Kevin Lenaghan on Inflation: Overstated Short-Term Risk

Ivy Academy Overview

Ivy Academy LLC provides investment advisory and admissions consulting services and is based out of Los Angeles, California. Kevin Lenaghan co-founded Ivy Academy LLC in early 2020 after a 12+ year career as an asset allocator and investor in hedge funds and other alternative asset classes. He has worked closely with many of the world’s largest and most sophisticated institutional and HNW/family office investors.

Ivy Academy’s investment advisory division, which is led by Kevin Lenaghan, provides strategic and tactical asset allocation and alternatives advisory services for HNW/family offices and institutional investors. The firm allocates capital globally, with an emphasis on sustainable alpha profiles and dislocated and/or opportunistic investments. The investment process is predicated on an awareness of macroeconomic and geopolitical considerations, but Ivy Academy generally avoids making directional bets on highly efficient, liquid asset classes. Ivy Academy works closely with clients on developing bespoke portfolio solutions, depending on their needs, preferences, and constraints.

Ivy Academy Insights

The following thought piece, “Inflation: Overstated Short-Term Risk”, is the first in a series related to investment issues and implementation challenges. These insights are meant to be relevant and thought-provoking, but certainly not dogmatic or necessarily definitive. It is important to highlight that the insights presented are based on Kevin Lenaghan’s collective experience and analysis, relying on publicly available sources.

Inflation: Overstated Short-Term Risk

Throughout 2020, several market commentators expressed repeated concerns about higher inflation as a result of the developed world’s extraordinary monetary and fiscal policy responses to the damage wrought by the COVID pandemic. Some of these forecasts were justified with specious economic reasoning and unreasonably high conviction levels, as well as what Kevin Lenaghan believes was a misunderstanding of the Fed’s flexible inflation targeting policies. One geopolitical market strategist stated in late May 2020 that “the biggest macro trend of 2020 is more inflation”.

Market participants were convinced about the inevitability of higher inflation for some combination of the following reasons: (a) monetary expansion, (b) fiscal expansion, © the Federal Reserve’s tolerance for higher inflation/embrace of Modern Monetary Theory, (d) the prospect for a “Blue Wave” ushering in increasingly progressive spending policies, and (e) continued trade tensions/deglobalization.

The purpose of this piece is to discuss the factors that cause higher inflation, as well as the near-term forward outlook and investment implications. Kevin Lenaghan’s belief is that investors should NOT be overly concerned about higher inflation over the near-term, although unexpected inflation expansion remains a longer-term tail risk.

The COVID Pandemic and Inflation in 2020

First, let’s review the trajectory of inflation thus far in 2020, as illustrated by the seasonally adjusted CPI index[1]:

Exhibit 1: CPI Inflation: 2008-Ocober 2020

The initial explosion of the COVID pandemic in the developed world was undeniably deflationary, with year-over-year CPI dropping as low as 0.24% in May 2020. Inflation recovered in line with fiscal and monetary policy responses, reaching 1.41% in September before falling to 1.20% in October. Importantly, inflation has remained persistently well below the Fed’s long-term target of 2%.

Inflation is generally a function of (1) expectations, (2) demand variables like unemployment, and (3) supply shock-like changes in relative import prices. Other variables that impact US inflation specifically include the strength of the US dollar, the change in money supply (M2) and the velocity of money. Thus far in 2020, the US dollar peaked in mid-March on safe haven flows before steadily falling through today (Exhibit 2). The money supply has dramatically expanded at rates far in excess of the post-2008 financial crisis (Exhibit 3). However, velocity of money has collapsed, suggesting that the dramatic increase in the money supply simply offset the COVID-related economic carnage, with limited inflationary pass-through to the real economy (Exhibit 4). Furthermore, personal savings rates have soared as consumers have banked the government transfers and cleaned up their balance sheets, with fewer outlets for spending available.[2]

Exhibit 2: Trade-Weighted USD Index: 2020 YTD

Exhibit 3: M2 Money Supply (YoY % Change): 2008-November 2020

Exhibit 4: Velocity of M2 Money Supply (Ratio): 2008-Q2 2020

To sustain higher inflation, there generally must be a wage-price spiral that becomes embedded in inflation expectations. Furthermore, unexpected inflation (or deflation) over the longer-term is usually the result of a monetary policy mistake. Central bankers and policymakers utilize macroprudential tools to properly “set the temperature” of short-term growth and rates. Kevin Lenaghan would agree with the consensus view that central bank dovishness and fiscal expansion in 2020 was appropriate, and not designed to cause unreasonably high inflation. Now there is broad consensus among most economists that further fiscal stimulus is needed to sustain the recovery until COVID vaccines are broadly available and adopted, ultimately resulting in a significant release of pent-up demand and a surge in economic activity.

