Inflation debate on the Pillow – March 9th, 2021
Over the past few weeks, global equity markets have been challenged by rising US bond yields (risk free rate used as the basis for valuing most financial assets in the world, from equities to mortgages), brought about by declining COVID cases, signs of an end to the recession and the Biden administration’s stimulus plan ($1.9Tril. this month and an additional $3-4Tril. infrastructure plan yet to come). As a result, we have seen the MSCI All Country World Index (ACWI) decline by 4.4% between February 2nd, 2021 and March 09th, 2021 (total return in US$). However, this relatively muted drawdown only tells part of the story, as the technology heavy Nasdaq 100 is down 10.9% during the same period. This can be attributed to US bond yields rising from 0.92% since the beginning of the year (and an all-time low of 0.50% on August 4th, 2020) to 1.6% on March 09th, reflecting rising inflation expectations and a rotation out of growth and into cyclical stocks.
As you know, in its pursuit of building wealth through long term compounding, Pillow Investment Partner (Pillow) has historically invested in quality growth stocks, with a preponderance of technology stocks. This communication will address the impact of this changing outlook on the Pillow Global Equity Compounders portfolio and why we remain confident in our investment strategy.
Are higher yields here to stay?
Because of the discounting techniques used in equity valuations, higher yields hurt long duration assets such as stocks, and particularly growth stocks, whose profits should accrue far in the future. The 0.66% increase in yields since the beginning of the year reflects concerns that inflation is just around the corner and will rear its ugly head once economies open up, following successful vaccination programs to end the current Coronavirus pandemic.
Indeed, vaccination campaigns have met with varying degrees of success around the world. The US in particular (57% of ACWI) seems to be headed for a reopening of its economy sometime this year, with the rest of the developed world following shortly thereafter. According to the Committee for a Responsible Federal Budget, the US government injected more than $4Tril. of stimulus in the US economy in order to combat the Covid pandemic in 2020. In addition, Congress just passed an additional $1.9Tril. recovery plan set to be signed by President Biden this week. Lastly, the Biden administration is expected to be considering a massive infrastructure plan, of around $3-4Tril. In aggregate, we could therefore be looking at close to 50% of GDP to be spent in the US over the 2020-21 period. Consequently, it is highly likely that inflation could rise this year, once the pandemic ends, as this surge of the demand for goods and services will almost certainly outstrip the supply. Given this backdrop, Federal Reserve Governor Lael Brainard acknowledged on March 2nd that “transitory inflationary pressures are possible if there is a surge of demand that outstrips supply in certain sectors when the economy opens up fully”. To us, this is the key element that investors are currently ignoring. Is the potential rise in inflation likely to be temporary or permanent?
As well, the Federal Reserve has already injected 3x more stimulus in the economy than during the 2008 Global Financial Crisis.
Some important early warning signals have begun flashing, as commodity prices are already up 9.4% year to date, as measured by the Bloomberg Commodity Index (30% energy, 23% grains, 19% precious metals, 16% industrial metals, 7% soft commodities, 6% livestock). Even though the latest reading (January 31st) of the US Consumer Price Index showed a relatively benign rise of 1.4%, inflation expectations have been more concerning. The 5-year 5-year forward inflation expectation rate rose from 1.7% in November 2020 to 2.14% on February 5th (2.01% currently), its highest level in 2 years.
Pent up demand for goods and services
Last, but not least, US families have saved a tremendous amount of money during the crisis ($1.6Tril. in addition to their normal savings, according to Oxford Economics. The US personal savings rate jumped from 7.2% of disposable income in December 2019 to 20% in January 2021; the corresponding figures for the Eurozone and Japan are 17.4% and 11.3% in Q3CY20. In developed market economies, where consumption drives large parts of GDP (67% in the US, 50-53% for Japan and the EU), temporary inflation is highly likely to ensue, as consumers release this pent-up demand, once the pandemic ends.
In response, we have already seen a tightening of financial conditions, with real rates, as measured by 10-year real yields, rising from -1.08% on Jan 1st, 2021 to -0.66% on March 09th , according to the US Treasury Department.
