surveillance and the dangerous path this can ultimately lead for society as a whole.

Infrastructure: Distributed ledger technology vs. existing banking technology

Whilst a CBDC could be introduced via the existing banking infrastructure or via distributed ledger technology, the use of either type of technological infrastructure will not likely have any meaningful impact on how a CBDC functions. Whilst discussions around CBDCs have generally associated them with distributed ledger and blockchain technology, there are variations of CBDCs that could be built using conventional centralised transaction technology.

Indeed, though true digital currencies of today (i.e. cryptocurrencies) are synonymously associated with decentralised distributed ledger technology, a CBDC utilising a centralised database would still be effectively digital, whilst retaining similar characteristics to today’s monetary payment systems. Distributed ledger technology on the other hand would be costly and difficult to operate for a CBDC to be used in a direct, retail iteration.

Will CBDCs be interest-bearing?

Whether a CBDC is interest bearing or not interest bearing is one of the most important considerations governments must decide upon developing their digital currency. The introduction of an interest bearing CBDC completely changes the fundamental nature of money itself. Whilst bank deposits and financial assets house the majority of the world’s currency, the distinguishing feature of money today lies in the fact that physical cash itself is a non-interest bearing instrument and has no associated interest rate.

The introduction of an account-based, direct, and interest bearing CBDC to replace digital cash would be a policy makers dream; opening the floodgates of liquidity and monetary intervention unlike anything we have yet seen. For example, if the central banker’s econometric models are telling them a negative 3% interest rate will stimulate the economy, an interest bearing CBDC would allow direct implementation of such monetary policy measures, instantly and selectively.

Such levels of direct stimulus are simply impossible today so long as the commercial banking system intermediates monetary policy and the real economy. The ability for central banks to attach an interest rate to a CBDC has significant ramifications for not only the functionality of monetary policy, but the way consumers and individuals view their currency. Such consequences are discussed in further detail in the following sections.

Regardless of the specific technology, infrastructure and type of CBDC ultimately introduced by central banks worldwide, it is important to understand that, at the end of the day, CBDCs are programmable money whereby the terms and conditions of that money are controlled by policy makers as a means to conduct monetary policy in a way that is simply impossible today.

Why Do We Need CBDCs?

As I have touched on above, there are a variety of reasons why Central Bank Digital Currencies are in development, most of which lies in the added power and broader range of monetary policy tools CBDCs would provide central bankers and policy makers.

In a world of interest bearing CBDCs, herein lies perhaps the greatest tool for the ever increasing manipulation and intervention in the economy. As with all stimulative measures available to policy makers, there will be both benefits and consequences. By directly controlling the interest rates of a CBDC, central bankers could charge different interest rates on their CBDC deposits to different people. This is where an account-based or identity-based CBDC becomes a powerful tool for central bankers.

By assessing the historic spending and savings habits of individuals and corporations, policy makers could offer a lower rate of interest or an outright negative rate of interest to whomever historically has saved more than they have spent, in the hope this will encourage consumption and generate economic growth. Political agenda could become the foremost determinant of interest rates and stimulus, along with ESG and populist considerations.

Indeed, as a means to counter the demographic problem facing the developed world, an interest bearing CBDC could be used by paying higher rates of interest to younger savers and lower rates of interest to wealthy retirees. This effectively becomes a tax for those who have been less inclined to spend and opens up a vast array of consequences.

An interest bearing and identify-based CBDC would indeed allow central bankers to target different outcomes for different people. What’s more, it is not just via interest rates a CBDC could undertake such targeted monetary policy measures. A direct CBDC allows policy makers to conduct true money printing. For businesses who have generally struggled to access credit in times of crisis as bank lending standards soar, the central bank could simply inject additional units of their CBDC directly into the business’s CBDC account.

This is direct stimulus in its truest form; afforded only by the introduced of CBDCs. In an economy where the structural drivers of growth such as demographics remain unfavourable and thus driving the disinflationary trends we have succumb to over the past 40 years, the types of stimulus offered by CBDCs will be far too tempting to ignore. As we issue more and more debt to try and stimulate, the productivity of debt and velocity of money remain at their lowest levels in over 70 years, central bankers are attempting to do whatever it takes to change this dynamic. To think they will not at the very least trial CBDCs seems folly, even in the more democratic countries like the United States.

Source: Hoisington Investment Management
Source: Hoisington Investment Management

A digital government money affords policy makers even more stimulus tools beyond just those mentioned above, however. Indeed, an extreme case could see expiration dates on people’s holdings of CBDCs as a means to encourage spending. CBDCs give policy makers and central banks the power to wipe out your savings. This is a powerful and scary tool.

Direct stimulus allows policy makers and central bankers the ability to conduct their policy decisions as a means to effect human behaviour and economic decision making in a way that traditional monetary and fiscal policies cannot.

Implications & Consequences Of CBDCs

What has become clear to me through my research on Central Bank Digital Currencies is how the negative implications of their introduction are more than likely to outweigh their benefits. From changing the nature of money itself, the potential for the direct injection of unlimited liquidity, to how a CBDC would impact the banking system, the implications for the dollar’s status as the global reserve currency, to the privacy concerns and the potential for abuse of power, the consequences of adopting CBDCs could be broad in scope and severe in nature.

As I have discussed, CBDCs provide policy makers with unprecedented tools for monetary intervention and economic influence to a point far beyond the monetary and fiscal tools of today. Whilst the now normal “unconventional” monetary policy we are seeing today has undoubtedly influenced asset prices via monetary debasement, CBDCs have the potential to create truly sustainable consumer price inflation. In doing so, central bankers would be altering the level of market functionality traditionally offered by a capitalist economy, all the while muting price signals for market participants entirely. Further inefficiencies, zombie corporations and lack to economic destruction would undoubtedly continue.

Whilst the benefits of a digital government money appear tempting at first glance, in reality, these purported benefits are likely illusory, and vastly outweighed by the consequences.

Potential for inflation

Central Bank Digital Currencies allow for limitless money creation in the truest sense. By removing the constrains of the banking sector, central banks can decide to increase the CBDC deposits on any or all individuals at their discretion, as I have discussed. The constraints on this ability of true money creation will ultimately befall to the inflationary repercussions.

In a recent podcast with Grant Williams conversing with the great Lacy Hunt, Lacy opined the following in regard to the potential introduction of CBDCs: “If a government digital currency is enforced, the government would be able to track and control everyone’s financial record, it would be a great intrusion on private freedom. A US CBDC would put the Fed in the money printing business and constitute a major break within out system.

Money would have no value as soon as the money illusion passed and Gresham’s Law would prevail. CBDCs are part of the view that financial transactions create income and wealth, not hard work, creativity and saving out of income, they would be a trump of the free lunch school of economics. The US at that point will have achieved banana republic status. To go along this path would lead to hyperinflation and widespread miserable conditions for the US household.”

For mine, this statement encapsulates the implications of CBDCs perfectly; inflation being front and centre. I have commented a number of times in my recent writings on inflation and deflation the implications of the introduction of CBDCs. With a CBDC fulfilling the role of money, the unit of account almost becomes redundant as money is created and given to individuals on the basis of wants and needs. Such a system is incredibly susceptible for abuse. Money would have far less value, and as a result consumers would be far more willing to spend rather than save. “CBDCs have the potential to become an inflation game changer, and may open Pandora’s box of unintended consequences.”

Implications for the banking sector

Whether CBDCs are introduced as an additional form of money alongside bank deposits or as a means to entirely replace existing fiat currency, and given how CBDCs are an avenue for central banks to provide direct stimulus – which by default circumvents the banking system – one would expect there to be significant implications for the banking sector itself.

The most significant impact on the commercial banking sector would be in the scenario whereby CBDCs are set to replace existing fiat money. If consumers are fully on boarded to a CBDC system, then much of the deposits and liquidity within the banking sector would cease to exist. The implications here are twofold, the commercial banks would lose their deposit base, and the role of lending would fall to the public sector over the private sector.

In the United States, whether it is from the lack of demand for new credit from the private sector or the unwillingness of commercial banks to lend to the broad public, commercial bank credit creation continues to be lacklustre. In the current system, private sector credit creation remains the truest and most impactful means of money creation for the real economy.

https://images.squarespace-cdn.com/content/v1/5edb072f48c9fd655031c59d/1629594548994-Q6S6KN0H89KQXYLN37YZ/Capture.PNG?format=1500w

Due to this lack of credit growth in the private sector, the commercial banking system is simply not in a position to contribute to economic growth at present and assist the Federal Reserve in stimulating the economy. We can see this trend by not only looking at the growth in commercial bank lending per the above chart, but also by looking at the commercial bank loan/deposit ratio, which has been in a decline for nearly two decades and with it the velocity of money.

Source: Hoisington Investment Management
Source: Hoisington Investment Management

This is an important point because the growth and supply of bank credit is the primary driver of productive economic growth today. If deposits flow out of the commercial banks and instead sit with the central banks under a CBDC system, it would be up the the central banks and policy makers to lend and create credit. As it stands today, central banks have no experience in lending nor are they designed to perform such functions.

However, by introducing a CBDC, it would be fully up to central bankers to reallocate liquidity, credit and money in a productive manner, which, ultimately leads us down the path toward a centrally planned economy. As well-meaning as they may attempt to be, policy makers in such a scenario would make their decisions via political agenda. For this to be a success, policy makers would need to be more efficient in their money creation and capital allocation than the private sector.

However, if CBDC’s were introduced to exist alongside the existing commercial bank system of today, these negative implications for the banking sector and money creation process would be lessened, though other implications would remain.

Firstly, an interest bearing CBDC would directly compete with bank deposits. Depending on the rate offered, this would effectively create a floor for bank deposit rates as banks would need to offer a higher rate to attract deposits. If banks were to offer a rate below that of its competing CBDC, then we could see bank runs whereby consumers withdraw their monies from the commercial banks and deposit these within their CBDC account, creating potential for liquidity issues within the banking sector.

For this to occur however, the CBDC and existing fiat money would need to be fungible, which as I have discussed is unlikely. If it were the case, this is where a cap on people’s CBDC accounts would be beneficial. Regardless, CBDCs have the potential to completely upend in the banking system as we know it. CBDCs could give governments virtually complete control over the entire monetary system.

Privacy concerns & government power

Two major concerns associated with Central Bank Digital Currencies, which are perhaps more so philosophical, are the effects their introduction would have on personal privacy and enhancing government power.

Beginning with privacy concerns, an account-based or identity-based CBDC inherently connects individuals to money and removes the fungibility of money in order to enhance governments control of said money. By default, such a form of money requires individuals to give up their freedom and ability to transact anonymously.

By removing the fungibility and token-based nature of conventional currency, a version of a CDBC which does not embody these characteristics creates a vast array of ethical and philosophical responsibilities for its issuer. We as a society must decide who we entrust with our personal data. An account-based CBDC would allow its issuer to gain access to all of our spending habits; what we buy, how much we spend, what we invest in and what we save.

Would we rather entrust this information to the government, a central authority who are notoriously successful at misallocating capital as political agenda is what drives decision making. Targeted stimulus based around such data would ultimately be conducted on a political basis, as it is done so today. With identity-based money, individuals and policy makers must consider how much monetary and personal information is attached to their CBDC, and, individuals must be able to trust their policy makers with such information and that it is used for the right reasons.

Under almost any CBDC design, the central bankers and policy makers would gain extraordinary power. Without these powers, the benefits of CBDCs for the economy in most developed nations are likely to be limited. To be beneficial, or at least attempt to be beneficial in democratic countries, CBDCs will place more and more responsibility in the hands of the state at the expense the private sector. As this would only serve to give more power to the central banks, their political “independence” would become more important than ever. I can’t imagine it wise to give entities such as the central banks whose independence is already in question greater responsibility.

This is particularly prevalent for the banking sector, as I have touched on. Depending on how much CBDCs were to disintermediate the commercial banking sector, the credit creation process would be at the discretion of policy makers. The money creation process will largely become a function of the state, reinforcing the central banks power over the economy. In this scenario, CBDCs effectively introduce state banking.

It is important to remember however these concerns over privacy and enhanced government power will vary for state to state. For example, the Chinese digital yuan (or “DCEP”) is likely being developed by the People’s Bank of China as a mean to further their authoritarian control over their people, whereas in more democratic states like the United States where there are far more checks and balances to contend with such issues, these concerns are likely to be less valid. However, if used incorrectly, the introduction of CBDCs could be a historic blow to personal liberty and privacy. Perhaps the biggest risk of CBDCs are they end up being surveillance disguised as currency, thus creating a link between money and social agenda.

Whilst there are societal benefits offered by Central Bank Digital Currencies, unfortunately, the privacy one would have to renounce will not likely be understood by the majority. The ease of use and “free-money” appeal will likely be welcomed at first. Think of smart phones tracking your viewing history and targeting advertising based on this information; people will be blinded by the purported benefits and not see the consequences until it is too late.