Over the long-term, investors must also consider fundamental factors in their inflation outlook, including technology, the supply/demand of labor, and demographics. There is substantial evidence that technological advances have had a meaningful deflationary impact on consumer prices. On the other hand, trade tensions and the general decline in globalization during the Trump administration is arguably inflationary. The net impact of these two macroeconomic forces is beyond the scope of this paper.

Near-Term Forward Outlook for Inflation

As noted above, market participants were convinced about the inevitability of higher inflation in 2020 and beyond for some combination of the following reasons: (a) dovish monetary policy, (b) the Federal Reserve’s tolerance for higher inflation/embrace of Modern Monetary Theory, © expansive fiscal policy, (d) the prospect for a “Blue Wave” ushering in increasingly progressive spending policies, and (e) continued trade tensions/de-globalization. We will now look at each of these factors, along with Ivy Academy’s forward outlook.

· Monetary Policy: The Federal Reserve and other developed world central banks have obviously already utilized many of the traditional tools available to them. Kevin Lenaghan does not expect the Fed to adjust nominal rates below 0%, as this idea has been repeatedly dismissed by the current leadership. Furthermore, a former Director at the Federal Reserve Board recently noted that the current Board of Governors is confident that they can achieve 2% inflation (still their long-term target) without resorting to negative rates. Ivy Academy expects the Fed to increasingly emphasize financial regulation (both macro-prudential and micro-prudential) as critical to maintaining financial stability, particularly given the current limitations of monetary policy. Therefore, monetary policy should have limited near-term impact on inflation.

· Fed’s Tolerance for Higher Inflation/Modern Monetary Theory: Fed Chairman Powell clarified the central bank’s stance on inflation over the next several years at the virtual Jackson Hole conference in August 2020, describing the flexible use of “average inflation targeting,” which enables monetary policy to “aim to achieve inflation moderately above 2 percent for some time” following periods when inflation has been below that level.[3]

Does this imply that the Fed is “hard-wiring” data dependent dovishness? Kevin Lenaghan believes that there is no reason to believe that the Fed is no longer data dependent. The institution has observed and carefully studied 10+ years of mostly underwhelming inflation and painfully slow economic growth. Furthermore, as part of their dual mandate, the Fed still has a core mandate to prevent the economy from overheating, and substantial room to raise rates in this scenario. Therefore, actual inflation may drift up to ~3% for 12–18 months, leading to “average inflation” of 2%[4], but that does not mean the Fed is going to let the economy descend into a hyperinflationary spiral.[5] And if the path towards higher inflation is well-messaged by the Fed, it is unlikely to cause much widespread market indigestion (although there could be the usual periodic volatility spikes). Therefore, “average inflation targeting” does NOT likely present a risk for excessive near-term inflation.

· Fiscal Policy: It is very hard to predict the size and timing of another fiscal package. While weaker recent data and Chairman Powell’s own statements may cause mounting pressure for a new fiscal package, it seems unlikely before the Biden inauguration, given the incredibly toxic environment in Washington DC, as well as the January 5th Georgia Senate elections. Some market commentators expressed confidence that both parties would compromise on a large fiscal package before the 2020 election, but the toxic partisanship and arguably self-defeating brinksmanship between President Trump and Nancy Pelosi prevented this from happening. Therefore, while highly uncertain, Ivy Academy does not believe that fiscal policy will have a meaningful impact on near-term inflation.

· “Blue Wave”/Progressive Spending: Ivy Academy’s base case is that the final outcome of the 2020 election will be a President Biden with a solid Republican majority in the Senate. It is pretty clear that the 2020 election was a repudiation of both President Trump’s mismanagement of the COVID pandemic AND progressive/left-wing economic policies. While the composition of Biden’s cabinet and staff is highly speculative at this point, there are indications that a future Biden administration will be more proactive about medium-term fiscal policy, with some potential advisors pointing to negative yields in advanced economies as an indication of inadequate private demand. While there will likely be some appointments that cater to the Democrat’s left-wing membership[6], Kevin Lenaghan expects pretty centrist appointments overall for the new Biden administration, with limited risk of irresponsibly expansionary, and inflationary, spending priorities. The bottom line is that highly progressive fiscal policies are unlikely for the foreseeable future, with limited positive (or outright negative) impacts on near-term inflation.

