Stig Brodersen (00:00:01): We have episodes we’re excited about. We also have episodes we’re even more excited to share with the world. And then, we have episodes like these with Cullen Roche that takes all of us to another level. You can’t find a hotter
financial topic than inflation here in 2021. And you probably can’t find a more misunderstood concept either. Ladies and gentlemen, hear our Masterclass Inflation with Mr. Cullen Roche. Stig Brodersen (00:00:49): Thank you for joining me and our audience here today, Cullen.
Cullen Roche (00:01:03): Hey, Stig. Thanks for having me on again. Stig Brodersen (00:01:06): Cullen, this episode is named Masterclass Inflation in our podcast feed. So, it might sound a little surprising that I would start with a, let’s call it a softball question, but there is more to it than it seems. So, let me kick this off by asking what is inflation and what is inflation not? Cullen Roche (00:01:27): We were just joking that we could do an entire podcast on just this one question. So, it’s so controversial and really complex.
So, from a really strict economic perspective, inflation is an overall upward movement in the price of goods and services. And so, the Bureau of Labor Statistics in the US, the BLS, measures this by basically quantifying the consumer price index, the CPI. And there’s a lot of different ways to measure this. The various Fed entities actually measure this in a very different way across the board. Cullen Roche (00:02:07): Some of them use the PCE, some of them use the trimmed median price. I mean, there are all sorts of different measures
of this. But as a general rule, what the BLS is trying to do is they’re trying to find an aggregated basket of consumer goods and services that roughly reflects what the median household consumes over the course of an average year. So, getting into what inflation is not, it’s probably important to cover what I think is one of the biggest and most misleading myths with inflation, which is the idea that inflation is an increase in the money supply. Cullen Roche (00:02:46): And I’ll tell you why I don’t find this to be a terribly useful definition. Because in the type of monetary system that we have, we actually experience the growth of the quantity of money over any sustained period of time due to, mainly, because of economic growth. And so, people have this view that money necessarily causes inflation. And this is old-school monetarist thinking or some Austrian School thinking that leads people to believe that the more money you create, the more inflation we’ll have and the worse off we’ll be.
Cullen Roche (00:03:22): And the reality is that the way that the modern monetary system works is that most of the money supply is in existence, basically, because money in today’s economy is mostly deposits. And deposits come into existence through the lending process. And so, what ends up happening is from an accounting perspective, money is just a really simple credit agreement. It is both an asset for the lender and liability for the borrower. And that, in and of itself, is never necessarily a good or a bad thing. Cullen Roche (00:03:58): People like to talk about the liability side of balance sheets but they often neglect that there’s an asset side of a balance sheet. And so,
from a deposit creation perspective, when a bank makes a loan and that has become the dominant form of money in the modern monetary system, the deposit is an asset for the borrower and liability for the bank. And so, from a pure just balance sheet perspective, from an accounting perspective, when a loan is made, no one is necessarily better or worse off and it depends on all sorts of other factors. Cullen Roche (00:04:32): And the fact that the money supply increases because of this, it really doesn’t tell you much about anything. It just tells you that balance sheets have expanded. And over the course of very long periods of economic growth, we actually want balance sheets to expand. And so, even though people like to focus on the liability aspect of this, the reality is that the asset aspect is just as important. And whether or not that has a positive
or negative impact on the economy, in the long run, depends on all sorts of different variables. Cullen Roche (00:05:04): I mean, to cherry-pick an example, for instance, I mean, if somebody borrows a million dollars and creates some world-changing invention that makes all of our lives fantastically better, well, yeah, technically, there’s a million dollars more of money that is in supply. But this invention, whatever it may be, will dramatically improve our living standards across time. And so,
it’s a lot more complex than money and the sheer quantity of it. Cullen Roche (00:05:35): And I think that a lot of people have a tendency to fall into a political bias with a lot of these conversations, where you think of the government primarily as being a money creator. And the reality is that most of the money today is created in, really, a fairly market-based type of system where it’s almost a meritocracy in terms of who can borrow and who cannot. And the banks are mostly assessing