Chinese digital yuan

The worst case scenario for individual liberty is not hard to imagine. In fact, China’s version of a CBCD, known as the Digital Currency Electronic Payment (DCEP), or digital yuan, is exactly that. The PBOC is most likely doing exactly what a CBDC allows; leverage the power and individual data capabilities of a CBDC to further their political agenda.

The authoritarian ambitions of China’s digital yuan is likely to be one of the biggest changes to the financial system in some time. Out of all the governments and central banks who are beginning to realise the potential and power of fully digital currencies, China has thus far been the one taking it the most seriously in both development and implementation. For China, having the enormously powerful data associated with an identity-based CBDC can be used to further their dominance over their people. The following excerpt from a paper released by the Bank Policy Institute does an excellent job summarising a worst-case Chinese CBDC:

Source: Central Bank Digital Currencies: Costs, Benefits and Major Implications for the U.S. Economic System
Source: Central Bank Digital Currencies: Costs, Benefits and Major Implications for the U.S. Economic System

History tells us authoritarian governments tend not to want to shed power, but instead continue to accumulate it. Indeed, whilst the PBOC have stated their development of the digital yuan is to enhance monetary policy and illegal activity, officials have also said the DCEP will have value as a tool for enforcing party discipline, as per the above. The CCP can decide who gets punished for being a bad citizen, and who gets rewarded for being a good citizen via the creation and destruction of the money supply a CBDC would allow.

However, it is not just through the means of furthering their political agenda leading China to develop their digital yuan at a pace far quicker than any other central bank, but it is also through a desire to bypass the dollar dominance and its influence within the world’s financial system.

It is undoubtedly true that many of the central banks developing Central Bank Digital Currencies are doing so as a means to bypass the dollar hegemy and its role as the world’s global reserve currency. China’s digital yuan is absolutely case and point in this regard. CBDC’s could offer an avenue of escape for many countries, if designed and implemented in such a way whereby their reliance on the dollar is somehow reduced. It is no secret that many countries do not necessarily favour a dollar based financial system. Recently, the Bank of England’s Mark Carney spoke of this very thing.

China’s digital yuan is being designed in part as a viable alternative to the dollar for the world’s economies. For example, in order to entrench and promote adoption of their digital yuan, China could impose requirements on foreign businesses who wish to operate in China to do so solely in their digital yuan. This means opening a CBDC account with the Chinese central bank. Recently, financial plumbing expert James Aitken discussed how significant this development is, opining how the United States and other western government officials are shocked at how advanced China is in the development of their digital yuan.

The penny has certainly dropped for the powers at be as to how game-changing a digital yuan could be and the dangers associated with China being at the forefront of Central Bank Digital Currency adoption. However, it must be stated the authoritarian ambitions associated with China’s digital yuan are likely to reduce its viability as a global alternative to the dollar. Whilst it is unlikely to be the digital yuan that supplants the dollar hegemony, the entire dollar based system will eventually give way to a digital based currency system, of which CBDCs as a whole are likely to play a key role.

Conclusion & Final Thoughts

Central Bank Digital Currencies are clearly significant in scope and in consequence. People are yet to come to terms with how money itself is going to be reengineered. CBDCs have the potential to change the financial system and money as we know it. From digital surveillance to unlimited direct stimulus, the introduction CBDCs appear inevitable and game changing.

Whilst it is most likely the case the introduction of CBDCs would in the end be a negative outcome for the citizens of the countries who adopt them, these considerations of intrusion of privacy are most likely to be lost or unforeseen by individuals until it is too late.

Economic Growth Is Slowing & What This Means For Investors

Within this article, I intend to delve a little deeper into the various leading economic indicators to assess where we are in the current growth cycle and what this means for investors.

As I discuss below, my reading of the current environment is relatively clear; both the longer-term and shorter-term leading growth indicators are pointing toward the heightened possibility of slowing cyclical growth. As a result, these downward trends suggest investors ought to be rotating out of the reflation and cyclical trades and into the defensive counterparts, or reducing risk entirely.

Beginning with the longer-term leading data, almost all of the variables I monitor peaked earlier this year and are now rolling over or trending downward. My favorite of which is the China credit impulse. Credit impulse measures the rate of change of new credit creation by both commercial banks and fiscal budget deficits.

As it stands, credit creation is the truest measure of money creation and thus leads many economic variables by around 10-12 months. We can see the credit impulse from China peaked some months ago and has since turned negative. This is important as China remains the worlds largest manufacturer and drives much of the worlds business cycle.

Source: TopDownCharts
Source: TopDownCharts

Drilling deeper into the commercial bank credit creation process, we can see commercial bank lending on a year-over-year basis has been trending downward for the past 12 months and is now in negative territory.

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To me, despite the impending shift to fiscal dominance and central planning, credit growth in the private sector is still the best driver of the economy and is one of the more reliable indicators of long-term growth prospects. The fact that growth in private sector credit is now contracting is worrisome. We can extrapolate this further by analyzing the private sector loan-to-deposit ratio.

A falling ratio indicates money is not leaving the banking system and being spent in the real economy, but instead remains trapped within the banking system. This ratio can be thought of almost as a proxy for the velocity of money. The loan-to-deposit ratio has been in a downward spiral ever since the COVID-19 crisis began.

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Confirming this trend in credit creation is building permits year-over-year rate of growth, which looks to have peaked. Like most assets, the housing market has been hot of late and if building permits are any guide, may be slowing down.

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It is important to keep in mind however these long-term indicators are, by definition, long-term in nature, and thus for there to be any actionable asset allocation decisions to be made based on their readings, we need to see the shorter-term leading indicators confirming the trend.

Of the shorter-term leading indicators, ECRI’s weekly leading index peaked back in April and has since rolled over. ECRI’s Lakshman Achuthan recently appeared on the MacroVoices podcast to discuss the implications of the weakening in their leading indicators.

Source: Economic Cycle Research Institute
Source: Economic Cycle Research Institute

Citibank’s Economic Surprises Index, a measure of economic data coming out better or worse than expected has too recently turned negative, again signaling peak growth has passed and better than expected economic data is no more.

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The manufacturing new orders subcomponent of the ISM Purchasing Managers Index (PMI) has flattened over the last new months, clearly signaling a slowdown in manufacturing demand.

Source: YCharts
Source: YCharts

Meanwhile, the University of Michigan Consumer Buying Intentions Survey for vehicles, houses and household goods have all recently plummeted to their lowest levels in some time. Clearly, the spike in inflation over the past number of months is beginning to take its toll on consumers. Demand is waning not just in the manufacturing sector but in households too.

Source: Quandl, Acheron Insights
Source: Quandl, Acheron Insights

Turning now toward the financial markets, some of the most cyclically sensitive and economically sensitive stock market sectors have too been confirming this message of slowing growth. The retail, transports, metals and mining, materials and industrials sectors all peaked back in the March to April period and have been out of favour ever since. Investors appear to be pricing in this slower growth and taking profits in the reflation trade that has performed so well over the past 12 months.

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In addition to the stock market sectors confirming the downward trend in growth, we can see other market performance data is sending a similar message. Indeed, the performance of stocks relative to bonds, commodities relative to stocks, copper relative to gold and lumber relative to gold all peaked in the April to May period. Should growth continue in its current downward trend over the coming months as the leading data suggest it might, we should expect to see these relative market performance trends continue rolling over.

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So, what matters then is the investment implications of a slowing economy. Firstly, it is important to remember the macro environment is inherently slow moving. Just because the long-term leading indicators suggest growth may slow in the coming quarters, unless the shorter-term leading and market data too confirm this message it can be costly to act prematurely. However, as I have endeavored to illustrate above, it seems as though both the long-term and short-term economic data are aligning and suggest we are well and truly entering a period of slowing growth.

As such, the most obvious step for investors to take is to allocate a greater portion of their capital to defensive bets that appear likely to outperform in a slowing growth environment. For instance, we should expect to see equities underperform bonds.

Source: Julien Bittel
Source: Julien Bittel

Defensives stocks to outperform cyclical stocks:

Source: Julien Bittel
Source: Julien Bittel

As well as long-duration type assets and sectors to outperform short-duration type assets and sectors.

Source: Julien Bittel
Source: Julien Bittel

Utilities is one such example of a defensive, long-duration equity sector that looks attractive from a purely technical perspective, recently breaking out strongly to the upside.

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The performance of utilities companies is heavily linked to interest rates, as rates are a strong driver of their earnings power given the high debt to equity ratios of the sector. The outperformance of utilities is thus a good indicator of the markets expectation of falling interest rates and slowing growth.

In addition to utilities, another attractive opportunity at present on the defensive side is the Japanese yen. The yen is effectively the ultimate risk-off, safe-haven currency. Even more so than the dollar. From a sentiment perspective, commercial hedgers (i.e. the smart money) in the futures market remain net-long whilst speculators (i.e. the dumb money) are the shortest they have been in years.

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Optix, another measure of investor sentiment, is also showing a relatively bullish reading.

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What’s more, seasonality is quite encouraging for the next few months.

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And from a technical perspective, a break of the 108.5 area would seemingly confirm this thesis and potentially provide a good tactical trading entry point.

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In all, we can see economic growth is clearly slowing and is beginning to be priced into risk assets. What this means going forward is we are likely to see a continued outperformance of defensive, long-duration type assets and equities, with the reflation trade likely done for the time being. Investors would do well to position their portfolios accordingly, whether that be taking profits from the cyclical trades, accumulating cash or deploying capital in defensive type opportunities as I have detailed above.

The Stock Market Is At An Important Inflection Point

Within my latest piece discussing the merits of deflation, I briefly touched on how several leading economic indicators appear to be signally growth may have peaked for the time being. Whilst these business cycle and growth metrics are not necessarily useful on their own, when the price action of equities appear to be confirming the macro message; it may be time to pay attention. Such at time appears imminent.

Looking at two of my preferred leading macro indicators of the business cycle, the ERCI weekly leading index and global credit impulse, both are signaling peak growth may be in the rear view mirror.

Source:    Economic Cycle Research Institute

Source: Economic Cycle Research Institute

Source:    Alfonso Peccatiello - The Macro Compass

Source: Alfonso Peccatiello – The Macro Compass

Confirming this message are the most economically sensitive sectors of the stock market. Retail, transports, metals/mining, materials and the industrials sectors have all underperformed these last few months relative to the S&P 500. When the markets goes on the make a new high and all economically sensitive sectors such as these do not confirm the new high, it is a clear signal the new highs are not being supported by economic fundamentals.

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Indeed, these recent highs have seen a significant rotation out of the reflation and value type sectors back into the growth darlings. Market breadth, another excellent measure of market internals, has too not confirmed the recent highs. We are seeing significant bearish divergences in almost all measures of breadth, and the recent rally is almost solely being driven by the likes of Apple and Amazon.

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In the past, periods of poor breadth amid new highs in the major indices have generally lead to at least some form of correction or consolidation. It is perhaps unsurprising then to see that small-caps and emerging markets have gone nowhere over the past six months (in a similar manner to the economically sensitive sectors illustrated above) whilst the broad market has continued to march higher.

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The market is now almost entirely being driven by a rotation out of cyclical sectors and back into tech, FAANG and defensive stocks.

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Such periods of tech outperformance coinciding with the market cap weighted S&P 500 outperforming the equal weighted S&P 500 have been reminiscent of market tops in recent months.

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Continuing this theme of non-confirmation are investor risk-appetites. Firstly, the pro-cyclical currency pair of AUD/JPY and AUD/USD both appear to be rolling over. The strength of the Aussie dollar is generally a good proxy for risk-on and risk-off type environments.

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Extending this out to a longer-term perspective, another chart I referenced within my deflation article was the long-term AUD/JPY FX pair, which looks to have broken out of its bearish rising wedge pattern at the top of its near decade trading range.

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Continuing with risk appetites via the VIX, which is effectively investors expectations of volatility over the coming month, the VIX has not made new lows over recent months as the market has gone on to make new highs. Such divergences between the two have typically preceded periods of market turmoil in the past.

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Turning now to the technicals, they too are bear a similar message. On the weekly chart, we are seeing slight negative divergences in RSI and money flow, accompanied by a 9-13-9 weekly DeMark sequential sell signal.

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What’s more, we are amidst a seasonally weak period of stocks, almost indicative of what I have detailed above. Clearly, we can see on many different measures that stocks are seemingly at risk of some form of correction, or at the very least, a period of consolidation.

SPY Seasonality.jpeg

In isolation, these indicators and measures are not of much use, but, in the case where they align to tell a similar story at once, it is important to take heed. I personally tend to favor trades and investment opportunities whereby fundamentals, technicals, sentiment and macro all align. For the most part, now appears to potentially be such a time.

However, I shall stress I am by no means predicting a significant risk-off event is imminent. For fear of being labelled a “perma bear”, let met be clear I am merely presenting a number of important measures investors should take heed of as part of their own due diligence and risk management. The clear takeaway from what I have presented above is that the risk-reward set-up for equities is not overly favorable at present. Nevertheless, there does remain pockets of value and opportunity still to be found within these markets.