The case for a more permanent inflationary regime
Let us first acknowledge that it is indeed exceedingly difficult to recognize a regime change in real time, as inflation has stayed low and under control since the early 1980s (when US inflation peaked at 14%).
Broad money supply growth
A key difference with the 2008 Global Financial Crisis is that broad money supply (M2) is growing very rapidly relative to its historical average: M2 increased by 26% yoy in January 2021 vs. 6% on average between 2000 and 2019. M2 is now at around 90% of GDP vs. 52-58% in 2008-09. In 2018, we saw an 18% increase in the US budget deficit, with more stimulus on the way: this is more than twice the increase in budget deficit during the 2008 financial crisis.
A different Fed
Another potential secular driver of inflation is that the Federal Reserve mandate has changed relative to what it was in the 1970s. Whereas Fed Chairman Paul Volcker, in 1978, said that he was going to tame inflation, “unemployment be damned”, now Chairman Powell is fixated on unemployment and resulting inequalities, with the risk that “inflation be damned”. This suggests that the Fed is committed to its current promise to let inflation overshoot its 2% target for a while in order to balance out the low inflation of the past 10-15 years: why inflation is not lurking in the shadows.
Splintering global supply chains
Lastly, geopolitical tensions between the US and China seem to be entrenched and ominously bipartisan, leading to at best a pause, at worse a reverse, in globalization. The resulting disruption and fragmentation of global supply chains could lead to a secular rise in inflation. In a 2017 research paper, the Bank for International Settlements estimated that global inflation would have been about 1% higher were it not for the supply chain enabled efficiencies of global production. Conversely, it should follow that a weakening of global supply chains should lead to a permanently higher inflation in much of the world. Or should it?
The secular deflationary forces
First, the US economy is massively indebted, and debt is highly deflationary as shown by Irving Fisher’s seminal paper published in 1933. Some of the consequences of over indebtedness identified by the great Austrian economist include: i) debt liquidation leading to distress selling; ii) slower velocity of money; iii) a fall in the level of prices.
Total debt to GDP is now at a record 130% in the US and rising: this is highly deflationary. We therefore believe that the US cannot afford higher interest rates. Rather, the country needs to generate growth in order to grow out of its debt predicament.
High unemployment rate
After peaking at 14.8% in the US, the unemployment rate remains relatively high, at 6.2%, with the Federal Reserve estimating that it is probably much higher. High unemployment contributes to lowering the bargaining power of labor, a trend that has been reinforced by weak labor unions. This is another secular deflationary trend since, historically, strong wage growth demands have been a driver of higher inflation.
Technological innovations are key to driving productivity and non-inflationary growth. This pandemic has only accelerated technological adoption across many sectors, including cloud computing, electric vehicles, e-commerce, industrial automation, etc. One example: online sales as a percentage of retail sales accelerated dramatically in the US, from 14-16% in 2018-19 to 21.3% in 2020. We think technology penetration will prove deflationary, or at least disinflationary, in the long term.
Lastly, life expectancy has been steadily rising around the world: from 66.3 years in 2000 to 72.6 years in 2019. As the example of Japan has shown, where life expectancy is 85 years (vs. 79 years in the US), population aging can be disinflationary: over the past 25 years, Japanese inflation has only reached 2% on 3 occasions.
While it is particularly challenging to identify a regime change, we believe that the balance of historical as well as prospective evidence points to inflation being temporary, not permanent. We therefore anticipate that the market will sooner or later come to that conclusion, which should lead to bond yields peaking at a lower level than currently anticipated, and the resumption of outperformance for quality growth companies.
How do these trends impact Pillow’s investment approach?
The short answer is that they don’t. At Pillow, we remain committed to building long term wealth through compounding by investing in quality growth global companies in a concentrated, yet diversified, portfolio. We remain confident that our portfolio will do well in most market environments, and certainly over our 5-7 years’ investment horizon. However, there will be some market environments where we probably would not do well. For instance, if interest rates were to increase in a rapid and disorderly fashion, this would be a challenge in the short term for our investment strategy and our type of companies, as the valuation challenges could overcome our quality focus. We mitigate these challenges through our “defense in depth” risk management system, where we adopt a multi layered system to control and manage risks: focus on quality holdings; portfolio construction with target weights for every holding and systematic rebalancing; stop loss strategies where appropriate.
