May 13, 2021

The InterPrime Newsletter - Issue #10 - Inflation, do you feel it yet?

By The InterPrime Team • Issue #10 • View online

“There are two main drivers of asset class returns - inflation and growth.” - Ray Dalio

Inflation is defined as the measure of the rate of rising prices of goods and services in an economy (source: Investopedia).

i.e. if prices are rising at a high rate, then inflation is high; if prices are dropping at a high rate then we have negative inflation or deflation.

There has been a lot of talk about inflation lately. We thought that the best way to share our perspective is with graphs of how key indicators and prices have changed in the last few years.

Inflation and how we monitor it

M2 growth in the last 5 years

M2 is a calculation of the money supply that includes all elements of M1 as well as “near money.” M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds, and other time deposits. These assets are less liquid than M1 and not as suitable as exchange mediums, but they can be quickly converted into cash or checking deposits. (source: Investopedia)

A simpler way to think about M2 is that it’s the amount of short term assets that can be easily used to buy goods & services. When this number spikes, it means that the economy is flush with $$ and buying power!

TIPS Breakevens - The breakevens are the difference in the yield between the nominal treasury bond and the inflation protected bond of the same tenor (i.e. 5 treasury year yield - 5 yr tips yield = breakeven yield). They are widely considered to indicate what the “market” is pricing inflation at, rather than the numbers we get from surveys.

10 year TIPS breakevens

5 year TIPS breakevens

When these rise fast (as they have in the last few months), the market expects there to be high inflation. For those of you interested in a deep dive on this inflation measure you can check out this article by Brian Romanchuk at BondEconomics.com.

Tracking core commodity prices to gauge inflation

Another way to track inflation is by the prices of core commodities like Lumber, Corn, Oil & Copper. These among others form key input materials for a lot of the finished goods we consume. Significant price movements in these can result in higher prices for end goods.

Lumber prices last 5 years

Corn prices last 5 years

Copper prices last 5 years

The price charts for Lumber, Corn & Copper look eerily similar, and you may have thought that I put the same chart there 3 times by mistake! But, the massive spike in prices in the last 8 months in all 3 key commodities could show impending inflation (especially if the prices hold at these multi-year highs).

Oil prices last 3 years

No list of commodities is complete without almighty Oil. This chart above shows a solid recovery post the COVID-19 panic in the middle of last year, with prices holding steady at pre-pandemic levels. If oil prices spike, then inflation will become a bigger worry than it already is for the markets.

Freight Prices - how much does it cost to ship things around the world?

In todays global world, supply chains are highly dependent on stuff being shipped all around the world. As prices to ship things increase, so do the end prices of the commodities and finished goods being shipped! Our two favorite indicators are the BDI (Baltic Dry Index) & the Shanghai Containerized Freight Index for Exports.

Baltic Dry Index (BDI) last 5 years

Shanghai Containerized Freight Index (Exports) last 10 years

Both of these indices are at multi year highs! Especially the Shanghai index. Continued elevation of prices will be a sure sign of sustained inflation, and high prices for consumers (especially in the US).

Tracking the prices of things we actually buy!

Now that we have a sense of the M2 money supply, what bond markets are factoring for inflation and core commodity & shipping prices, let’s take a look at how prices of things we actually buy are tracking!

Median US home sales last 5 years

U.S. home sales have been on FIRE over the last 5 years increasing from $300k, to over $360k! The bulk of the increase from $320k to $360k has just come in the last 9 months - phew!

Used Car prices since Jan'19 (source: cargurus.com)

Another one of our favorite measures of inflation is Used Cars! The incredible move higher in their prices in the last 6 months is breathtaking. Aren’t cars supposed to depreciate?!

And finally, the prices of the humble chicken! We see the dip in the COVID-19 panic and then the subsequent near DOUBLING of the price.