Those who have been readers of my previous writings will be well aware of how I have deemed there to be several decent buying opportunities in the gold and precious metals market of late. At the risk of repeating myself once more, dare I say it but today stands as another such opportunity for investors seeking to deploy capital. In terms of valuations and fundamentals, the gold miners are clear standouts.

Source:    Sprott via Ronnie Stoeferle

Source: Sprott via Ronnie Stoeferle

However, fundamentals in isolation may not necessarily be meaningful if they are already priced in. It does however appear this is not the case. We can see this by comparing the divergence between the gold price and real interest rates. This is an inverse relationship that has historically nearly always held up, and is a key driver of the gold price. Given how real rates remain deeply negative today, it seems only a matter of time before the gold price catches up to real rates. One way to view this is by using TIPs as a proxy for real rates relative to gold.

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Will gold follow real rates? Seasonality suggests it will.

deflation.jpeg

To conclude, the market appears to be running our of gas. I for one would use a potential pull-back as a buying opportunity for several sectors and assets I am bullish on. I love the green-energy trades in uranium, copper and carbon credits, but, given how far these sectors and assets have come in the past year I would love to see further weakness before I begin buying. Again, that does not mean opportunities are not present right now, gold is perhaps the perfect example, and it looks like it may be an excellent time for investors to take profits out of the favored and deploy capital into the unfavored.

For a look at all of today’s economic events, check out our economic calendar.

The Case For Deflation

Back in March, I laid out the case for inflation in comprehensive fashion, now, as all good investors ought to do, I will present my case why the disinflationary and deflationary trends that have engulfed markets over the past 40 or so years may continue.

We all know the major deflationary forces of today; debt, demographics, globalization and technology. I will endeavor to address these throughout this article. However, there are also a number of lesser known deflationary forces that perhaps do not get as much attention as they deserve. These too I will endeavor to explain below, along with where we stand with the current inflationary pressures, transitory or not.

Debt

For listeners of Erik Townsend’s excellent MacroVoices podcast, you will be aware of Erik’s proclamations of how many of the best and brightest minds in finance and macro have shifted from the deflation to inflation camps; with Vincent Deluard, Russell Napier and Louis-Vincent Gave being some such examples. However, there does remain a few “deflationists” out there, the most prominent being Lacy Hunt, and it is from Lacy’s arguments for debt and economic growth driving deflation where I will begin.

The chief problem facing most of the worlds developed economies today is the level of outstanding debt, both private and public. Whilst the creation of debt can represent an expansion in the broad money supply, the destruction of debt conversely equates to a contraction in the money supply. As all debts must eventually be repaid, debt by nature is deflationary over time.

This is not so much a problem if the marginal return on debt exceeds the cost of debt. We have however long past that point whereby the creation of new debt lead to a greater increase in productivity. The marginal productivity of debt, or simply the return on debt, is at its lowest levels in over 70 years. As the below chart illustrates, we are now at the point whereby each new dollar of debt created is only able to increase GDP by less than 40 cents.

Source: Hoisington Investment Management
Source: Hoisington Investment Management

An increase in debt is an increase in current spending at the expense of future spending unless the income generated on the debt is sufficient to repay principal and interest. Stimulus hardly meets this criteria. Additionally, given central bankers and policy makers have never allowed the over indebtedness to resolve itself (rightfully or wrongfully) via the process of austerity and creative destruction, what has resulted is the dynamic of this ever falling return on debt being subjugated by the creation of even more debt in a negatively convex manner.

As much as the “MMTers” will argue this is solvable, what we know for sure is this has never worked in history. Folk love to harken how the tale of Japan will not be the fate of the US and how Japan was different (to which Lyn Alden has previously presented an excellent case for, and one in which I largely agree), though we are yet to see any evidence the United States’ spiral down this deflationary debt dynamic is actually different.

This is the greatest flaw in the argument fiscal dominance and MMT will create growth and inflation: we are searching for an easy solution to economic growth, one that has never worked in history. Yes, fiscal dominance may be the catalyst for inflation, but the debt overhang simply does not allow this to be accompanied by sustained growth. Instead, at best we may see stagflation accompanied by financial repression, as I discussed in my previous musing on inflation.

Debt & Money Velocity

To get inflation, we need a pickup in the velocity of money. Money velocity is largely a function of the level of debt relative to GDP. In the chart below, you can see how the year-over-year change in the velocity of money (red line, inverted) has a significant inverse relationship with government debt/GDP (blue line).

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As debt is a constraint on money velocity, for velocity to increase, the economic growth needs to exceed the growth in debt, meaning the debt must be put to productive uses such that it spurs growth greater than its cost. A bet on inflation is a bet on an increase in the velocity of money, which is a bet on the increase in the marginal productivity of debt.

So long as the MMT-style stimulus is debt financed, this dynamic will struggle to reverse. As a result, the historic increases in money supply could be somewhat irrelevant unless the velocity of money increases. You simply cannot look at the growth in money supply without also looking at the velocity of money. Debt financed stimulus ultimately leads to the same conclusion; more debt and less growth. History tells us this has never been more than a temporary solution.

In the long-run, debt is simply a constraint on aggregate demand, and, for prices to rise demand must exceed supply. Whilst certainly possible, unless we go through a period of creative destruction and austerity (unlikely), the debt constraints on the US economy create a significant headwind for sustained inflation moving forward.

Demographics

Demographics remain one of the most powerful drivers of long-term economic growth. I have written extensively on the topic of demographics in the past, as it is a force whose impact on all facets of economics should not be underestimated or overlooked.

The developed world has a demographics problem that is not going away. The largest generation in history is retiring and as a result the number of retirees relative to workers is rising and is likely to continue to do so over the coming decades. Empirical evidence shows productivity, consumption and economic output peaks for workers roughly in their 20s-50s. Conversely, the contribution to GDP growth for the average worker falls negative as people enter their mid-to-late 50s and thus are no longer a contributor to economic growth.

The below chart from the work of Research Affiliates illustrates this relationship between age and economic output.

Source:    Rob Arnott, Denis Chaves, Research Affiliates
Source: Rob Arnott, Denis Chaves, Research Affiliates

A falling support ratio (working age population relative to children and retirees) for countries with an aging population is a powerful constraint on economic growth. This makes sense, as consumption (being the largest input for GDP) is largely based on age. The older we get, the less we consume and contribute to the economy. This dynamic is a deflationary force over the long-term.

As we can see below, the labor force in the US has long since peaked.

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The relationship between the labor force and economic growth is better comprehended when comparing the two in rate-of-change terms.

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Clearly, we can see above how the two are related. Whilst there has been a significant jump in the labor force compared to 12 months ago, it is important to consider the base effects of year-over-year data. This time last year, the worlds economies were on stand-still. On an absolute basis, we remain near the lowest level of labor force participation in about 40 years.

What’s more, similar to how debt is a constraint on the velocity of money, so too is the labor force participation rate.

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The labor force is highly correlated to the velocity of money. To get a pick-up in velocity, what is really needed is a growth in the level of the population who are more willing to spend and consume, which, as we know from the previous chart comparing age groups and growth in GDP, is an increase in those aged between 20 and 50.

However, as we look forward, we can see the level of retirees relative to those working (support ratio) is only going to continue its downward trend for at least the next decade or two as the average age of the population increases. There is a stark contrast between the median age of today relative to that of the structural inflationary 1970s and 1980s.

Capture.PNG

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The immediate future will continue to see more people leaving the economy and retiring compared to those entering the economy. The demographic headwinds facing not just the US, but most of the developed economies worldwide undoubtedly continues to provide a significant headwind to any form of sustained inflation.

Other Deflationary Forces

Whilst debt and demographics have been two of the most significant deflationary forces at play, along with technology and globalization, there remain a number of lesser known but meaningful dynamics working to reinforce deflation.

Technology & Productivity

Technological advancement and increasing productivity are inherently deflationary. Technology creates efficiency, which increases productivity which reduce costs. Technological innovation is not a trend that will plateau or reverse, technology is exponential.

The trend of investment in information technology hardware and software continues to rise.

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Likewise, productivity on a year over year basis is at its highest point in a decade. Growth in productivity is an inflation killer (core-CPI inverted below).

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Technology will only further allow for the transformation of labor to capital through automation and efficiency. Going forward, the continued shift to a digitalized economy and growth in decentralized finance should only exacerbate this trend. Technology is an inflationary headwind unlikely to subside any time soon.

Money Creation, Quantitative Easing, Banking Lending & Interest Rates

There are two ways broad money supply is created; commercial banking lending and directly monetized government spending. I discussed the dynamics of money creation within my article on inflation in detail, and have again detailed this process as follows.

Historically, it has been the commercial banks that have been able to claim sole responsibility for the growth in the broad money supply. The notion that quantitative easing (QE) conducted by itself is money creation is false. The Federal Reserve and other central banks have the ability to influence the base money supply (M0), but not the broad money supply (M2). They can lend, but they cannot spend. Commercial banks create money via fractional reserve banking when lending occurs between said banks and consumers and businesses.

QE is a means of capitalizing the banks, allowing them further scope to be able to lend against these freshly printed reserves with the central banks, whilst also pushing down interest rates in the hope this will spur an increase in lending. QE is effectively just a swap of government bonds for central bank reserves; unless lent against the two are negligible. Getting banks to lend is what increases the broad money supply.

Unlike the Fed, the Federal government does have the power to spend. If the central banks and governments work together, they are able to rapidly increase the base money supply and the broad money supply. If the central banks are directly funding government spending and outright guaranteeing loans made by banks, then this is money creation and has no doubt played a role in the expansion of the broad money supply we have seen of late.

Indeed, the shift of using monetary policy in isolation to monetary stimulus combined with fiscal stimulus will likely lead to a continued increase in the broad money supply. However, the misunderstood aspect of this dynamic is that ultra low interest rates and QE are in fact more likely to be deflationary, not inflationary. What’s more, whilst the government is spending central bank financed money, the traditional means of broad money creation in the form of commercial bank lending is still non-existent.

Focusing in on QE and interest rates, the primary goal of quantitative easing has been to lower interest rates to spur lending, create economic growth, increase asset prices and create a wealth effect. QE has succeeded in only two of these aspects; increasing asset prices and lowering interest rates. It is no secret QE has been by and large a failure.

The first problem associated with QE is suppressing interest rates to artificially low levels. Artificially low interest rates are not stimulative. In fact, there is evidence to suggest artificially low interest rates are only stimulative to a certain level, once they reach the ultra-low levels of today, these positive effects disappear to the point whereby they could be argued as being entirely deflationary. The below chart illustrates this dynamic well.

Source:    Visual Capitalist
Source: Visual Capitalist

By artificially suppressing interest rates, this works to reduce the interest costs associated with existing debt. Reducing interest costs allow debtors more flexibility to repay the associated principal in addition to the interest payments, and, if these low interest rates are not spurring additional lending and creation of money to offset the repayment of principal, then this process is in fact the outright destruction of money. Likewise, those who live off fixed-income interest payments receive less interest, which leads to less income and thus less consumption.

To solve this problem, banks need to lend. The problem here is demand for credit is still largely contracting. Outside of fiscal stimulus, there is little growth in the broad money supply from commercial bank lending.

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Despite ultra-low interest rates, highly capitalized bank balance sheets and lending standards near-decade lows, this lack of growth in consumer credit creates a headwind for continued structural inflation.

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Broad money is created when consumers borrow and is destroyed when they repay principal. When you have interest rates artificially pinned near the zero-bound, money is destroyed as loans are repaid. It becomes unprofitable for banks to lend and as a result, there is less money moving around the system. This all leads to the suppression of money velocity.

Unless banks are willing or able to lend against the increase in their QE funded bank reserves, the liquidity provided by QE gets stuck inside the banking system. Ultra low interest rates and QE do not create money over the long-term unless they are accompanied by a commensurate increase in commercial bank lending, and a productive use of this debt. Whilst the direct financing of government spending is one avenue to solve this problem, the traditional means of fractional reserve banking needs to follow suit if sustained inflation is possible.

Wealth Concentration

A deflationary force not commonly cited is wealth concentration. As is common knowledge these days, wealth concentration in the top percentiles currently stands at the largest discrepancy since World War 2.

Source: Ray Dalio, Bridgewater Associates
Source: Ray Dalio, Bridgewater Associates

Put simply, those who have amassed more wealth have a far lower marginal propensity to consume. An additional dollar of income for those who are wealthy is far less likely to be spent on the consumption of goods and services than those who are less wealthy. This pushes down the velocity of money, reducing the flow of money throughout the economy.

Capitalism & Free Markets

Capitalism and free markets are not necessarily inherently deflationary. However, a capitalist regime promotes and encourages progress and innovation, which today primarily occurs through technological innovation. As I have discussed above, technology is inherently deflationary. Whilst markets may not necessary be “free” today, so long as we remain a capitalist economy for the most part the result will be continued innovation and progress.

