Paying for protection
Watch out for Covid cost push inflation and the bad ideas that'll come with it
TLDR:
Every time we buy something now it includes covid19 costs
CPI measurement lags mean those costs should show up soon
Eurozone CPI indicates higher prints to come
Inflation hawks will blame the money supply and think its risk off, but it would really be a sign of health
At school, I learnt that inflation was a sustained increase in the general price level. In markets school, I learnt that you could often make money by taking the other side of trades of people who thought they knew what inflation would do next, especially as a result of analysis using other macroeconomic variables. I claim no such knowledge, but there’s one inflationary force that I’m seeing little commentary on that I am confident is coming. When no one is talking about something that could very well happen, there ought to be a trade.
When we pay for a good or service we are paying for a whole bundle of things at once. The revenue my hairdresser (infrequently) makes from me must cover the costs of rent, labour, utilities, materials, depreciation, capital and so forth - and that’s before any margin they make on top. Should one of those costs increase uniquely for that hairdresser, they’re likely to have to eat the difference in their margins because their pricing power is likely not that high. Should the cost increase for all hairdressers, there’s a better chance of them hiking prices without losing business, though only to the extent that hair care isn’t substitutable with other things. If however there’s a cost increase across even all potential substitutes, it’s more likely to be passed on.
The Covid19 pandemic introduces costs across entire economies. My hairdresser must invest in PPE for staff, and serve fewer clients in the same space - increasing the rental cost of each cut. Seemingly insulated businesses such as those relying on home delivery still face increased costs - presumably the lack of overwhelming negative media attention from Amazon’s many known failures to protect employees is costing Mr Bezos a tidy sum in PR money. Though I suppose owning a major newspaper probably helps. More seriously, the limited hazard pay, closure of distribution centres and higher rates of staff absence are certain to have represented a real increase in the cost of doing business for even companies that rely on online sales.
It’s reasonable to ask why this hasn’t already been seen in post virus inflation prints, but as a friend and inflation expert points out, the normal process of surveying prices by statistics agencies simply hasn’t been taking place for the past few months. Either prices are missing due to businesses being closed, products or services unavailable, or surveyors unable to contact businesses. Response rates for the May print of the US CPI survey were 68%, meaning 32% of prices had to be imputed, double the normal rate. A move to online collection that began in March means that 40% of prices that used to be determined on the phone or in person are now assessed online, meaning actual conditions will feed slower into CPI estimates. Missing data is being imputed from similar products or regions, meaning the worst affected by Covid 19 are being excluded. It’s therefore reasonable to expect a lagged impact.
Eurozone estimates for June appear to give some grounds to this theory. European CPI is reliably flat May to June on a NSA basis, but this June saw a a respectable 0.33% increase. My colleagues and I have identified some potential trades to take advantage of cost push inflation arising from Covid, so please contact me via Bloomberg if that’s of interest to you professionally. For now, I want to share a few quick thoughts about sources of inflation and how the market narrative will likely shift if we’re right about the next few months.
Whilst I may be a hedgehog about money, I’m no monetarist about inflation. The evidence linking any measure of the quantity of money to any measure of consumer price inflation is basically negligible. My university Econometrics supervisor told me that the precursor to any sensible econometric analysis is to stick what you’re looking at on a chart and think for a while about it, so let’s take a sober look at zero maturity money and inflation for the US:
Not only does the quantity of money and inflation have no stable relationship, CPI moves can anticipate the money supply - as in 2008/9. Rapid spikes in zero maturity money are associated with falls in CPI in 2001/2, and today. With inflation targetting central banks, this kind of unstable relationship is what we should expect. Whilst central banks mostly use interest rates as their policy tool, the quantity of money remains part of the control mechanism. In any case, Goodhart’s law reminds us that a measure chosen as a target ceases to be a pure measure, so the relationship between inflation and other macroeconomic variables must have become more reflexive. That’s why I watch monetary aggregates carefully, but not because I expect them to be predictive of future inflation - rather to see how they respond to policy and preferences in the present.
There is no doubt however that cost push covid inflation, if it arrives, will be squarely blamed by many on the ballooning US money supply. The intuitive appeal of the quantity theory of money is strong, and there are some interpretations that fit the evidence quite well once the definition of inflation is expanded to include financial assets. If the quantity of money has been hugely expanded by a combination of loose monetary policy and government spending, and that is seen to have caused high inflation, then policy tightening will have to be priced in. My sense of speculative positioning is that many still hold steepeners in developed market bonds, anticipating plenty more governnment spending and pinned front end yields. For this and other reasons, that view looks vulnerable to me. To the extent that belief in loose policy is supporting stock prices, I suspect there’s vulnerability there too.
If it arrives though, I’d look to fade any negative sentiment. High inflation as a result of costs doesn’t have any negative implication for the performance of financial assets given that the monetary costs of protecting against covid 19 are someone elses revenues. We should be much more worried about seeing a world where firms lack the pricing power or optimism to raise prices to cover increased costs, and where deflationary expectations are becoming entrenched. I’m already bearish on earnings, but if inflation doesn’t show up soon that view would be substantially reinforced. If it does show up, that’s a positive sign for stocks.
NB: This post is not investment advice and is not a trade recommendation. The views expressed here are my own and do not reflect those of my employer.