Poultry prices

All this data leads us to believe not only that inflation is here (we see it in higher prices across the board), but also that it’s going to be this way for a while. We will need to wait a few months to see if this is just pent up demand, or something more permanent.

May 2021 Markets Update

It’s time for our monthly temperature check on financial markets. Is the porridge too hot? Too cold? Or just right?

It’s near impossible to foresee when the temperature gauge on the economy will strike red hot. Usually what happens is inflation starts to creep higher. Then boosts with such velocity that government intervention misses the mark and they need to play catch up.

As the previous section showed inflation is in fact rising. The most recent CPI reading for April 2021 showed a jump of 4.2%. That is the highest increase since 2008!

Financial markets like certainty. Up until now investors were banking on free money and low rates for years to come. This inflation increase now has them skittish that the FED will have to act and raise rates soon. That thinking is starting to show up across assets.

An increase in rates is wonderful for savers. But hellish for companies and industries who can thrive and grow with cheap capital. i . e. Tech and growth companies.

Let’s take a look at how assets are reacting to this increased worry about rising inflation rates.

Bond’s & Interest Rates

A quick look at US 2-year, 10-year & 30-year bond yields show much ado about nothing so far regarding inflation increases. Each is firmly holding in the balance zones we noted in our last quarterly update.

US 2-year bond yield

US 10-year bond yield

US 30-year bond yield

For now, yields are not reflecting a major concern about the FED raising rates in 2021 or 2022. This can quickly change so it’s worth monitoring on a weekly basis.

It is worth highlighting that bond investors hedge against inflation by owning TIPS (Treasury Inflation Protected Securities). A simple way to see how those bonds are trading is by looking at the iShares TIPS Bond ETF (TIP).

Just a quick glance at the chart reveals a +4.5% move since March 2021. If investors continue to be bullish on TIPS and this ETF. It signals a growing concern about inflation in the future.

US TIPS ETF (iShares TIP)

Stocks

The recent worries about inflation and an early rise in interest rates is reappearing in equity markets. Let’s visually cruise by the main indices.

Nasdaq 100

The tech focused Nasdaq is now ~ 7% off the recent high. This move has yet to equal the March 2021 drawdown of ~ 12%, but does have investors shaking. The Nasdaq is likely to see more downside movement with each daily worry about inflation and yields rising.

S&P 500

The more broadly based S&P 500 is holding near the recent high with a ~ 3% decline. Previous declines in March 2021 and April 2021 maxed out at ~ 5.75%.

Due to the expanded pool of industries in the S&P 500. One should expect less severe downward price movement for the time being.

Dow Jones Industrial Average

The Dow Jones Industrial Average is down ~ 3% from the recent high. This is well within previous drawdowns in 2021. One would expect this index to hold up better than the rest thanks to market rotation.

As investors book profits and transition to other sectors not as rate sensitive as technology. Industrial and cyclical stocks should find investment dollars.

For now - nothing too alarming in equity land.

Bitcoin

BTC / USD

The most recent bullish move was ~ 124%. Bitcoin has since paused and is building a balance zone between ~ $64,750 & $44,250. This rough $20,000 range (64,750 - 44,250) helps inform investors about the next potential move.

One school of investor theory states that when an asset creates a balance zone. The expectation is that when the zone breaks - the next move should be equal to the size of the zone. In this case - some would expect Bitcoin to move to ~ $85,000 OR ~ $24,250!

Of course nothing is a guarantee. But consider viewing $65k & $44k as the triggers to the next move. Rocket higher or submarine lower.

Wrapping Up

After looking at the above assets it is safe to say that the smooth sailing in Q1 of 2021 is now over. Be prepared for a more volatile Q2 as inflation fears grow, pressure increases on the FED to raise rates, and active investors exit / rotate out of positions.

The porridge is not too hot just yet. But if we leave it on the stove too long, it may burn.

If you want to dive deeper into anything markets or inflation related do reach out!

Did you enjoy this issue?

By The InterPrime Team

The InterPrime Newsletter

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