Challenging The Inflation Narrative

Commodities & Supply Driven Inflation

Many people believe commodities and inflation are one and the same, this is simply not the case. Whilst commodity prices and inflation are certainly intertwined, using broad commodity prices as a measure of inflation is inaccurate. On the whole, the impact commodity prices has on core-CPI is less than you might think.

The US economy is largely a service economy, as the growth in globalization has resulted in the US offshoring its labor and supply chains. As such, strong movements in commodity prices generally will only have a small impact on core-CPI. We have had a number of commodity cycles over the past few decades, and as we can see below, the correlation between commodity prices and inflation is not significant.

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Sustained inflation requires a permanent increase in demand relative to supply. Demand driven inflation occurs as a result an increase in demand that is unable to be met by a sustained increase in supply. For example, the 2002-2010 commodity bull market resulted from a sustained increase in demand led by China and the broad adoption of commodities as an asset class by institutional investors and pension funds. Likewise, during the inflationary 1970s and 1980s, the inflationary pressures were a function of an increase in demand as the largest generation in history, the baby-boomers, entered the workforce and significantly increased the labor force participation rate. I have discussed these demographic forces above. Today, we have a contracting labor force and an aging population, which will see a continued contraction in demand.

The commodity and price increases we are witnessing at present appear to be largely a result of supply side constraints, as opposed to a sustained increase in demand. The COVID-19 induced shutdowns interrupted supply chains and the transportation and availability of raw materials. Supply will come back to meet this demand for most commodities, if it hasn’t already.

Supply is almost always less elastic than demand. A result of inelastic supply constraints are short-term disruptions as aggregate supply cannot meet aggregate demand, pushing up prices and lowering corporate profits as less supply results in less revenue. Unless the price increases are demand driven and sustainable (like we saw in the 1970s/80s and 2000s), supply driven price increases are likely to be temporary. The solution to higher commodity prices is higher commodity prices.

However, it is worth noting there will be exceptions to this dynamic. I would argue copper and electrification metals will have a sustained increase in demand due to the electrification of the worlds economies. Longer-term inflationary pressures may indeed result from such trends.

Short-Term Inflation Expectations

Due to this belief held by many that commodities equal inflation, it is unsurprising to see that short-term inflation expectation measures are simply based off commodity prices, the most notable being the price of gasoline and oil.

The issue here is commodities may be more so driven by inflation expectations, or inflation expectations driven by commodities, than any actual increase in aggregate demand capable of sustaining inflation. Commodities are only a part of the inflation story.

Where Are We Now?

The June core-CPI reading of 3.8% is the highest year over year number in nearly 30 years. Whilst this is meaningful, it is important to consider how base effects exacerbate such data. During 2020, the economy basically shut down. Year-over-year economic data for 2021 must be taken with a grain of salt, especially considering core-CPI bottomed in the May to July period of 2020. The pandemic caused a global shock to the worlds economies.

The fall in demand more than offset the fall in supply, creating the conditions of severe disinflation. Now, as the worlds economies are beginning to function closer to full capacity once more, this dynamic is working in reverse. Demand has roared back, spurred on by fiscal stimulus, whilst supply is yet to follow suit. As I have mentioned above, supply will eventually come back to meet demand. This will likely be sooner rather than later.

Indeed, when we look at longer-term inflation expectations, there is still a lack of any significant concerns of structural inflation. The Cleveland Fed’s 10-year inflation expectations measurement is not signaling any long-term inflation.

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Meanwhile, the 10-year breakeven inflation rate and 5-year, 5-year forward inflation rate may be sitting at roughly five year highs respectively, but both remain well below the highs seen post GFC, and below the 2.5% mark. These long-term readings are not meaningfully high.

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It’s not just the long-term inflation expectations sending us this message, but it appears as though the reflation trade and global growth may be nearing a peak. Chinese credit impulse, which measures the creation of new credit and has been an excellent leading indicator of global growth, has rolled over significantly these past months. China is the largest manufacturer in the world and is a key driver of the worlds business cycles.

Source:    Julien Bittel
Source: Julien Bittel

Likewise, the ECRI leading indicator appears to be confirming this message, the business cycle looks to be topping

Source:    Economic Cycle Research Institute
Source: Economic Cycle Research Institute

A slowdown in global growth looks to be the potential story for the second half of 2021. This is what the bond market has been telling us. Despite the continued inflationary pressures through the first half of 2021, long-term yields topped back in March and have been falling ever since. Whether or not the 30-year falls below 2% or holds the line will be telling.

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In every recession over the past 50 years, we have seen a temporary spike in bond yields due to rising inflationary pressures. In almost every instance, the spike in yields were temporary and reversed to the downside as the natural deflationary forces once again took hold. Historical precedence tells us this time will likely not be different.

Looking at the reflation trade itself and using the AUD/JPY as a proxy, this looks a lot like a broken rising wedge pattern at the top of a long-term trading range. A continued pullback in the AUD/JPY would likely signal a further correction in the various reflation trades is imminent.

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Likewise, if we look at tech relative to small-caps, the former appear to be reasserting their dominance.

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However, as I detailed in my article arguing for inflation, there is potentially a path toward sustained inflation laid out in front of us. The move to MMT-style sustained central bank financed fiscal dominance, combined with labor onshoring and de-globalization are both inflationary tailwinds whose forces are only likely to grow over time. For now, despite fiscal stimulus putting money directly in the hands of those with a higher propensity to consume, much of this direct stimulus thus far have not been necessary contributing to economic growth. According to the New York Fed, roughly one-third of all stimulus payments received have been used to pay down debt, which as we know is the destruction of money, whilst only one-quarter is being spent on consumption, with the remainder being saved.

Source:    Federal Reserve Bank of New York
Source: Federal Reserve Bank of New York

Going forward, it is a matter of whether these forces are enough to overcome deflation, history suggests otherwise. However, should such measures as central bank digital currencies be introduced, or laws passed to allow the Fed the ability to spend, not just lend, both would certainly be game changers and would likely spur inflation.

Investment Implications

If it is true these deflationary forces will continue to suppress inflation over time, then for us investors it is important to consider how this might effect our investment decisions.

Unsurprisingly to most of you, the best performing asset classes and equity sectors over the long-term during a deflationary or disinflationary regime are those of a defensive, long-duration nature. Basically everything that has underperformed over the past 12 or so months.

Source:    Incrementum
Source: Incrementum

As boring as it is for investors, in a low growth world of little inflation, we are likely to see continued outperformance of the growth darling FAANG stocks on the whole, despite where valuations sit. We would likely see a continued bull market in bonds, as hard as that is to believe. Until the long-term trend for bonds tells us otherwise, the years ahead may just see more of the same.

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Whether you reside in the deflation camp or the inflation camp, it is important investors assess both sides of the debate and come to their own conclusions. Whether we get inflation or deflation, investors should be prepared for either outcome. It may be we just end up somewhere in the middle.

Why The Dollar Matters (A Lot!)

With the recent rally this past week in the dollar, it is important for investors to understand why such a move matters. For those who love charts, this article is for you.

The most obvious and well-known correlation between the dollar and equities is the association of a weak dollar with the outperformance of most commodities and real assets. It is no coincidence the significant gains in commodities over the past 12 months have come during a period of a declining dollar. We can clearly see this inverse relationship in play by comparing the performance of copper and oil against the dollar.

Dollar & copper
Dollar & copper

Dollar & oil

Dollar & oilAn extension of this relationship is how periods of dollar weakness coincide with the relative outperformance of equity markets sectors reliant on economic growth. As we have witnessed over the past year, the falling dollar has resulted in the outperformance of consumer cyclical versus consumer defensive stocks, as well as materials, industrials, small caps and energy stocks outperformance relative to the broad market. Likewise, this period of dollar weakness has seen the underperformance of defensive sectors such as utilities and bonds.

Consumer cyclicals vs defensive
Consumer cyclicals vs defensive

Basic materials vs S&P 500

Basic materials vs S&P 500Industrials vs S&P 500

Industrials vs S&P 500Utilities vs S&P500

Utilities vs S&P500Small Caps vs Large Caps

Small Caps vs Large CapsDollar & bonds

Dollar & bondsFrom a fundamental perspective, these relationships make sense. A stronger dollar is generally a function of a contractionary or disinflationary outlook. During deflationary shocks à la March 2020, dollars are in high demand and act as a safe haven or risk-off asset. Conversely, a weaker dollar is generally a function of economic growth and rising inflation expectations.

What this means is the dollar tends to appreciate when bond yields fall. This comes about due to the safe have characteristics of the dollar. If the economic outlook looks sluggish and appears to be slowing down, we tend to see money flow into dollars, and by extension, we see money flow out of the growth and inflationary dependent sectors and asset classes of commodities, small caps, cyclicals, industrials and materials and into those of a defensive nature.

Perhaps the most well-known implication of dollar strength or weakness is the performance of foreign and emerging markets relative to the US. Emerging markets in particular are inherently cyclical and dependent on the dollar. This is particularly the case for those countries with high levels of US dollar denominated debt or the commodity producing countries.

Emerging markets vs S&P 500
Emerging markets vs S&P 500

I detailed the dollar and emerging markets dynamic in depth in my article arguing the bull case for emerging markets, most of which is detailed as follows:

A rising US dollar causes the domestic currency of emerging economies to fall and inflation to rise amid weaker economic growth. Contrary to a developed economy whose economic growth is generally associated with inflation, being beholden to foreign-denominated debt reverses this dynamic. Higher inflation results in the central bank needing to raise interest rates and sell their foreign exchange reserves to defend their currency from hyperinflating, which acts as a further headwind to economic growth and exacerbates this dynamic in a self-reflexive manner.

These countries are unable to simply print money to monetize the debt, as is commonplace in developed countries whose debt is denominated in their own currency. The governments will then look to use fiscal policy as a means to stimulate, resulting in increasing budget deficits at the same time foreign and domestic capital flees the country for a safer alternative to preserve wealth, resulting in a negative current account balance along with a budget deficit.

Of course, these dynamics work in reverse too when the dollar is falling and create an economic tailwind that results in strong economic growth and asset price appreciation generally superior to developed markets. As the domestic currency strengthens, inflationary pressures fall, allowing the central banks to lower interest rates whilst the economy is booming, spurring lending and reinforcing growth.

At the same time, the governments are not required to run budget deficits, nor are the central banks required sacrifice their foreign currency reserves and run current account deficits to defend their currencies. You could almost think of a rising dollar as a form of quantitative tightening for most emerging markets, whilst a falling dollar could be considered a form of quantitative easing.

Therefore, for one to be willing to bet on the outperformance of EM relative to US equities, one must have a bearish outlook for the dollar.

Is this dollar rally sustainable?

In my view, the dollar has appeared to be in need of a rebound for a few months now. To be clear, we are far from seeing the start of a new trend higher in the dollar, but, as the consensus towards the dollar has been and remains almost exclusively bearish, it is not often we see price action conform to consensus.

Speculators are still betting heavily against a rally in the dollar.

Conversely, speculators are betting heavily on the relative outperformance of the euro. Meanwhile, commercial hedgers (i.e. the smart money) remain long dollars and short euros.

Technically, the coming weeks will be telling for both the dollar and the euro. With a potential head and shoulders bottom forming on the dollar index, and conversely a head and shoulders top for the euro, should these patterns follow through and the dollar move further to the upside, many of the “consensus” inflationary and growth orientated trades in which investors are all in on, may experience a period of underperformance.

A continued rally in the dollar over the coming months may well be a signal the inflation trade has gotten too ahead of itself. I have written previously how this may be the case. What’s more, the bond market also appears to be signaling a pause in this narrative for the time being, as I too mused upon recently. If the dollar does move higher, expect to see reflation trades dip and thus the outperformance of defensives, utilities, bonds and tech.

Regardless of whether we do see a meaningful move higher over the coming months, it is important for investors to understand the implications of such a move, as is the purpose of this article. Whilst a move higher would not bode well for risk assets, it would likely be unsustainable and thus brief.

With US debt to GDP at an all-time high of 130%, US net international investment position (NIIP) of -65% of GDP, lack of foreign investment in treasuries and an economy heavily reliant on the appreciation of equity prices, for mine, policy makers will understand the damage a dollar rally could cause. In the long-term, I do remain in the dollar bear camp. However, we need to see a rally and wash-out of the negative sentiment before the downtrend is able to continue.

Finally, I will leave you with this excellent chart by Julien Bittel, summarizing the relative return of the major equity sectors and asset classes to moves in the dollar.