your lending capabilities, your borrowing capacity based on, really, how valuable they think those loans might end up being, or what the collateral is that exists. Cullen Roche (00:06:11): And so, it’s a really complex issue. And narrowing it down to purely the money supply just doesn’t tell you anything because, frankly, the money supply pretty much always increases over any long period of time. Stig Brodersen (00:06:26): We’ve recently seen many headlines with inflation numbers in the quarter 5% range, again, depending on how you measure it. Some of that is so-called base effects, meaning that it would look artificially high because it compared to 2020 prices when prices were falling and that was, at the time, primarily due to the drop in commodity prices at the time, especially in the spring. Now, how much of the inflation numbers we’re seeing right now are due to these so-called base effects? And how much of that is, let’s call it the true inflation? Cullen Roche (00:07:01): Yeah, good question. Base effects are essentially…
the way to think about this is that the way that the BLS measures the CPI, for instance, is just a simple price measure. If you were to look at just a chart of the pure price inflation, it basically is just a measure that goes from the bottom left of the chart up to the top right. And it pretty much always goes up a little bit. And what the Fed is focused on is the rate of change, the annual or year-over-year, or month-over-month rate of change. Cullen Roche (00:07:33): And so, what happens with base effects is that it’s a lot like the stock market, actually. When the stock market goes down
25% or 30%, like it did in March of 2020, you have a base effect where if you measure the gain from that base, from the lows, it looks really big. Whereas if you measured it from the previous high in, say, January of 2020, it doesn’t look as high. And the CPI works the exact same way where we had a little hint of declining inflation back in March. Cullen Roche (00:08:08): And so, you had this base or a low that on a year-over-year basis, it exaggerates the way that the gain looks. And so, this is a really hot topic right now on whether or not a lot of the inflation that we’re seeing is going to be transitory or not. And the thing that makes that so difficult to measure is really whether the base effect that we’re seeing from last March is something that is going to be more sustained, or is it something that is actually going to end up being transitory.
Cullen Roche (00:08:42): And what’s confusing and I think almost counterproductive about the way that the Fed talks about this stuff is that inflation, like I mentioned, with the way that the chart always goes from the left to the top right, basically, is that inflation never really is transitory in any useful sense. I mean, at least in the eyes of a consumer especially, I mean you know that if a beer at your favorite bar cost $5 in January of 2020 and then all of a sudden, in January of 2021, it cost 5% more, you walk in and it cost $5.25, you pretty much know that that price change is not going to be transitory. Cullen Roche (00:09:24): Meaning, that $5 beer, you’re never going to drink another $5 beer at that bar. It’s going to go 5.25 to 5.35 to 5.50 or whatever. But the thing that’s, I think, almost counterproductive in the way that the Federal Reserve and a lot of economists talk about this is that the term transitory implies that that $5 price might come back at some point, and that’s really not the way that they’re trying to communicate it. What they’re really trying to say is that the rate of change will decelerate over time. Cullen Roche (00:09:59): So, when Jerome Powell says that inflation is likely to be transitory in the future, what he really means is that you’re not going to see 5% year-over-year continued inflation going forward. You might see two and a half percent inflation in 2022. Or if we were to see 0% inflation in 2022, for some
reason, he would argue that that’s transitory, even though your beer still cost $5.25. Stig Brodersen (00:10:28): I think that’s a great segue into my next question because whenever we do talk about inflation, we also have to consider expected inflation. Expected inflation is a very important metric because expectations in itself can drive the actual inflation number. How so? Cullen Roche (00:10:46): Well, this is a big concern with any inflation spirals that it becomes self-reinforcing, almost a snowball effect inside of it. And so, you see this in periods of very, very high inflation where the way to think of this is basically that it’s very similar to a decline in the stock market, where people’s emotions basically become the dominant driving factor in what is causing the price declines. And so, you see this in really panicky environments. And inflation is essentially a panicky price decline in, basically, your purchasing power.
