Sunday Supplement – Inflation Revisited

Welcome to the Supplement and I am fairly sure there will be a few readers with an eye on something else tonight, I’ve heard a rumour that “It’s coming home” but my hearing isn’t great, so perhaps it was “It’s coming Rome”, hopefully not.

Poor gags out of the way, let’s get on with the meat of the course – there won’t be many spare minutes today I’m sure. For the macro side of this week, I want to once again delve into the inflation breach, and explore a few things that I haven’t before, including the likely outcome of the pandemic on long-term investment returns. On the micro side, I wanted to talk about the slowing market in some of the areas we have been considering, in the least surprising news ever after the “end of the beginning”, the first half of the stamp duty “cliff” having been passed 11 days ago.

So – the inflation picture continues to build. Those who were talking about inflation are in a bit of a “told you so” place right now, but it is difficult to say why. Really, this was all expected (prices up from a falsely low base year) – the scale of price increases in things like lumber, and other commodities, was not called anywhere I saw in any detail, and has caught a fair few by surprise, although it “makes sense”. It also “makes sense” on the back of this to expect prices to drop on the next cycle, which may be next year (depending on what commodity you are talking about, of course). It doesn’t include the commodity of Gold – that is a separate discussion!

There is no doubt this is transitory inflation, the transition from a pandemic economy to a post-pandemic economy. Wells, yards, mines etc. get closed because the expectation is no demand – in some cases, like oil, there WAS no demand – but then demand comes back bigger and better than expected, and faster (after the lockdowns had taken hold) – and this is the result. So, does this make inflation more or less likely going forwards? You would have to vote for “more”. But HOW MUCH more? Well, that’s much tougher to say of course. 

What has happened of late other than the obvious price rises to those who are in construction or development, even if only in a small way? At the macro level, the US Fed has moved “officially” to “average inflation targeting”, that’s a new thing to allow for poor (i.e. below the 2% target) inflation over recent years in the US. The UK doesn’t have as much room as the US do, although last year had incredibly low inflation – the question SHOULD be of course, average of what (2% presumably) over what period (as soon as you use the word average, this can be moved – there are more averages that we would like to think if you want to use past data to make a point, of course. 3-month? 2-year? 5-year? Etc. etc. etc.

The European Central Bank (ECB) have used similar language. Just read this from the President of the ECB: “We know that 2% is not going to be constantly on target, there might be some moderate, temporary deviation in either direction of that 2%. And that is OK.” Before this Thursday, the target was “below or close to 2%”, now it is “2%”. Extra room for rates to stay low for longer, in the face of inflation.

That target had been in place for 20 years……so that’s the scale of the significance of the change. The surprise is that the Germans, often characterised as extremely cautious on inflation because of the Weimar republic and hyperinflation, above all else, have signed this off. It must be a strong argument in their eyes!

I enjoyed an interview with Louis-Vincent Gave some weeks back on a podcast that I listen to, and he has spelt out 4 possible scenarios for the post-pandemic world which are worth summarising. 

1. Reopening doesn’t complete, supply chain disruptions persist. Governments carry on with massive stimulus and spending. (Australia looks a bit like this, potentially, at the moment, to me).
2. Vaccines work, cases rise but severe hospitalisation and death falls (note – from Covid). Demand surges on a consumption basis and also for capital items to produce consumer goods. This means inflation remains high. (Gave has this as his most likely scenario, and I would tend to agree from what we are observing in countries that are well in front of the global vaccine program). 
3. Stimulus pulls back, even without a reasonable reopening. (This seems unlikely, political pressures are a strange thing, but in the UK I just can’t see or hear the calls for this to happen, at all – even if there isn’t that reasonable reopening which seems to be happening).
4. Stimulus goes on, but supply outstrips demand. The capital spending hasn’t yet taken place for this to possibly occur, and also protectionism means this is unlikely (agreed, seems the least likely out of the four scenarios to me).

3 feels more like an outcome a policy maker might WANT, rather than a likely one (to me). 1 feels very possible, and it would be very typical of us as humans to be overoptimistic. Is all Covid disruption done? Absolutely not. I realised yesterday while reflecting that a deal I am looking closely at is actually a Covid deal, i.e. it would not be on the table without the pandemic having occurred. That much was not obvious. I then let my mind run on, and imagine there will be Covid deals all the way through this decade, to be honest – and also Covid opportunities.

We then need to get into the puzzle in the US (and to an extent, the UK, although less so, happily) of unemployment. There are some commonalities and some differences between the two.

