Transitory or Permanent, Inflation is Under Our Skins

The U.S. Office of Management and Budget on Friday revised its inflation outlook for the fourth quarter of this year upward to 4.8%, more than twice the 2% level forecast in May, after the Commerce Department reported consumer prices in July grew more than 4% from a year ago. It means back in May, although talks about the global economy’s reopening were full-fledged, the official forecast didn’t anticipate such a rapid spike of inflation. That increase brings the White House at par with the Federal Reserve forecast. Both see inflationary pressure easing rapidly next year, dropping to 2.5% by the fourth quarter of 2022 and 2.3% by 2023, however, both provide little evidence supporting their views.

But inflation is running hot. The reported rate of inflation in the 12 months ended in July represents the highest rate since the first Gulf War in 1991. According to the very same Friday’s report, the personal consumption expenditure in the U.S. or PCE price index, a well known inflation gauge used by the Fed to monitor its target, climbed 0.4% in July. It was the fifth consecutive big increase. So the inflation reading for July is more than double the Fed’s long-term target.

Let’s see what options investors have available to protect their holdings from either transitory or continuously elevated inflation levels. Unlike many think, investing in stocks cannot be viewed as a foolproof inflation hedge – nor is buying bonds. About a half of S&P 500 companies don’t offer any specific price stability (let alone resistance) mechanisms for the mere reason of these companies’ exposures to the U.S. dollar borne costs.

Revisiting Jerome Powell’s speech at last Friday’s Jackson Hole Symposium’s online event, there were many repetitive references to the unknown path of economic reopening based on lack of reliable information concerning Delta Covid variant and numerous existing bottlenecks on the supply side. However, there is a simple study showing a consistently increasing reliance of the Treasury on Fed asset purchases as non-residents (especially those of the third countries like China) keep winding down their UST purchases. This data series is known as TIC (Treasury International Capital) flows. Hence, the greatest unknown might not necessarily be the Covid pace – rather it’s the dynamic of the U.S. debt’s foreign purchases.

As this year’s Congressional vote on the so-called debt ceiling looks to have been postponed, while new infrastructure bill alone with likely extensions of many government support measures including issuance of personal checks imply still enhanced levels of the government debt issuance, Fed simply cannot afford to wind down its asset purchases – be it Covid or no-Covid – unless there will be substantial inflow of regular resident and non-resident institutional investors, most importantly, non-residential purchases of the U.S. treasury securities.

Pic. 1. Study of Foreing purchases of US securities

Pic. 2. China’s Holdings of U.S. Treasury Bonds

Basically, what we see on both of the above charts is very much self-explanatory and clearly underpins my point of inability for the Fed to give up it’s prime lender for the Treasury’s mission.

Eyeing Rising Inflation Investors Exit Both Stocks and Bonds

Flight of institutional investors from stocks in favor of alternative types of instruments is also pretty much obvious and straightforward, since it is accurately portrayed by the falling trade volumes of stock indices even though their trends are still bullish:

Pic. 3. U.S. S&P 500 Bullish Trend Impaired by Falling Trading Volumes

Note, that this represents a long term tendency rather than episodic market reactions on possible changes in the Fed’s monetary policy.

Let’s check now if a possible beneficiary of this outflow is the bond market:

Pic. 4. Counterintuitively, as Investors Exit Equities They Weren’t Found Entering Fixed Income

Source: sifma.org

So if not stocks and bonds, then what is the ultimate anti-inflationary remedy for the more and more alarmed investors? The most frequently cited in this respect is, of course, gold and other precious metals, but also Bitcoin and other cryptocurrencies. But what about Bitcoin vs. gold?

Whilst cryptocurrencies have contributed to some extremely high returns, admittedly, they have also added significant risk to mixed assets portfolios. Gold is still a highly liquid asset and portfolios with crypto could actually benefit from simultaneous allocations to gold thereby improving their VaRs, or values-at-risks. Although historically, Bitcoin has been preemptively discussed in the news and among investors as a nascent and volatile asset outside of the traditional stock and capital markets, much of the volatility over the past few months and even years, derived from sensitivity to relatively small (albeit constantly growing) total market size, regulatory hurdles and generally limited penetration in mainstream stock and capital markets. We see that, unlike global inflation, these factors appear to be temporary and transitory.

VaR of Bitcoin vs. VaR of S&P 500

Although such prime metrics evaluating warrant of inclusion of an asset in portfolio as value-at-risk of Bitcoin, Ether and the number of other second-tier coins exceeds the one of gold and other precious metals – mainly due to the latter’s stalled growth over the past year–year-and-a-half, Bitcoin’s VaR still lags behind the one of S&P500 and even Nasdaq (Bitcoin has been three times more volatile than the S&P 500 in the past two years). However, based on the above displayed information, both equity indices’ and fixed income instruments’ trading volumes have been witnessing outflows whereas the allegedly still-muddling through cryptos – exactly the opposite, acting as magnets to both individuals and institutional investors seeking for better yields while hoping for diminishing volatility as more institutional investors jump in the bandwagon. Can this be interpreted as a leading indicator of an impending shift of an investing paradigm? Time will tell.