Source: Julien Bittel, CFA
Source: Julien Bittel, CFA

Financials Look Ripe For A Reversal

The financials and banking stocks have been some of the best performing of the reflation trade since the second half of 2020. Banks in particular have benefitted handsomely from the rise in yields and steepening of the yield curve. Since last October, the KBE banks ETF is up roughly 100%, rewarding investors who saw fit to take advantage of the immense value on offer at the time. However, there are a number of signs suggesting now may be a prudent opportunity for investors to begin to take profits and redeploy capital elsewhere.

Firstly, from a valuation perspective, the group can no longer be considered cheap on a relative or absolute basis. Of the “big four” banks, JP Morgan Chase and Bank of America are trading at their highest valuations in a decade, as measured by price to book value.

On the whole, we know banks like to make their profits by lending long-term and borrowing short-term. With long-term yields looking to have stalled for the time being, or perhaps even rolling over, the yield curve did not confirm the recent highs in the sector. It looks as though banks may have some catching up to do on the downside.

As banks and financials have largely proven to be a de-facto short-bonds trade of late, the bond market is sending a similar message as the yield-curve.

For the banking sector to continue its outperformance, it needs the tailwind that rising yields provide. With the US 30-year yield recently breaking its uptrend to the downside, it is looking as though this tailwind may be turning into a headwind for the time being. A move down to the 200-day moving average would put the 30-year yield at around 1.9%.

Additionally, there is strong overhead resistance for yields around their current levels. This breakdown coincides with the 30-years recent rejection of said resistance.

Couple this with the fact that small speculators (i.e. the “dumb money”) in the 30-year treasury futures market remain nearly as short as they have ever been, all the while commercial hedgers (i.e. the “smart money”) remain heavily net-long. Such positioning in the past has usually preceded favourable performance for bonds, and thus seen yields fall.

What’s more, we are now entering a seasonally favourable period for bonds and conversely an unfavorable period for yields. This adds to the bearish headwinds for financials.

Turning to the technicals of the financials sector itself, a number of indicators are signaling exhaustion. We are seeing DeMark setup and countdown 9 and 13’s trigger on the daily, weekly and monthly charts. When such exhaustion signals begin to appear on multiple timeframes simultaneously, it is generally a fairly reliable indication a pullback, or at the very least a period of consolidation, is imminent. The 9-13-9 is considered one of the most reliable of the DeMark sequential indicators.

Focusing on the daily chart of the financials sector ETF, we have just seen a breakdown of its ascending wedge pattern. This coincides with bearish divergences in momentum (RSI) and money flow, in conjunction with the aforementioned daily DeMark 9-13-19 sequential sell signals.

A rally to test the underside of the broken trendline could be an attractive point for those looking to take profits, or for those who are so inclined to trade from the short-side. Additionally, seasonality of the financials sector is also signaling that it may be time to take a bearish, or less bullish, stance towards financial stocks.

In summary, the risk-reward setup for banks and financials in the short-term does not appear to be overly favourable, nor do these companies offer the kind value they provided last year. Depending on your intermediate to long-term outlook for the direction of interest rates and whether your are in the inflationary or deflationary camps, a potential pullback may provide an attractive buying opportunity for the inflationist. For the deflationists or for those who believe rates may be peaking, this may be a good time to take profits and redeploy capital in alternative opportunities set to benefit from falling rates.

For a look at all of today’s economic events, check out our economic calendar.

The Best Trades For The Green Energy Revolution

The great bond bull market of the past 40 years has made millionaires out of many, so has the rise of blockchain, cryptocurrencies and the digitalization of the financial system. Another such paradigm shift upon us is the worlds unified move to decarbonize and green the economy.

What we are witnessing is a worldwide push for industries to move away from excessive greenhouse gas (GHG) emissions. Such unification around a common goal is perhaps unlike anything we have witnessed in the entire history of humanity. With governments and companies worldwide fully committing to the green transition and most aiming for net-zero emissions by the middle of this century, many are taking several significant steps to achieve this goal.

The move from internal combustion engines to electric vehicles (EVs) is the most obvious and popularized move thus far. For example, the EU has announced a target of 30 million electric vehicles by 2030, Britain plans to ban the sale of new traditionally powered petrol and diesel engines by 2030 and so too are the Japanese. California is also adopting a similar goal. Likewise, the automakers themselves are largely embracing the change as they realistically have no option but to do so. Ford, Jaguar and Volvo are some such examples. What is abundantly clear is the climate change goals of nations are no longer within the realm of speculation; the transition is real and it is coming, whether we are prepared or not.

People are now far more open-minded, educated, and aware of the potential damage to both our environment and our economy that global warming can unleash. Our world leaders and notably the Biden Administration are agreeing there is much to be done to green the economy. This is a huge task and is occurring from a global, country, sovereign and individual level. Whilst the evidence above suggests most of the action thus far has centered around the use of electric vehicles and renewable energies, the process of electrifying everything is enormous in scope. Upstream, midstream, and downstream; the way we generate, transport, store and use energy must be revolutionized.

The green energy transition is a once-in-a-lifetime paradigm shift that we can trade and profit from. Much will change during this generational transformation.

Copper

Copper and other metals used in the electrification process are undoubtedly a popular way to trade the green energy transition. Regardless of the rapid price appreciation in such metals over the past 12 months, there are abundant reasons why so many investors are bullish over the long-term. The role these metals will play in the green energy transition is so very important.

Front and center of the electrification metals sits copper; perhaps the biggest winner of the green transition. Its role is critical in all aspects of the push to electrify the economy. With the world’s motor vehicles set to become almost completely electrified over the coming decades and coppers use therein being three to fourfold relative to traditional vehicles, we are going to need a lot of copper.

According to the International Copper Association (ICA), a battery-powered electric vehicle (BEV) uses 83 kg of copper, a hybrid electric vehicle 40kg and an internal combustion engine only 23kg of copper. From just the transition to electric vehicles alone, the demand for copper is set to increase three to four times from its current levels. Indeed, the ICA predicts the number of electric vehicles will rise to 27 million by 2027, a nine-fold increase from the roughly 3 million as of 2017. Such an increase is set to increase copper demand for the production of EVs from 185,000 tons to 1.74 million tons.

Source: International Copper Association - The Electric Vehicle Market and Copper Demand
Source: International Copper Association – The Electric Vehicle Market and Copper Demand

Based solely on the adoption of electric vehicles, we can clearly see the demand for copper is set to increase dramatically over coming decades. What’s more, such projections as those of the ICA are modelled only on coppers use within EVs, the green energy transition will require an immense amount of copper for much more than just its use within electric vehicles.

Indeed, according to the ICA, electric vehicle chargers themselves will require from around 0.7 kg up to 8 kg each, equal to an additional 216,000 tons of copper demand by 2027. Additionally, the adoption of renewable energy sources such as wind and solar are heavily dependent on the use of copper n their construction. According to the Breakthrough Institute, a California based environmental research center, “wind energy requires on average 2,000 tons of copper per gigawatt, whilst solar needs 5,000 tons per gigawatt – several times higher than fossil fuels and nuclear energy”.

The graphic below illustrates coppers use in the generation of electricity from conventional methods compared to wind and solar. Copper will be required to a significant degree in all forms of renewable energy generation.

Source: Kutcho Copper
Source: Kutcho Copper

A hugely underappreciated and at this stage seemingly underfunded part of the green transition for many developed countries, notably the US, is the need to rebuild, or at the very least significantly improve their electrical grid. For the most part, the electrical grid does not have the ability to store electrical energy. One of the major issues with wind and solar-generated power is their intermittency, that is, their inability to constantly generate power. The sun is not always shining nor is the wind always blowing. Thus, the ability to be able to store the electrical energy created from such sources for future use becomes paramount.

What’s more, the United State’s electric grid as is currently constructed is not able to provide and transmit the necessary electricity to power an entirely electrified economy. If the majority of the population came home from work in the evening and were to plug their EVs in to charge, the grid would simply be unable to support such demand and would shut down. In some parts of the US, the electrical grid is nearly a century old. It was designed and built from a completely different era. Those living in Texas can no doubt attest to the limitations of the grid.

Rebuilding the electric grid will require astronomical amounts to copper and other important metals. The importance of this enormous task will only become more prevalent in the minds of policymakers as we continue down the road to electrification.

What makes copper so useful is its ability to conduct electricity and transmit heat. It is roughly twice as conductive as aluminum, making it far more efficient in its use. Copper is the primary source of conductors in wires and cabling, electrical equipment and renewable energy infrastructure. Whilst silver is another such metal that can serve a similar purpose, it is simply too expensive and not as abundant.

Precious metals aside, pound-for-pound copper is the best conductor of electricity and heat. It is also one of the few commodities that cannot be feasibly replaced by any alternatives in the electrification process in the way that battery technology is susceptible to innovation. Additionally, copper itself is also renewable and is one of only a few materials that is fully recyclable.

Also favoring copper is its long-term supply dynamics. In spite of this huge forthcoming growth in copper demand, copper itself is notoriously difficult to source. As detailed by energy and commodity experts Leigh Goehring and Adam Rozencwajg in their Q4 2020 market commentary; “a structural deficit has crept into global copper markets that will become increasingly obvious to investors as the decade progresses. Confronting this strong demand is copper mine supply that will show little in the way of growth over the next five years.

Few large copper mining projects are slated to come online over the next five years”. They also note that “the lack of massive new copper mining projects, coupled with an ever-accelerating copper mine depletion problem, means growth in mine supply should remain minimal over the next five years. Global copper consumption exceeds copper mine supply and recovered copper scrap by about 500,000 tons per year presently and will get worse”.

Whilst an increase in the price will of course lead to further capital injected into the sector to source further supply, the process of getting this new supply online to meet demand is not as simple as it may appear. Clearly, there is a structural supply shortage of copper. This presents an incredibly favorable demand and supply dynamic for copper over the comin years, one in which the copper price and the miners themselves will benefit enormously.

Finally, turning to the technicals, lovers of a long-term chart will find it hard not to appreciate the recent bullish breakout from copper’s near two-decade wedge pattern.

Source: StockCharts.com
Source: StockCharts.com

Whilst much of the rapid price appreciation we have seen over the past 12 months can somewhat be attributed to the COVID-19 lockdown induced supply shortages and rampant speculation, it is important to remember this is a long-term trade. Though the immediate risk-reward may not be as attractive, any significant dips in the price of copper and the copper miners should be bought with earnest for those who believe in the long-term viability of this trade, as I do.

Copper and copper miners are the simplest long-term play on the green energy transition.

Uranium

With so much focus and capital being directed towards renewable sources of energy in wind and solar, there is relatively little thought given to the limitations of these as sources of clear energy. Due to such limitations I will endeavor to detail below, herein lies the inevitability of nuclear power’s role in electricity generation as we progress through this green revolution.

The limitations of renewables

Whilst renewable energies will play a significant and important role in the green energy transition, they are not the panacea for carbon reduction as one might initially believe. There are significant limitations to the sole use of renewables as a means to reach net-zero emissions.

Both solar and wind are inefficient generators of electricity. This is primarily a result of their intermittency and energy density, as I have only briefly touched on. According to Goehring and Rozencwajg, who have also released some excellent research on the limitations of renewables, note that a standard solar panel is likely to only generate between 12-20% of its capacity due to intermittent sunshine, whilst a wind turbine is only marginally better at around 25% due to the intermittency of wind.

Goehring and Rozencwajg have developed a metric to track the efficiency of energy generation from its various sources, measured as Energy Return On Energy Invested (EROEI), estimating that between 25-60% of the energy generated by renewable sources is consumed internally by the process of actually generating that electricity, meaning the EROEI for renewables is roughly 3 to 1. Compare this to a traditional gas plant, whose EROEI is around 30 to 1, meaning that it internally consumes only 3% of its generated energy. Traditional and less carbon friendly sources of energy are roughly 30 times more efficient in their energy generation compared to renewables.

What’s more, due to the inefficiency of renewables and their need of servicing and maintenance, which in itself is quite impactful on carbon emissions, in addition to the need to overbuild solar and wind farms as well as the ability to store the energy to counter their intermittency, has largely resulted in those countries who have adopted renewables to a significant degree not seeing the reduction in carbon emissions they would have hoped for.

Source: Goehring & Rozencwajg - Ignoring Energy Transition Realities
Source: Goehring & Rozencwajg – Ignoring Energy Transition Realities

As we can see above, much of the gains toward a green economy made by the adoption of renewables will be offset by their inefficiencies and the additional energy requirements to maintain the infrastructure and store their sourced energy. Few people understand how energy intensive the green transition will be.

Whilst they will play an important role in the green energy transition, renewables will not solve problem of global warming to the degree that is desired. This leads to nuclear power, one of the few solutions able to provide the carbon-free, base load power required.

Why uranium?

Uranium is the fuel that powers nuclear reactors which then generates power. Nuclear power is generally misunderstood. On the whole, it is a clean, safe and reliable source of of base-load energy.

If we return to Goehring and Rozencwajg’s Energy Return On Energy Invested (EROEI), “a modern nuclear reactor generates electricity with an EROEI of nearly 100 compared with 30 for gas and 1-4 for renewables. As a result, only 1% of the generated electricity is consumed internally compared with 3% for gas and 25-60% for renewable energy”.

