Three Things I Think I Think – Transitory Stuff

Here are some things I think I am thinking about:

1) “Transitory” inflation….Contrary to popular opinion, I am not the Director of Communications at the Federal Reserve. I don’t even work for the Federal Reserve. I’m just a lowly asset manager who happens to oversee a big chunk of fixed income so I worry incessantly about inflation and interest rates. That led me to obsess about how the Fed actually works and so here I am constantly writing about how the Fed works and how they think about things. If I am being honest, I think the Fed is generally terrible at communicating things to the outside world. So, they end up being an easy target for pretty much anyone who wants to dunk on them.

Anyhow, the Fed loves using the term “transitory” to describe blips in inflation. But I’ll be blunt, I think this term is a really bad one. It implies that something is going to come and go. And inflation doesn’t really come and go. Inflation is pretty much always positive. This is massively oversimplified, but the basic reasoning for this, in a nutshell is:

• We live in a credit based monetary system and so new money is almost always being created.
• Aggregate demand is generally positive and supply doesn’t always keep up because resources are scarce and all that.

The result of this is that some moderate inflation is basically the price we pay for having developed an economy with a dynamic money supply (and no, fixed money supply systems do not and cannot work). The thing is, most of us notice when the price of a beer rises at our local bar. And we know, for a fact, that that price isn’t “transitory”. When that ice cold delicious Bud Light costs $5 we know that it’s going to cost $5 for at least the rest of our lives.¹ In fact, we pretty much know that that Bud Light will cost more in the future. So, “transitory” sounds disingenuous at best and misleading at worst.

Fed Truthers love to dunk on the Fed for this, but this isn’t really what they mean. The Fed means that the current high rate of inflation isn’t likely to persist. The proper term for this is “disinflation”. Basically, prices are rising, but the rate of change declines over time. So, instead of the current 3% core PCE inflation, the Fed is saying that we’re likely to see 2.8% then 2.5% then 2.25%. Or something like that. It’s not going to be “transitory” in the way most people think of it. But the high-ish rate of change is unlikely to persist.

2) Stocks Are a Transitory Inflation Hedge. I wrote this tweet last week and some people tried to dunk on me for it:

That’s from my buddy Josh Brown on CNBC. The point is simple – stocks are a very very good inflation hedge in the long-run. Not perfect, but very good. The basic thinking is simple. Corporations produce stuff and then they sell that stuff at a mark-up. So, they play a huge role in setting the cost of goods and services and they hedge their own books by earning an excess return over their costs. If you own shares of corporations you have a pretty good embedded inflation hedge because corporations have natural pricing power. Now, some people correctly pointed out that stocks had 0% real returns from 1966-1981. Not great. But I have a few quibbles with this criticism:

• 0% real return isn’t great. But it’s still an inflation hedge because you didn’t actually lose purchasing power. You just maintained your purchasing power.
• The stock market isn’t a 15 year instrument. Corporations are inherently long-term entities since it takes a very long time to build a company and get it to a point where it earns significant cash flows. I always tell people that the stock market is like a very high quality 30 year bond that yields about 5-7% per year on average. But you won’t get that coupon like a bond. You’ll get it very sporadically and in big chunks. And you might even go 5, 10 or 15 years without any coupon at all. So, it’s not surprising that there are 15 year periods where things aren’t great. In fact, that’s fully expected. Short-term pain is the trade-off for long-term premium.

Further, I am not saying that there aren’t other good inflation hedges. I know that gold and real estate and other real assets are a thing and I am perfectly happy owning those things knowing they can hedge inflation. But I also like to keep things super simple in my actual financial asset portfolio and for that reason I think it’s useful to know that stocks are a very good low cost way to get access to an inflation hedge.

3) Contango Loss is not Transitory. There was a very popular tweet going around this week from the founder of CoinBase. Basically, he thought volatility was on the horizon and so he said he was buying UVXY, a leveraged volatility ETF. The smart people of Volatility Twitter rightly dunked on him for this. But Barry got the last laugh as the VIX surged late last week and he earned a tidy 20% in less than a week. MarketWatch even published an article dunking on the dunkers.

I wanna be real clear about something here. Making a bet using a very bad product doesn’t mean it was a smart bet. In this case, UVXY is a horrific way to hedge against market volatility. Not only does it cost 1% in fees, but the fund is a leveraged volatility ETF that incurs a huge drag via leverage and futures roll. Basically, there are huge hidden costs in this fund that mean you will definitely lose money if you hold it long enough. I’m a big fan of ETFs in general, but these are very bad products and I’ve previously explained my view on the dangers of leveraged ETFs. And I don’t think we should applaud a bet that works when it’s implemented using a bad product. I mean, I don’t think you should gamble at all with your savings, but if you wanted to gamble I wouldn’t recommend that you play poker with Doc Holliday. That results in a different type of permanent decay, but it’s a sub-optimal outcome in the long-run compared to other alternatives.

The point is, if you want to gamble, at least be smart about it by using products that aren’t guaranteed to kill your portfolio in the long-run.

¹ – I don’t actually drink Bud Light. I am very fancy so I drink Pacifico and other high quality light beers.