Most of the quality companies that we focus on have strong balance sheets and generate solid cash flows. They generally operate with incredibly low levels of debt, which protects them from higher rates, from a fundamental perspective. Our portfolio currently has a weighted average net debt to EBITDA ratio of -0.16x (i.e., our companies are in net cash position) vs. 1.07x for the MSCI ACWI benchmark. As well, our median interest coverage (EBIT / interest) is more than twice that of the market, at 16.3x vs. 7.3x (source: Credit Suisse HOLT Lens).
Sustainably higher returns
We also spend a lot of time and effort trying to identify whether these businesses can sustain their quality. For example, can they continue to generate superior EPS growth and ROE/ROIC or Cash Flow Return on Investment (CFROI)? Understanding the sources of competitive advantages and the width of the competitive moat is critical. In general, our companies enjoy superior pricing power (think of US$1,400 iPhones), which will allow them to win in an inflationary environment, as they can pass on higher input prices to their clients. For example, the 3year median CFROI for our portfolio is 20.3% vs. 12.4% for MSCI ACWI; as well, our portfolio’s median ROE is 26.5% vs. 10.3% for the benchmark.
Another way to sustain a company’s competitive advantage is through continual innovation. The median R&D to sales ratio is 8.7% for our Pillow Global Compounders portfolio vs. 2.6% for the MSCI ACWI benchmark.
Where we believe our strategy can get challenged, certainly over the short term, is when rates rise inordinately as has been the case recently. We acknowledge that our portfolio trades at a higher weighted average 12 month forward PER than the benchmark: 35.4x vs. 24.3x for the MSCI ACWI. However, if we look at a PEG ratio (PER / annualized EPS growth for the next 5 years), our portfolio trades at 1.31x vs.2.42x for the benchmark. This 46% discount of our portfolio’s PEG ratio relative to the benchmark’s reflects the fact that our holdings are expected to generate a 27% compound annual EPS growth over the next 5 years vs. 10% for the MSCI ACWI.
Indeed, at the beginning of an economic upcycle (as we are currently in), higher rates tend to disproportionally hurt growth stocks initially, as valuation multiples contract and investors rotate out of growth into value (cyclical sectors include financials, energy, materials, industrials). However, as the economic cycle matures, quality growth, including technology, tends to outperform. A recent study by Strategas showed that in the US, technology stocks outperformed the market in 5 of the past 7 rate rising periods. In particular, during the last interest rate rising regime (2016 to 2018, when rates rose by 225bps to 2.5%), the S&P Technology subindex rose by 18% annualized, or double the 9% achieved by the S&P 500 (total return US$). Therefore, technology can outperform during periods of rising rates.
Additionally, our clients are aware that we have been bullish on digital currencies both as a store of value (admittedly a volatile one) and as a hedge against money printing (or potential inflation). We are thus investing in cryptocurrencies as we believe that they are in their infancy, in terms of their institutional adoption. However, we also believe that the direction of travel is getting clearer, as banks (BNY Mellon), fintech (Paypal) and other corporations (Tesla, MicroStrategy) start to offer custody services in bitcoin, accept it as a means of payment or hold it to diversify their cash holdings. Interestingly, despite its perception as a very risky and speculative asset, bitcoin is up 14% between the market peak on February 2nd, 2021, and March 09th, 2021, handily outperforming the MSCI ACWI, which was down 4.4% in that period.
Notwithstanding the current challenging environment, as demonstrated in this communication, Pillow Investment Partner remains committed to its investment philosophy of compounding over the long term by investing in quality growth companies in a concentrated, yet diversified, portfolio of at most 30 holdings. We remain confident that our investment strategy will outperform the benchmark over our 5-7 year investment horizon.