Compared with renewables, nuclear energy is anywhere from 40-100 times more efficient. What’s more, nuclear energy is far more scalable than renewables and completely avoids their intermittency shortcomings. The green energy transition simply must have an increased reliance on nuclear energy, it is one of the few sources of clear energy that has the ability to drive the green energy transition in an efficient way.

Not only is nuclear energy the most efficient source of electricity generation, but it is also less carbon intensive than renewables.

Source: Sachem Cove Partners
Source: Sachem Cove Partners

Perhaps the biggest reason behind the lack of reliance on nuclear as a source of energy is the negative sentiment towards it. Nuclear energy certainly gets a bad wrap. There have been three significant nuclear incidents responsible for this; Three Mile Island, Chernobyl and Fukushima. Despite the actual loss of life being surprisingly less than one might have thought, these incidents have largely left the industry bereft of capital and acceptance as a source of energy over the past 40 or so years. However, what will likely surprise many is that nuclear energy is actually the safest form of electricity.

Source: Sachem Cove Partners
Source: Sachem Cove Partners

The use of uranium within nuclear energy does have somewhat of a dark history. The uranium cycle of nuclear energy creation, as opposed to using the thorium cycle, was chosen as the by-product of creating electrical energy using uranium is plutonium, which was used to make nuclear weapons.

The reasoning behind this choice was because the heyday of nuclear energy occurred during the Cold War, and it was the agenda’s of the worlds governments to create nuclear weapons. However, the Cold War has long since past. It is now time for policy makers to revisit the use of nuclear energy within their climate goals. Indeed, this negative view towards nuclear energy has created a huge mispricing for the sector. The math no longer is equal to the narrative.

Convincing environmentalists that the positive impacts of nuclear energy do indeed significantly outweigh the negative impacts will likely be a game-changer for how the world produces energy. Likewise, an education of the general public is needed in regards to nuclear energy. We cannot meet our climate objectives without nuclear energy in the mix.

Indeed, we now are seeing sentiment towards nuclear slowly begin to change. The pressure of governments to meet their green energy objectives will ultimately lead to nuclear power having an ever increasing role as a source of carbon free base-load energy. On the whole, nuclear energy is actually very clean, safe and reliable. Nuclear energy simply must be a part of policy makers plans should they wish to achieve their green objectives.

The industry fundamentals for nuclear energy and uranium is quite different to most other commodity and energy markets. As the sector has been in a bear market since the Great Financial Crisis, it has largely been bereft of capital. This seemingly paints a positive picture for the price going forward. Due to the lack of capital and investment, there is very little in the way of new production set to come online in the next few years in order to meet the increasing demand for uranium. This lack of new capital has been beneficial for the sector, as only the strongest, most profitable and best-run producers have survived.

Likewise, the production of uranium is a highly concentrated industry, with the two largest miners, Kazatomprom in Kazakhstan and Cameco in Canada, accounting for roughly 60% the the worlds uranium production. With both producers significantly reducing their production over the past 12 months due to COVID-19, a structural supply shortfall could well be with us for years to come so long as nuclear energy becomes a significant part of the green energy transition. Furthermore, what could result from such supply shortfalls is the producers themselves entering the spot market in order to fulfill their supply obligations to the various reactors; a bullish outcome to be sure.

From a technical perspective, the spot uranium price appears to be finally bottoming after its prolonged bear market.

Source: TradingEconomics.com
Source: TradingEconomics.com

Due to how the industry contracts uranium supply between producers and users, the spot price is perhaps not the most relevant and is a very thinly traded market. For me, I am happy to invest via the URNM ETF, which is superior to the older URA ETF. URA is more of a nuclear energy ETF than a play on uranium, and as a result there are many constituents of the fund which makes little sense as they are not related to the production of uranium. URNM is a better vehicle for those looking for a purer exposure to the uranium miners.

However, similar to copper, it is important to keep in mind the uranium trade is for those with a long-term time horizon. Given the near doubling of the price of both URA and URNM since the reflation trade took off in November of last year, the risk-reward for the immediate-term is perhaps skewed to the downside. Of course any significant pullbacks should be bought in earnest for all those who buy into the long-term bull case for uranium, as I do. The 38.2% Fibonacci retracement of the Novembers lows looms as one such attractive entry point.

Source: StockCharts.com
Source: StockCharts.com

The case for uranium is simple; nuclear energy will ultimately be required in order for governments to meet their carbon goals.

European Carbon Credits

What are European Carbon Credits?

European carbon credits, or perhaps what are more accurately defined as carbon allowances, are part of the European Union’s Emissions Trading Scheme, or EU ETS. The EU ETS is at its core, a market-based approach to controlling carbon emissions introduced by the EU as the cornerstone of their efforts to control emissions and meet their carbon goals. The Emissions Trading Scheme is what’s referred to as a ‘cap and trade’ system, which attempts to set a maximum limit of emissions certain companies and industries involved in the scheme are allowed to emit during a certain period of time. The EU ETS is the worlds first and largest ‘cap and trade’ system aiming to reduce GHG emissions.

The system works by setting an emissions cap and issuing a certain number allowances, which are referred to as EU Emissions Allowances (EUAs). The cap is set by the EU, and all the companies within the scheme are required to accumulate a certain amount of allowances (EUAs) for every ton of CO2 they emit each year. These allowances are issued via auction each year (or issued for free to various industries where there is considered to be a potential risk if they were required to pay the full cost of the allowances they need to cover their emissions), and are tradable between companies. At the end of each year, the participants are required to return an allowance for every ton of CO2 they emitted during that year.

Those companies who were unable to accumulate a sufficient number of allowances to cover their emissions (i.e. the more carbon intensive industries), are required to reduce their emissions or buy surplus allowances from companies whose allowances exceed their carbon emissions during the period. These surplus companies are also allowed to accumulate their unused allowances for use in later years.

The following graphic provides a helpful illustration of how the system works.

Source: EU ETS Handbook
Source: EU ETS Handbook

For those companies who fail to accumulate sufficient allowances or reduce their emissions accordingly, they face a fine of approximately 100 euros per excess ton of carbon emitted, as well as being required to accumulate allowances in future years to cover those not covered in past years. The system is structured such that there are significant penalties for the participants who do not meet the emissions goals.

The benefits of using a ‘cap and trade’ system as a means to meet carbon emissions goals is it allows the market to determine how the emissions can be reduced at the lowest cost to consumers and to the economy. What this means is the price of carbon is effectively set through the market via the supply and demand for allowances. Relative to more traditional methods of simply taxing carbon emitters, a ‘cap and ‘trade’ system offers far more flexibility and efficiency, resulting in carbon emissions being cut by companies and industries who will incur the smallest cost for doing so.

First launched in 2005 as a pilot program, the Emissions Trading Scheme is now in its fourth stage, and has undergone several changes throughout its history. Phase 1 (2005-2007), was the testing phase where too many allowances were issued, resulting in the price effectively falling to zero. This oversupply was partly driven by the companies themselves overestimating their carbon emissions on purpose, allowing them access to a greater number of allowances.

Phase 2 (2008-2012), was similarly driven by an oversupply of allowances from Phase 1, and coincided with the Great Financial Crisis, both working to keep prices down. Phase 3 (2012-2020) on the other hand worked to reduce the supply and increase the amount or participants. Phase 3 has been very successful and has established the EU ETS as one of the worlds most effective measures to combat carbon emissions. The system is set to further reduce supply and increase participants throughout Phase 4 (2021 and beyond).

What is important to note in regards to Phases 3 and 4 is the number of allowances available has been declining, along with the number of participants who were previously entitled to free credits is declining, and finally, the number of industries and countries included as part of the scheme is increasing. As it stands, 27 countries within the European Union are part of the scheme, along with non-EU countries Norway, Liechtenstein and Iceland. As I will touch on the in following section, the supply and demand dynamics for the scheme indicates the prices of these allowances is heavily skewed to the upside.

Demand and supply dynamics

The current supply of allowances is what’s referred to as the Total Number of Allowances in Circulation, or TNAC. This is currently set at around 1.4 billion tons of carbon emissions annually. The emissions targets of the scheme is a reduction of emissions by 43% relative to the 2005 levels when the system was initiated. This implies a linear reduction in emissions of 2.2% annually from 2020 to 2030. The TNAC will reduce accordingly in line with the targeted reduction in emissions. Simply put, the supply of allowances will reduce each year.

This creates a simple dynamic within the scheme; a reduction of supply coupled with an increase in demand. The system is skewed towards higher prices. The brilliance of the scheme is it creates incentives for higher prices of the allowances for almost everyone involved. The higher the price (i.e. the higher cost of emitting carbon), the greater the incentive for companies to own credits and thus fewer greenhouses gases are emitted. What’s more, the governments not only have an environmental incentive for higher prices, but as a result of the sovereign governments of the many nations involved in the scheme being the ones who actually distribute the allowances to the participating companies, they directly receive revenue via the auctions for doing so. Again, higher prices equals higher revenue.

To a certain extent, the allowances themselves are being viewed by the participants as a store of value. They are aware the prices are going to rise, they are aware the supply of allowances is going to continue to fall, and they are required to all hold enough allowances to conduct their business as it stands. There is little incentive to sell. Analyzing this supply and demand dynamic from a stock-to-flow perspective as one would gold, bitcoin or other scarce assets again presents a favourable outlook for the price. What’s more, unlike gold or bitcoin, it is in the governments best interests to see the prices rise. The system is being championed by government policy as opposed to an alternative to government policy.

To give some idea of how the supply and demand dynamics of the scheme are set to work within the coming years, Lawson Steele of Berenberg Bank, one of the worlds leading experts on the EU ETS, projects a cumulative supply shortfall of around 99% by 2024! If such projections were to modestly prove true, there is huge upside of the price of allowances in the coming years.

However, it must be noted the EU is somewhat cautious of a too-rapid increase in price, and do have measures in place to combat such a rapid price rise if it were to be too damaging for the companies involved in the ETS. Should it be deemed necessary, the policy makers will (attempt) to intervene via what is known as the Market Stability Reserve (MSR), as well as there ability to alter the supply of allowances as defined by Article 29a of the ETS.

The MSR is basically a feature of the system that helps to control over an oversupply or undersupply of allowances. Introduced in 2019, the MSR works to reduce the supply (i.e. the TNAC) when there is an abundance of allowances, and increase the TNAC when there is a potentially harmful allowances deficit. The idea behind the MSR is to allow prices to rise in a smooth fashion with minimal volatility.

Likewise, Article 29a of the scheme’s directive obliges the policy makers to monitor the supply and demand dynamics and intervene by reducing or increasing supply should this be deemed necessary. Whilst the purpose of Article 29a is again to try to ensure prices rise in an orderly manner, the actual rules therein are cloudy in nature and very much open to interpretation. What’s more, the many different sovereign’s involved will want different prices depending on their industries included in the ETS, thus creating somewhat of a potential conflict of interest between participants and thereby increasing the difficulty of intervention via Article 29a.

Whilst the biggest risk is an excessive rise in prices to the point whereby policy makers deem it appropriate to intervene, such a risk could be considered immaterial given that prices must rise in the first place to warrant such intervention. To be clear, the policy makers most certainly want higher prices. These measures are more so designed to achieve those higher prices in an orderly manner. At the end of the day, the priority of the scheme is to reduce GHG emissions, and if the price must rise to achieve this then so be it.

Technicals and ways to trade

Capping off the bull case for the EU carbon allowances are the technicals. The allowances themselves can be traded in the futures market. This futures market of EUA’s has a near $300 billion market cap with a significant level of liquidity.

From a long-term technical perspective, the recent breakout of the decade plus basing pattern remains immensely bullish.

Capture.PNG

The allowances can also be traded via the KRBN and GRN exchanges traded funds. The KRBN ETF is made up of roughly 70-80% of EU allowances, with the remaining constituents being that of other, smaller Emission Trading Schemes over the world. The GRN ETF, which is smaller than KRBN, trades nearly exclusively off the EUA futures. I have positions in both ETF’s and intend on adding more as attractive opportunities present themselves. Though the price action over the past 12 months has been near parabolic and I would be more inclined to wait for a pullback of some sort before buying more, the supply and demand dynamics suggest further upside is ahead.

The EU ETS is Europe’s flagship way to meet its carbon goals over the coming years. There remains a vast amount of institutional money yet to make its way into this trade as the ESG incentives for pension funds and institutions to buys allowances will only grow. Remember, a higher price equal fewer emissions.

Final thoughts

What I have discussed here are my favourite trades for the green energy transition. I do not doubt there will be other investments who will benefit significantly over the coming years as the world moves to decarbonize. Whilst EV’s has certainly been the winners to date, the risk-reward for such a trade is not necessarily skewed to the upside as much as one would like.

