Unbalanced Fantasies of Inflation

Charles Hugh Smith, whom we picked on a few days ago, has a new post out titled The Fantasy of "Balanced Returns" Funding Retirement. While we shouldn't get caught up in the notion that any investment strategy is foolproof, it doesn't mean there's merit to the economic analysis being made. Let's dive in...

He seeks to counter a prevailing belief that a balanced investment portfolio is a sure-fire recipe for retirement success. His major concern, as before, is with massive inflation that will be caused by government spending. He demonstrates that nominal yields can be much lower than real yields in the face of inflation. But really, anyone unfamiliar with real vs. nominal yields shouldn't be handling their own investments in the first place.

He warns that, once asset bubbles pop, runaway inflation will distort the massive losses people are actually accruing, and the government will print feverishly to cover its liabilities. Perhaps Of Two Minds economic analyses should be prefaced with a disclaimer. "Assuming hyperinflation, [...]" Let's not assume hyperinflation, and consider investment returns in the face of general inflation.

First, we have to remember there are two sides of inflation. You couldn't balance a budget by only looking at income. Spending must be considered as well. Likewise, inflation is more than just the money supply. It's the ratio of the money supply to the real economy. Smith fixates on inflation driven by the expansion of the money supply. But a contraction of the real economy could also cause inflation. He almost seems to get it at times. Consider this paragraph:

If inflation (i.e. the currency loses purchasing power) gets out of hand due to excessive money creation to fund interest on debt, entitlements and obligations, the only cure is to raise interest rates significantly. Higher rates destroy the value of existing bonds and they strangle speculation and debt-dependent projects and spending.

Here he defines inflation as the currency losing purchasing power, instead of just saying a growth of the money supply. It's tempting to give him credit, that he actually does understand the principles here, even if he frequently writes in shorthand. But consider that whole sentence. He's saying that, in response to inflation, the government will increase interest rates. (In this analysis the central banks would be regarded as an arm of the government.) But he's also saying that the government is going to flood the money supply to pay its own debts. Well, which is it? Will the government expand or contract the money supply? He seems to suggest that the government will seek to expand the money supply by taking on more debt, while at the same time containing the money supply by raising rates, causing its own debt payments to skyrocket. The government does irrational things, to be sure, but there needs to be compelling reasons to make predictions like that.

Smith doesn't actually make the argument that inflation will hurt stock prices. He argues that the government's actions to contain inflation will ruin the market. (This follows up on his recent piece where he says the government will certainly drive runaway inflation.) So what is the effect of inflation on the stock market? Well, it depends. If inflation is driven as he says - by government spending - then that means the money supply grows while the economy remains constant-ish. That's a recipe to hurt cash holders, lenders, people holding government bonds, etc. Stock holders own a portion of the real economy and shouldn't be too affected by inflation. Even more, Smith himself already told us in his last post that inflation was driving an increase in stock prices. If you're holding stocks, you must want an expanding money supply.

The other cause of inflation would be a shrinking economy, which would also cause lower stock prices. It would be incorrect to say, in that scenario, that the inflation causes stocks prices to fall. The shrinking economy is the cause, of which inflation and stock market measures would be results. Confusion on the matter must be common. One of the top hits in a relevant web search is Investopedia's Inflation's Impact on Stock Returns, written by a CFA.

Numerous studies have looked at the impact of inflation on stock returns. Unfortunately, these studies have produced conflicting results [...].

As expected. Inflation is not really a measurement, but a combination of two measurements.

Most studies conclude that expected inflation can either positively or negatively impact stocks, depending on the investor's ability to hedge and the government’s monetary policy. Unexpected inflation showed more conclusive findings, most notably being a strong positive correlation to stock returns during economic contractions [...].

The first sentence makes some sense, although it counters Smith's claim that all the hidden inflation has been going to the stock market. Expected inflation is priced into the market. To hedge against it, people will sell cash-denominated assets and buy commodities like gold and real estate. The stock market isn't strongly affected either way, being somewhat in the middle as far as inflation risk goes. The second part isn't so easy to make sense of. In times of economic contraction, unexpected inflation is good for stock prices. Or at least, less bad. Economic contractions tend to be deflationary. Yes, the real economy falls, but, thanks to fractional reserve lending, the money supply shrinks even faster as loans fail. Perhaps unexpected inflation helps keep people from bailing asset-backed investments for cash instruments.

I tend to believe that Smith is correct that upper-class wealth increases put upward pressure on stock-market prices, and that the study referenced (but not sourced) in the Investopedia article may or may not account for that. But in his overall analysis, it's quite a story. Government-driven inflation will cause government-driven deflation, which will hurt investments. He actually has to argue that rising interest rates will hurt retirees! Talk about fantasy... A better argument to make is the simpler one. Balanced return investments are likely to do well in a good economy, and poorly in a shrinking economy. Investments should be tuned in response to inflation, but it won't do any good to pay attention to arguments that amount to your retirement is doomed by inevitable inflation, and certainly not to logical contortions like inflation is bad because deflation is bad.