Both have had lots of immigration over the years, and at the most crude level, immigrants have done the jobs that the indigenous population don’t want to do or can’t be bothered to do – usually because they are hard, undesirable, poorly paid, and the likes. The other side to that coin is also the lack of provision for skills in manual industries – back to the Blair era of 75% should go to university – knowledge workers have much better pay, conditions and ultimately lifespans and health – but sadly, not everyone is equipped to be a knowledge worker. So, in the East Midlands we have to “import” upholsterers, because that skill is dead without immigration. In the construction trade in general, there are not enough skilled trades. Great at this time with a real genuine shortage/burst of demand, but not great for actually building anywhere near enough homes, etc. etc. 

In the US, the red/Republican side of the argument is that people are not going to work because the stimulus is too generous. Let’s depoliticize that. If you incentivize people with a universal basic income (effectively), then at a certain level, a huge percentage would stop going to work. If everyone got 10k a month and prices stayed the same, arguably it would be quite irrational to go to work. (Prices wouldn’t stay the same, but you understand my point). It is fair to imagine this is a continuum – and so, with some support then when there is a choice, some will choose not to work – but not many, at the subsistence levels provided. So there’s likely some validity – but, as always, the danger is that the conclusion reached is “that’s the problem, that’s why it is happening”. That’s likely wrong. The vast, vast majority of problems are multivariate – they have more than one variable to change that in order to solve them. 

The blue/Democrat side is that people have finally realised some of these minimum wage jobs, relying on tips, truly are rubbish. They can’t afford to live (with shelter costs up) on the same basis that they used to. The ride stopped, and they just realise it was rubbish, and choose to do something else. Most will understand that a large percentage of these workers are either “at the right age” for the job, i.e. a student or similar, OR cannot get another job easily and thus are a bit trapped in the position. The luxury of choice sounds like a comment from the liberal elite, to be honest. 

We also need to consider – there are savings, and/or fewer debts than pre-pandemic. In both the UK and the US household savings balances have improved by an incredible amount. In the US, we can see that wage growth is below core inflation, which is the first time for, almost, ever. If as a business you haven’t got the pandemic “right”, it might well be more sensible to close (or stay closed) than bid up workers wages to get people. Margins simply might not allow for wages to go up. But those who have got it right do seem to be doing excellent business. This is also, of course, where non-wage factors come into it.

There are arguments in there for inflationary spirals – you can also consider that there are arguments for the Central Banks being right, rather than just saying what they think they should be saying (I suspect they are ALWAYS doing the latter these days, personally, even the “outspoken” ones like Haldane seem to be more, to me, to be in character – let’s wait for the sensationalist book when he’s stepped down, says the cynic in me) – and inflation being transitory. 

One other piece I read this week of great interest was an article from back in April 2020 when we were all (well, all the geeks anyway) looking back at previous pandemics. The doomsayers were busy talking about 2008, the great depression and this being “the big one”. Humans always do that in my experience, I suspect if you were in a bar in 1950 you would have heard the same thing as 1970, 1989, 2000 and 2008 and 2020 – “this is it, this country is finished, etc. etc.). Of course, there were consequences and have been changes since then, although evidence is overwhelming that we are doing quite a lot better than all of those dates, thank you.

I never put much stall in looking back at the last recession to tell us what the next one will be like. It just doesn’t work. It is human “recency bias” at its best, and you should eliminate that sort of thinking from your mind where you can. As with all behavioural biases, you need to “catch yourself” because you can’t cure yourself. We all do it.

What have pandemics always led to in the past? Slower growth is the first one. Coming in from an anaemic 2010s, this is not ideal. What’s the other point? Social unrest. Coming in from a socially disturbed 2010s, this is ALSO not ideal. What are the other academic conclusions that seem inevitable, that MIGHT reverse some of the latter (and perhaps the former too) – labour (the people, not the political party) tends to gain an upper hand over capital for some time. As someone with capital, who employs labour, you might think I would be quite upset about this – however, I would welcome it with open arms. For some years now I have followed a specific part of the Nick Hanauer argument – basically, the pitchforks are coming – because again, I am a big fan of relevant history when it has an impact on the economy and economic matters! If you look at any study of previous revolutions, there were quite a lot of reasons why we might have been on for one before the pandemic, and with an acceleration in that direction then problems may well be rife, but if labour DOES get the upper hand after a decade of QE where capital has absolutely crushed labour, evening out the balance will be no bad thing at all. There will still be a healthy rental market, housing market, functional economy and functional society, most importantly of all. 

So, this COULD be a reversal of social disruption. We would hope so – every revolution in history is characterised by one thing – everyone saying there would never be a revolution. Whilst I think things like the Doomsday Clock can get a bit too political to be overly useful, I was still perturbed to see where it was at BEFORE Covid hit! 