Geothermal, battery technology and nickel are all themes in which I am sure will receive much investment and whose investors will likely benefit, along with many others.

For a look at all of today’s economic events, check out our economic calendar.

Gold Is Breaking Out

Capture.PNG

While we were teased with a false breakout at the turn of the year, the landscape has changed for the precious metals since which leads me to believe we are set to see the sector continue its march higher.

Encouragingly, the miners have lead the metal itself on this breakout, a bullish sign for the sector.

Capture.PNG

Zooming out, a longer-term perspective is always helpful in seeing how healthy these sort of consolidation periods are during an uptrend. There appears to be plenty of upside potential ahead for precious metals.

Capture.PNG

From a sentiment perspective, gold is still being viewed relatively negatively on the whole. Whilst not at the attractive levels that provided the excellent buying opportunity back in February, the managed-money positioning in the futures market (i.e. hedge funds and CTA’s, who love to be long and the tops and not-so-long at the bottoms) is still at a level that has proved to be attractive buying opportunities in the past.

Capture.PNG

The same can be said of the miners bullish percent index ($BPGDM).

Capture.PNG

Similarly, fund flows out of the GLD ETF look to have completely washed out the weak hands.

Capture.PNG

Seasonality also looks to be painting a rosy picture for the next six months.

Capture.PNG

Should this breakout hold, the miners are the place to be and look set to recommence their upside outperformance relative to gold.

Capture.PNG

Compared to the broader equity markets, the price action again appears favourable for the miners.

Capture.PNG

Fundamentally, the miners are very attractive also.

Source: Tavi Costa - Crescat Capital
Source: Tavi Costa – Crescat Capital

As I mused upon recently, we have had several very favourable opportunities for those bullish precious metals to add to their core long-term holdings, should these breakouts hold, it now appears to be an excellent opportunity to get tactically long the sector. One would expect the smaller gold and silver miners to outperform in such times. Best to take advantage.

For a look at all of today’s economic events, check out our economic calendar.

Inflation: Catalysts And Consequences

Inflation is a tricky topic to discuss given its broad definition and applicability among different people. Whilst we have largely lived in a disinflationary world for the past 40 years in terms of consumer prices, monetary inflation in terms of asset prices has skyrocketed. This has resultingly driven wealth inequality and political divide to breaking point.

Traditional consumer price inflation itself is not applicable to all individuals, but rather has been a tale of two indices. The baby boomers, who as a group hold the majority of financial assets and real estate have been the biggest beneficiaries of this consumer price disinflation and asset price inflation. On the other hand, though the younger generations too have benefitted from consumer price disinflation in many areas such as technology, they are yet to accumulate financial assets or real estate to the same degree to have benefitted from monetary inflation.

Additionally, they have arguably experienced consumer price inflation in many areas. Unaffordable housing, rising daycare costs and school fees are some such examples. Demographics is a powerful force of which I have written about previously.

Source: INTL FC Stone
Source: INTL FC Stone

Regardless of this divide, what can be agreed upon is the presence of several structurally inflationary tailwinds going forward, and, if they are to take hold of the economy, then what we will experience over the coming decades will be very different what was experienced in recent times. Investors must prepare for such a scenario. However likely or unlikely it may be, consumer price inflation in its oldest form could be making a comeback.

The Case For Inflation

The reasoning behind the ever-increasing view toward an inflationary future is plentiful and justifiable. I will attempt to detail these inflationary tailwinds that could lead to a structural shift toward an inflationary future, beginning of course the most prevalent: the broad money supply.

The Money Supply

When it comes to the money supply and inflation, what matters is the broad money supply, or M2. We all know by now the unprecedented growth in the broad money supply since the onset of COVID-19. This extraordinary growth has become the means of explaining the swift rebound in asset prices. Whether the growth in the broad money supply is the sole perpetrator is up for debate, what is not though is its impact on the economy and equity markets over the past 12 months.

Source: St. Louis Fed
Source: St. Louis Fed

Money can be created in two ways; the traditional means via commercial bank lending or via direct monetization of newly issued federal debt. Up until recently, it has been the commercial banks that have been able to claim sole responsibility for the growth in the broad money supply. The notion that quantitative easing (QE) conducted by itself is money creation is false. The Federal Reserve and other central banks have the ability to influence the base money supply (M0), but not the broad money supply.

They can lend, but they cannot spend. What must be understood is commercial banks create money via fractional reserve banking when lending occurs between said banks and consumers and businesses. QE is a means of capitalizing the banks, allowing them further scope to be able to lend against these freshly printed reserves with the central banks. QE is effectively just a swap of government bonds for central bank reserves; unless lent against the two are negligible. Getting banks to lend is what increases the broad money supply.

Unlike the Fed, the Federal government does have the power to spend. If the central banks and governments work together, they are able to rapidly increase the base money supply and the broad money supply. This is what many believe will be the impetus for a return of secular inflation; central bank financed fiscal spending. Many believe this is in fact already the case.

The great Russell Napier, who himself has been a deflationist over recent decades is now championing the inflationary paradigm shift. His belief is due to governments now stepping into the realm of guaranteeing bank credit and their direct monetization of the government debt, both tools we have seen various governments employ over the past 12 months, is a means of governments and central banks finally entering the realm of true money creation.

If the central banks are directly funding government spending and outright guaranteeing loans made by banks, then this is money creation and has no doubt played a role in the expansion of the broad money supply. If such a fundamental shift is the norm going forward then in my mind, I do side with Russell in that this would be structurally inflationary. When a central bank is mandated to guarantee bank loans or does so on its own accord, or directly monetizes the federal deficit using freshly printed currency, then it is in the business of creating money. Consumers will spend free money.

We can see how this relationship has played out in the past. The chart below from Lyn Alden is the perfect illustration of how growth in the broad money supply over the past 15 or so years has not been a function of QE or government spending in isolation, but rather is a result of a combination of the two.

Source: Lyn Alden Investment Strategy
Source: Lyn Alden Investment Strategy

With the dynamic of central bank funded money creation, the Fed and government are able to rapidly increase both base and broad money without crowding out the private sector (which would generally occur when governments run large fiscal deficits funded by the private sector) or being restrained by the lending practices of commercial banks.

Going forward the question then becomes, how does the increase in broad money supply filter through to traditional consumer price inflation, or will it simply continue reinforcing asset price inflation. The issues with QE were (and still are) that the money printed by central banks was never able to leave the banking system as commercial banks did not make additional loans proportionate to their increased central bank reserves.

As a result, QE has not historically increased the broad money supply or found its way into the hands of consumers. What is potentially different this time is that by definition, an increase in the broad money supply largely means this money is beginning to find its way into the hands of consumers. It now rests more generally in households and businesses, notably smaller businesses who are more inclined to spend for productive reasons.

The gauge for how the broad money supply will impact consumer prices is of course the velocity of money. Put simply, the velocity of money is the rate at which money is exchanged in an economy through transactions between lenders and borrowers, buyers and sellers. Whilst the relationship between money velocity and CPI is clear, unfortunately, M2 money velocity still remains near its lowest point in over 60 years:

Source: St. Louis Fed
Source: St. Louis Fed

Many believe the velocity of money will pick up once the COVID-19 lockdowns and restrictions subside, allowing consumers and businesses to finally spend and releasing a wave of pent up demand that ought to provide a reflationary tailwind to CPI. To a certain extent, I do not doubt this will be the case.

Fiscal Dominance & Political Instability

History suggests that paradigm shifts are quite often reinforced by political shifts. As I touched on above, we are entering an era of central bank financed fiscal spending. In all likelihood, Congress will no longer be constrained in their spending efforts to what they can do, but rather what they are politically obliged to do. The populist movement is real. Driven in large due to the error of quantitative easing, easy monetary policy and the continuous central bank bailouts of Wall Street at the expense of Main Street, it appears as though such measures as regular payments to individuals, universal basic income and straight up MMT are indeed slowly becoming the norm. The seeds of fiscal dominance have been planted.

We witnessed the power of fiscal spending during the height of the pandemic, when despite of the temporary shutting-down of the economy, personal income in fact went, a result of the reliance on government transfer payments and stimulus:

Source: St. Louis Fed
Source: St. Louis Fed

One huge appeal of fiscal spending is its potential ability to bridge the wealth gap via inflation. If fiscal dominance does eventually lead to inflation, such inflationary periods over the past century have seen large declines in the wealth divide among the rich and poor.

Source: Ray Dalio, Lyn Alden

Fiscal dominance and MMT are easily justified by politicians. Central bankers have tried endlessly to get inflation; it is a palatable solution to the wealth divide. Direct payments to individuals are the easiest and most assured way to get the money into the hands of individuals who actually have a higher marginal propensity to consume. QE alone does not and has not done this. If fiscal dominance is not able to increase the velocity of money in today’s economy then nothing will.

Other Inflation Catalysts

Whilst my belief is that the single largest determinant of a shift to a period of structural inflation will be fiscally driven spending and payments to individuals, there are several other notable inflationary catalysts worthy of discussion.

De-globalization/protectionism

One of the most deflationary forces of the past 40 years, globalization has seen the US forfeit its entire manufacturing sector, favoring capital at the expense of labor. De-globalization, protectionism, tariffs and trade barriers would go a long way to reverse this trend.

World trade as a percentage of GDP peaked back in 2008 and has been stagnant since, as the chart below illustrates.

Source: MacroTrends.net
Source: MacroTrends.net

Should we start to see this trend reverse course, it would go a long way to once again turn favor to labor at the expense of capital. The past twelve months have perhaps been the catalyst that an over-reliance on foreign supply chains does have consequences. Indeed, we are already beginning to see the Biden administration implement these very measures.

Protectionism would transfer power back to the younger workers and spenders, forcing companies to raise wages and thus provide a strong tailwind for a rise in consumer price inflation. This is perhaps one of the most important factors likely to lead to an inflationary regime; in order for a sustainable rise in inflation to occur, then wages must be a primary driver, and protectionism and de-globalization could indeed help to push up wages.

Source: St. Louis Fed
Source: St. Louis Fed

Likewise, regionalization of supply chains would resultingly need them to be shortened, bringing about further increases in the price of input costs, which in turn would be a cost borne by the consumer through higher prices and thus higher inflation.

US dollar bear market

A weakening dollar would too be somewhat contributory to an inflationary paradigm shift. Firstly, it is my expectation that the falling dollar environment we have entered post-March 2020 will continue over the long-term.

Source: Bill Campbell, DoubleLine Capital - Bilateral Digital Currency Payments and the Twilight of the Dollar
Source: Bill Campbell, DoubleLine Capital – Bilateral Digital Currency Payments and the Twilight of the Dollar

Considering the US runs one of the world’s largest trade deficits relative to its economy, a falling dollar for a net importer would result in rising import prices for both businesses and consumers. This in turn contributes to rising input costs and thus higher prices. A falling dollar is also generally bullish for commodity prices.

However, it is worth noting that for the dollar to have a significant impact on inflation via rising import prices, it would need to be a substantial move downward, and any inflation would largely be contained within goods, as goods are imported whilst services are not. Goods prices only make up around one-third of CPI.

Commodities bull market

The past decade has not been favourable to commodities. Since 2008 the Bloomberg Commodities Index has more than halved, driven by a period of persisting commodity oversupply providing a deflationary force for consumer prices. Commodities relative to financial assets are near their all-time lows. Were we to enter a period of continued commodity scarcity and thus a commodity bull market, this would no doubt provide an inflationary tailwind going forward.

Source: Crescat Capital
Source: Crescat Capital

The lockdown driven supply restrictions have contributed to the rapid rise in things such as copper, lumber and oil over the past few months. For this commodity bull market to be sustainable going forward, we would need to see a pick-up in the demand side of the equation along with continued supply shortages. In regards to the latter, we have seen commodity producers massively cut capital expenditures to cope with the COVID driven fall in demand. Continued underinvestment would certainly support this dynamic.

Another factor at play is how investors will likely seek out hard assets such as commodities to provide a source to protect their purchasing power in the event of inflation. There is also a political tailwind for commodities, with the Biden Administration’s proposed infrastructure package set to contribute to the increased demand for more industrial commodities, as well as the shift to a green economy I will discuss below.

Green Energy & ESG

Whilst not an immediate inflationary catalyst, the focus on green energy and ESG is a trend that is only gaining in popularity, acceptance and political support. The move towards green energy policy will undoubtedly put upward pressure on commodities such as copper, lithium, nickel and cobalt, all used in large as part of the production of electronic vehicles. Indeed, as noted recently by Knowledge Leaders Capital, “electric vehicles contain 183lbs of copper compared to 43lbs for combustion vehicles, while wind turbines contain 800lbs of copper”.

With this shift toward green energy and the Biden administration making green energy policy a priority, we have since seen copper explosively breakout to the upside of its pennant pattern dating back over a decade; very much a long-term bullish technical sign.

Source: StockCharts.com
Source: StockCharts.com

Dr. Copper is prescribing inflation.