· Continued Trade Tensions/De-Globalization: The future Biden administration is likely to be more accommodative with foreign counterparties in general. However, there is limited clarity about future trade policies at this point, although Ivy Academy agrees with the consensus view that there will be continued pressure on China. It is remains to be seen how effectively, and quickly, President-elect Biden can make concrete progress towards re-globalization. However, it is worth noting that overall inflation pressures remained well-controlled during the Trump administration despite the “America first” policies and China tariffs. Therefore, it is difficult to see how near-term changes in trade policy will result in any real impact on US inflation.

Investment Implications

Investing successfully over time is most critically a function of timing, and this is especially true of the future trajectory of inflation. Many market strategists were simply wrong about their “high conviction” calls for higher inflation in 2020. Other market participants were more open-ended about timing, with legendary investor Stan Druckenmiller recently describing the Fed’s current policy as “dangerous” and arguing that “I think we could see 5% to 10% inflation in the next four of five years”.[7] Mr. Druckenmiller predicated his statements on the assumption of a Blue Sweep in the 2020 elections, which now seems unlikely. He also noted that the Fed and other developed world central banks will not raise rates quickly enough to combat higher future inflation.

While Kevin Lenaghan has enormous respect for Mr. Druckenmiller, he is potentially not giving the Fed enough credit for maintaining their independence, credibility, and data dependency in the future. However, it is possible that the Fed’s historical adherence to its dual mandate of price stability and maximum sustainable employment could be called into question if Chairman Powell is not re-appointed at the end of his four-year term in February 2022, and there are material changes to the composition of the broader Board of Governors.

For the investable future, Ivy Academy has no reason to doubt the Fed’s publicly stated “lower rates for longer” inclination, although the framework for monetary policy over the medium term is difficult to know given the cloudy, COVID-contaminated near-term outlook. From an investment perspective, the highly uncertain timing, and path dependency, of higher inflation makes it very challenging to protect against this (arguably remote) tail risk in an efficient, cost-effective manner.[8]

Kevin Lenaghan recommends that Ivy Academy clients maintain a balanced portfolio that should outperform across a variety of inflation, growth, and interest rate scenarios. Ivy Academy is explicitly avoiding nominal bonds and the traditional 60/40 portfolio construction, but this is due to the extreme unattractiveness of both real and nominal bond yields for “risk-free” fixed income securities, even in the absence of ANY increase in future inflation. Ivy Academy is continually searching for uncorrelated alpha and opportunistic/dislocated asset classes to help clients generate strong returns irrespective of the macro environment.[9]

[1] One could choose a different inflation benchmark, as the Federal Reserve uses core PCE as its primary benchmark. However, the trajectories of different inflation measures look very similar in the post-2008 period. Furthermore, the underlying components of inflation have varied this year, with reasonable evidence of inflation in 2020 in some categories like food and personal protective equipment, offset by outright deflation in sectors like energy.

[2] That being said, white collar workers with steady employment through the pandemic have continued to spend on big ticket items, driving price increases in the single family housing and auto sectors.

[3] Some market commentators misinterpreted Chairman Powell’s statement, suggesting that the Fed was going to “let inflation overshoot”, while the actual messaging was more nuanced.

[4] “Average” is itself a fuzzy term highly dependent on the lookback period. For example, seasonally adjusted CPI averages are 3.5% starting in 1948 (through the present), 2.1% starting in 2000, 1.7% starting in 2008, and only 1.5% since the beginning of 2015.

[5] Some market strategists have suggested that dovish US monetary and aggressive fiscal policy would somehow evolve into Argentina-style macroeconomic mismanagement, ultimately resulting in much more pronounced, and uncontrolled, inflationary pressures. However, Ivy Academy believes that this conclusion reflects a misunderstanding of the Fed’s future path dependency.

[6] Biden’s recent announcement that he has chosen a Treasury Secretary who will appeal to both moderate and progressive Democrats is mildly concerning, especially if the implication is that the chosen candidate is Senator Elizabeth Warren.

[7] Source: https://www.ai-cio.com/news/fed-will-trigger-hot-running-inflation-druckenmiller-warns/

[8] It is worth noting that certain securities associated with higher inflation, such as 10-year breakeven rates and gold, have performed well in 2020, although sentiment and momentum factors have driven these price increases, and expectations of future inflation are likely priced in at this point.

[9] Please contact Kevin Lenaghan at kevin@ivyacademyllc.com for additional details.