Labour winning the battle would see rising wages, and probably a virtuous circle of consumption on that basis. Would it not crush the rental market and promote home ownership? Possibly. But it depends. There will always be a private rental market, and it really will in the next decade serve 2 broad purposes. 1) Renting to households. Obvious I know. This will be split into those who need to rent, and those who want to rent. What’s the current split? We don’t know. Does that change geographically? Definitely. You already have some areas with really cheap housing where a 5k deposit or smaller would get someone on the ladder. A couple of years saving for a couple on minimum wage, full time, gets a house. They aren’t buying houses. This isn’t price driven, but is a lifestyle choice (whether that be experience driven, or financial naivety – that is an intergenerational problem and also, to an extent, a choice in not pursuing financial education as part of your life, but spending time on other things – a little unfair maybe, but financial IQ is unlikely to rise massively in the next decade in such areas, in my opinion, although fintech may help a little!). 

2) will be renting to organisations (registered providers or similar). This is booming, and my prediction is that it will boom on for the next decade. The reality shows more people who need some support post-pandemic, financial, mental, physical or a combination of the three. Hundreds of thousands of unknown problems have been washed out into the open by the pandemic. Most of these organisations follow a lease model not a purchase model. If capital does cede ground to labour, that’s unlikely to change. Thus leaseback to LAs who don’t have enough property or larger, more organised/consolidated RPs is quite likely in my view. It is certainly forming a decent % of my strategy going forward.

So, I wouldn’t be fearing this. Indeed, the “last bastion” argument comes back into force, and sees more money for investment property. 

Tracking back to the academic piece regarding pandemics – one sentence really jumped out at me:

“pandemics are followed by sustained periods—over multiple decades—with depressed investment opportunities, possibly due to excess capital per unit of surviving labor, and/or heightened desires to save, possibly due to an increase in precautionary saving or a rebuilding of depleted wealth.” 

So – we can expect the marginal propensity to consume to NOT go back to where it was, not quickly anyway. This means slower velocity of money, and therefore perhaps not as much inflation as the most hawkish have predicted. We can also expect lower returns from equities and bonds are already on the floor – back again to the last bastion argument. We could be in a situation in some years time where a yield of a couple of percent is a really solid result for some pension funds.

This is, of course, disastrous. Many pension funds are already underfunded, and this gap will struggle to be bridged. The problem I have is that the only place this leaves me is……in property. Which I already am!

Weaker inflation of course means even lower rates for longer – and the same study concludes that generally, growth outpaces rates after pandemics for a long time. With rates at near-zero however, we could easily be talking 0.5-1% GDP growth per year after the big “snap back”/return to normal, which as mentioned before, looks WELL into 2022. 

So – there seems to be a case for under-control inflation, which will remain very attractive to governments carrying these gigantic debts. These debts are multi-decade, and if inflation doesn’t get significant, it will likely limp along a little, meaning rates will be able to stay super-low in order to inflate the debts away as much as possible. We could go 20 years with very low rates from here – in the same way Japan has done – but don’t expect incredible returns from ANY passive investments. I don’t set out to write pieces that are “all roads lead to Rome”, but this one really does qualify (let’s hope the same doesn’t apply to the trophy tonight). Property is looking increasingly like the only answer.

Micro-wise, this week, I wanted to more formalise some of the data I’ve talked about in recent weeks and months. A table seems the best way to approach this. This is taking data from Rightmove to measure the temperature of different areas and types of stock. If you can make a case for including any other areas of interest, please make a comment or even better, send me a message!

The same trends seem to be continuing. These are well worth monitoring and I will seek to update this more regularly, because data is always good. Birmingham City Centre has been struggling more than any other notable metropolitan centres, and that’s continuing. Solihull, over the border, seems to be still doing very well. Manchester looks weak but is effectively doing around half as well again as Birmingham. 

London flats are clearly dragging down London performance – looks at the disparity between flats and houses. Devon is still in there to set the “seaside standard” – a big robust sample, and outperforming the Brummy ‘Burbs by a few percentage points. However, Ilkeston (big favourite investment destination of mine in the East Midlands) stays very warm indeed, outperforming Devon (beware the small sample numbers though!), and just edging out Stoke, also warmer than Devon. Interesting stuff……

So, the slowing market that’s been reported in the press, with no real evidence whatsoever? Depends on area I’d say. Solihull has slowed a bit but not as much as you might think, has plenty of stock between 250k and 500k (most affected by the stamp holiday). Stoke and Ilkeston, not so likely to be affected almost at all – seems to have had no impact. Look forward to seeing this numbers on October 11th rather than July 11th though – would always rather have emotionless data than feeling, although gut feel and heuristics are important to me.

What I can say is that I’ve not seen the number of chain breaks that I would have expected, and neither have many of my contacts. So, the fear of missing out in the rising market has clearly meant more people have swallowed missing the stamp duty deadline than expected – either that or the conveyancers did the impossible and all cleared their caseloads before July 1st. Got any first hand experience or stories to share? If so, please share them!