Cullen Roche (00:11:26): And so, what you’ll see is that people’s expectations end up driving the snowball effect where inflation can get out of control. And the Federal Reserve and the government worried about this just because obviously if you were to lose control of the narrative, you risk the potential that people’s fear of future prices caused them to go out and buy more goods and services today, which causes prices to surge even more and exacerbates the whole thing. It’s become controversial whether or not inflation expectations are as important as people assume. Cullen Roche (00:12:06): Because especially in the last 10 to 15 years, we’ve seen this environment where inflation concerns have been fairly high at times, and inflation just never really came in to materialize the way that a lot of people expected. Not that there hasn’t been inflation, but mainly that looking at things like the Fed’s balance sheet or the amount of government spending that we’ve seen at times, a lot of these things that people expected to cause inflation didn’t really cause much inflation at all.
Cullen Roche (00:12:37): And so, I think my big conclusion from the last 10 to 15 years in all of the different policies that have been implemented and everything is mainly that inflation is one of the most complex things that we try to measure in the global economy. And the factors that drive it are so much more complex than just looking at the Fed’s balance sheet, or the amount of government spending, or the amount of money that’s been created. There are all these other factors that can have an impact on it. Cullen Roche (00:13:11): Things like demographics and technological changes and globalization and the power of the labor class versus the capitalist class, all of these things have varying degrees of impact on the rate of inflation. And they’re all different in different economies. That’s the other crazy thing is that you can have economies where some of these items have a huge impact. I would argue demographics has a humongous impact in places like Japan. Cullen Roche (00:13:39): Whereas demographics aren’t quite as important in other countries because the amount of demographic change… the rate of change of the population growth just isn’t as material in a lot of other economies as it is in a place like Japan. And so, in Japan, regardless of what the government does,
I mean, from a policy perspective, they’re almost a decade ahead of everybody in terms of the way they’ve been doing QE, the way they’ve been implementing fiscal policy. Their debt to GDP is depending on how you measure it, 250% to 300% of GDP. Cullen Roche (00:14:14): They have all of these things that you look at and you would have assumed would cause some inflation. And here we are, they have 0% inflation year after year after year. And I think the main driver of that is just a really unusual demographic situation that’s very specific to Japan and applicable to other parts of the world. But it’s interesting in the specific case of Japan because it proves that these other items are so… they can be so much more important than simple policy measures.
Cullen Roche (00:14:45): That looking purely at the policy measures or things like the quantity of money just provides such a narrow perspective that it doesn’t provide you with a very coherent conclusion. Stig Brodersen (00:14:56): Cullen, I wanted to go back to one of the other things you said about Jerome Powell and this whole thing about, is the current inflation temporary or not? Since August 2020, the Fed was targeting an average inflation rate of 2% over the entire economic cycle. And currently, the Fed expects inflation to be 3.4% at the end of the year. So, we can talk about what Jerome Powell said, but I’m curious to hear what do you think? Do you agree with him? Cullen Roche (00:15:27): It’s interesting. I think that the Fed is likely to be more right than wrong in the end on this, but I do wonder if the Fed is underestimating some variables. Gosh, I mean, I was super vocal coming out of the financial crisis that I thought disinflation was coming and that was largely because of the policy perspective that I had.
But coming out of COVID, I had, I wouldn’t say a polar opposite view but I was much, much more worried about inflation coming out of COVID than I was the financial crisis, mainly because the size of the stimulus packages were so enormous that it just… and combined with the supply chain issues. Cullen Roche (00:16:12): There was just no way we weren’t going to have 3%, 4%, even 5% inflation. So, we’re in this really interesting period where, yeah, we’ve had this 4% to 5% inflation readings. The really strange thing about the current inflation is that from a measure like the Bureau of Labor Statistics’ CPI, you’re seeing the driver of this come from a very specific set of the underlying indicators. And so, for instance, in the last month, the used cars and truck measure was accounted for 33% of the overall increase in the CPI. Cullen Roche (00:16:52): And so, everyone knows by now used cars and trucks are up, but I don’t know what the exact number is year-over-year, 50%, 60%, something like crazy, something that nobody ever would have predicted. And that has been just a huge driver in the CPI.
And how sustainable is that? Is that likely to continue? In fact, we’re starting to see that like the Manheim Used Car Index has started to moderate substantially already. Cullen Roche (00:17:18): And so, I think that a lot of the drivers, in addition to the base effect issue that has exaggerated a lot of this, the underlying core drivers have been so acute, that I do suspect that the rate of inflation is likely to moderate. I don’t know that we’re going to revert right back to the 2% range that we had for so long in the post-financial crisis period just because there’s a lot of stuff that’s different right now. For instance, one of the big drivers that I worry about increasingly is real estate, where real estate prices have gone just totally crazy in the last 18 months.