Source: The Felder Report
Source: The Felder Report

What’s more, “green energy policy will seek to raise fossil fuel prices in general (either through taxes, a reduction in subsidies, or other hindrances to new production).” The shift toward green energy will indeed help provide the demand for a sustainable commodity bull market.

Not only does a green energy and ESG movement provide an inflationary tailwind via this increased demand for commodities, but it also plays a role in restricting the investment of capital in less environmentally friendly resources like oil. As we still remain a long way off completely removing our reliance on oil and energy, supply shortages via insufficient capital expenditure will only add fire to the supply driven rise in oil and energy.

Pent-up demand

The post lockdown release of pent-up demand is what many are pointing to as being the catalyst for a coming inflation. Due in large to the fall in demand for many goods and services consumers have not needed nor been able to consume during lockdowns over the past 12 months, the supply shortages for many goods will of course only exacerbate the effects of a release in consumer demand once spenders are allowed to spend. Cinemas, airlines, hotels and restaurants are some such examples of areas where this pent-up demand will funnel.

Source: St. Louis Fed
Source: St. Louis Fed

We have seen the savings rate as a percentage of gross domestic product spike to historic levels, as such, if we were to simply see savings return to its average over the past couple of decades, this spending would no doubt trickle down into consumer prices. Whilst it may only have somewhat of a temporary effect, some form of demand-pull inflation ought to ensue as a result of a release of this pent-up demand.

Central bank digital currencies

The introduction of central bank digital currencies (CBDCs) is perhaps the most important factor at play in regards to completely changing how the elected officials are able to generate inflation. Whilst the act of governments guaranteeing bank credit and central bank financed fiscal spending are the first steps into the realm of MMT style direct payments to individuals, the introduction of central bank digital currencies will take this entire dynamic a step further to the point where the entire financial system we know today would be upended.

CBDC’s would completely destroy whatever remains of the proverbial wall between fiscal policy and monetary policy. This is without a doubt an inflation game changer. If we are to see the introduction of a digital currency that can be directly provided to individuals via the Federal Reserve, this would allow the central banker’s stimulus tools beyond anything seen today.

They would have the ability to directly give money to certain people they deem more likely to spend, charge different types of people different interest rates depending on their spending habits, punishing savers with lower or negative interest rates in order to influence consumption. The entire commercial banking system and traditional means of money creation would be bypassed. This would put the Fed into the true money printing business and no longer be tied to the bank’s inability to lend and increase the broad money supply despite their massive QE programs.

Such measures undoubtedly would be abused and be an intrusion on private freedom, but are nonetheless likely and seemingly represent the culmination of the wrong headed policies of central bankers we have seen now for decades. None of the currently available tools at their disposal would allow them to micro-manage in the way a central bank digital currency could. The likely outcome will be inflation beyond what the central bankers bargained for. Bill Campbell opined the introduction of central bank digital currencies would be akin to opening Pandora’s Box of unintended consequences.

Average inflation targeting

The Fed has failed to meet its prescribed 2% inflation target every year since originally mandated in 2012. A recent shift in how they will attempt to reach this target is a signal of their increased willingness (or desperateness) to create inflation. As opposed to aiming for their traditional target of 2% annual inflation, they will instead now attempt to create average inflation of 2% annually. This subtle change is significant.

Average inflation targeting affords the Fed the ability to overstimulate the economy (as if they weren’t doing this already…). Nonetheless, this policy shift allows even more scope for their new forms of stimulus by way of directly monetizing the MMT style fiscal stimulus described above.

Incrementum AG detailed why this new inflation targeting policy is important in a recent report; “previously, if the economy had an inflation rate of 1.5% in year 1, then in year 2 the Federal Reserve would start from scratch in its attempts to reach 2%, and it would still aim for a 2% inflation rate in year 2 regardless of what occurred in year 1. However, under inflation targeting, the Fed can use the difference of 0.5% from year 1 to exceed the inflation target in year 2 by just that amount. Even with an inflation rate of 2.5% in year two, the Fed would still have met its inflation target. Where it would otherwise have had to tighten its monetary policy, it can continue its loose monetary under AIT.”

You can thus see from their example how this provides ample for over stimulation, particularly so if their inflation targeting time frame is a greater number of years. This creates the very real possibility of a policy mistake, particularly if we do experience an increasingly inflationary future ahead of us.

Implications Of An Inflationary Regime

Inflationary or not, what is almost assured is that we are entering a period of fiscally dominated, MMT style, direct to consumer stimulus. The biggest consequence of this will be the ever rising debt burden of the government. Whether directly monetized by the Federal Reserve or not, how yields react to such measures will perhaps be most telling as to how the coming decades will unfold under an inflationary regime.

Inflation & yields

It is no secret that many bonds offer the least risk-reward in the long-term of perhaps any other major asset class in history. “Reward free risk” is how Jim Grant describes investing in the bond market. A period of sustained inflation would be the nail in the coffin for bonds. Such a regime raises several questions. How far can yields rise? How long can such stimulus be sustained before something breaks? Would the government and central bankers want to stop rates rising?

So long as the government intends to continue down its current path of fiscal dominance, which from a political perspective they almost have no alternative, then negative real rates will be their preference. To get an understanding of how significantly costly it is for the government to finance its deficits, in a recent interview, macro expert Louis-Vincent Gave noted how a 15 basis point increase in funding costs is equivalent to the annual cost of the entire US Navy, whilst a 30 basis point increase is equivalent to the annual cost of the US Marine Corps. As long as the budget deficit continues to expand and is primarily funded on the long end of the curve then rising rates are unsustainable for the government.

Rising rates as a result of inflation would mean the government would either need to issue more debt to finance its existing discretionary spending in the form of social security, defense, Medicare as well as to cover its increased interest costs, or correspondingly reduce spending in these areas. As there is simply no political impetus to be able to cease its discretionary spending, but rather expand this spending, anything other than negative real rates is unlikely to be sustainable.

Rising rates are equally as impactful on the private sector too. Corporate debt as a percentage of GDP remains at all-time highs.

Source: St. Louis Fed
Source: St. Louis Fed

Perhaps more importantly however is how much of this corporate debt is set to mature in the next few years.

Source: Wells Fargo and Bloomberg L.P via FFTT-LLC
Source: Wells Fargo and Bloomberg L.P via FFTT-LLC

With long-term yields continuing to rise and likely to rise much further if an inflationary backdrop occurs, corporations will have no choice but to refinance this debt at higher yields. Corporate profit margins would not bode well in such a scenario.

The country simply cannot sustainably afford a meaningful rise in rates.

If we do get inflation and central bankers do not allow bond markets to function property and price this inflation, then they will at some point need to step in with some form of yield curve control (whether explicit or implicit); we would then have entered an era of financial repression. Financial repression will be indicative of a completely different financial market than what we have experienced over the past 40 to 50 years.

Financial repression

A structurally inflationary environment that is not able to be priced in by the markets due to central bank intervention is not a scenario many alive today have experienced in the developed world. If inflation is allowed to run hot, whilst the government is allowed to continually finance its deficits at capped negative real yields, then this allows the government to essentially inflate away its debt. This is an indirect default on the national debt and is at the heart of financial repression and yield curve control. The bonds will get paid back, but are paid back in a currency with less purchasing power.

Yield curve control works to remove the market’s ability to price long-term yields. The consequences of this must be understood. If inflation is rising without a subsequent rise in interest rates, then the purchasing power of debt will be inflated away without an increase in the purchasing power of consumers. Savings are unable to match inflation and growing prices. Savers are taxed whilst borrowers are bailed out. This would be a complete shift from a free market economy to a planning economy. We would be almost exclusively relying on the growth of the public sector in the place of the private sector.

Furthermore, fiscal dominance and MMT put the onus on the government to then attempt to control inflation. As central bankers are effectively tied to the actions of the government, it will be up to the government officials to act to increase taxes or reduce spending to control inflation. We would see an economic recovery in which central bankers will respond to rising inflation by increasing liquidity by purchasing treasuries to stifle yields, as opposed to withdrawing liquidity.

Given how politically incentivized government officials are, for them to be able to reduce spending or increase taxes in any meaningful way would be difficult. Indeed, given the wealth disparity of today, inflationary environments typically favor borrowers at the expense of lenders and have historically resulted in decreased wealth inequality during such times, as I mentioned earlier. Whether financial repression will allow this wealth divide to subside as it has done previously will be telling.

What Does This All Mean For Investors?

At the end of the day, for us investors what really matters is how a structural bout of inflation or stagflation will impact our investing decisions.

Many back-tests will show you what you would largely expect from asset returns during times of inflation; real assets, commodities, energy, value would do very well relative to things like tech, utilities and bonds. Nothing you didn’t know already.

Source: Knowledge Leaders Capital
Source: Knowledge Leaders Capital

Source: Incrementum

Source: IncrementumWhilst this does represents a huge shift from the market darlings over the past 10 years, there are some challenges with these sort of analyses that ought to be addressed. The problem is, much of the investing that is conducted today based on inflation is done so with a significant data availability problem. Though it is likely the best performers during the previous structurally inflationary periods should once again outperform, because we haven’t had true CPI inflation since the early 1980s, we have a limited sample size to compare to. Likewise, back during the highly inflationary 1970s the economy, demographics, global financial system and its interconnectedness were very different to today.

Additionally, given how many of the investing strategies, quantitative algorithms and portfolio construction of today is based on data that only really dates back 30 or 40 years, there is a huge risk in how these strategies will react to a completely different structural market an inflationary regime would bring about.

What is of course a certainty is the death of the bond market. Structural inflation and rising interest rates are undeniably a bond’s worst enemies. In regards to equities as a whole, Russell Napier, an avid student on market history believes that equities would indeed perform well up until inflation rates start to reach around 4%, as it is his belief this is the point whereby monetary authorities will start an aggressive attack on inflation by way of raising interest rates.

Countries with relatively low debt levels such as emerging markets would also likely do well, given their lower debts allow freedom from the sort of financial repression developed markets are likely to see in such an environment. Likewise, gold and precious metals are undoubtedly a standout asset class in an environment of financial repression and expanding fiscal deficits, as well as inflation.

It is also worth noting how the likely financial repression of an inflationary environment could impact the historically favourable inflationary trades. Value and financials for example do not respond well to yield curve control, given that it is the rising rates that generally are a function of inflation that allow the fundamentals of banks and such to improve.

So, Where Are We Now?

The reflation trade has been hot over the past several months. I wrote about this recently here. Commodities have perhaps been the biggest beneficiary of the inflationary narrative to date.

Source: StockCharts.com
Source: StockCharts.com

Prices too are rebounding strongly. The ISM manufacturing prices paid index recently reached near 10-year highs.

Source: Investing.com - US ISM Manufacturing Prices Paid Index
Source: Investing.com – US ISM Manufacturing Prices Paid Index

Indeed, we are seeing inflationary (or reflationary more accurately) pressures pop up all over the place. Food prices have reached their highest levels since 2014, with such things as meat soaring. It appears only a matter of time before such inflationary pressures start to impact CPI, or perhaps more importantly start to impact the PCE index, which is the Fed’s preferred measure of inflation. The US Empire State Manufacturing Index suggests this is imminent.

Source: Julian Brigden
Source: Julian Brigden

The same can be said for the Michigan Inflation Expectations survey.

Source: Jesse Felder
Source: Jesse Felder

It cannot be denied there are immediate reflation pressures present, and as such the recent move up in nominal yields makes sense. However, my concern over these inflationary pressures we are seeing is they more representative of a reflationary economy as opposed to a shift to structurally inflationary environment. Much of what we have seen thus far is arguably a result of supply side inflation, which is very short-term in nature.

If we look at the longer-term inflationary expectations, inflation is not yet much of a concern. The following chart from Hedgopia shows the spread between the University of Michigan’s inflation expectations for the next year and the next five years. A positive spread indicates inflation expectations for the next 12 months are greater than that of the next five years.

Source: Hedgopia
Source: Hedgopia

Likewise, the five-year, five-year forward inflation expectations rate remains well below its average for the past couple of decades, despite a strong pick up since last March. It is not yet signalling any long-term inflationary concerns.

Source: St. Louis Fed
Source: St. Louis Fed

So, all the inflationary pressures we have seen over recent months should perhaps be more accurately described as reflation. If we are to see a shift to a structurally inflationary environment play out, we would need those longer-term inflationary catalysts I have detailed throughout this article to accelerate in force. Sustained central bank funded fiscal spending (i.e. MMT) and de-globalization to name a few would encourage sustainable demand pull inflation that can increase wages and money velocity, as opposed to the shorter-term supply driven inflation we are witnessing.

There a distinct possibility of a paradigm shift to a structurally inflationary future and only time will tell if that is the path ahead of us. But, for now, we are more likely to see cyclical bouts of inflation/reflation. This type of environment would still create uncertainty. If it is one thing investors don’t like, it’s uncertainty.