Cullen Roche (00:18:01): And the way that we typically experience inflation through housing prices is not the housing prices themselves really, but really, it’s primarily, especially the way the BLS measures, it is through rents. And rents tend to lag prices a little bit. So, homeowners typically can’t pass on the cost increases that they’ll experience during a housing price boom immediately. So, they end up having to renegotiate prices over the course of a longer period of time. And so, rents end up lagging typically a little bit. Cullen Roche (00:18:33): And rents and shelter in the CPI are about a third of the overall measure. And so, you can have a situation here where the CPI is lagging the house price indexes over time and causing inflation to look a little bit higher than it otherwise would. And I suspect that some of these underlying factors are not going to be
so transitory. Going back to what I was talking about earlier, I do not think we’re going to see anything like the 1970s. It’s not an environment that’s ripe for stagflation, something like that. Cullen Roche (00:19:12): I mean, the ’70s were really more so an oil crisis than anything else. But I don’t think we’re in an environment where we’re likely to see very high sustained to say 10% inflation or something like that just because I think that the secular headwinds are… they’re so big. They’re so much different this time around where you have not necessarily a Japanese type of demographic issue in the developed world, but it’s much more similar to Japan than it is, say, like a baby boom situation or something like that, where the population is growing pretty significantly, meaningfully.
Cullen Roche (00:19:47): But in addition, you have all these other factors like the technological factor, the globalization factor is one of the biggest. I mean, you could argue that the world has never had so much accessible, cheap labor in its existence. And so, globalization puts a huge secular downward trend on inflation. And so, a lot of these big macro trends, I think, they don’t necessarily put a ceiling on inflation, but they make it very, very difficult especially for policymakers to create a lot of inflation.
Cullen Roche (00:20:18): And I think that the thing that is most interesting about the last 18 months is that you had this big, huge policy response. It wasn’t really the Fed so much, it was mostly the US Treasury, I would argue, that really caused a lot of the inflation because the government… the Treasury spend six and a half-trillion dollars in the last 12 to 18 months. The numbers are colossal. And so, it’s interesting because mainly going forward, those numbers are not going to continue.
Cullen Roche (00:20:51): We’re likely to run trillion-dollar deficits going forward, but we’re not likely to run six and a half-trillion dollars of spending year after year after year. And so, you don’t have the sustained fiscal tailwind that caused a lot of the inflation that we’re experiencing right now. And I think as a lot of these things taper off, you are likely to see prices that look what the Fed would call transitory but that will end up probably not being as transitory as the Fed, I think, expects. Cullen Roche (00:21:23): And so, if you end up with even inflation that’s in the, say, three and a half percent range by year-end and let’s say that that sustains in 2022, you can have a situation where the Fed is getting pretty concerned about that feedback loop, where they start to worry about the snowball effect, in essence, of the price increases, where you have something that’s a little more sustained and so far from their target. Cullen Roche (00:21:53): I mean, three and a half percent is a pretty significant shift away from their target range of 2%, that you could have easily rate increases, I think, in 2022 that starts to reflect the Fed’s concerns about continued inflation.
Stig Brodersen (00:22:12): Let’s talk about real estate prices. We generally don’t talk a lot about real estate. But if the stock market is hot, don’t get me started on what’s happening in real estate right now. American Home prices are 15% more expensive than the same time last year. Yet in America, the euro area, Britain, rents remained beneath their pre-pandemic trends. And in Australia, rents have fallen through the pandemic. Stig Brodersen (00:22:38): So, this might sound super weird and it’s important to understand since rent is called the third of CPI. So,
could you please paint some color around this? Cullen Roche (00:22:49): I mean, it’s interconnected to a lot of the other stuff that’s going on. There is such a supply shock across so many segments of the economy and real estate is one of the really big ones. Where coming out of the financial crisis, I think Home Builders had built so much that inventories had jumped so much that, once prices collapsed 30% and you had this unprecedented environment, I think a lot of the builders, well, in addition to just going out of business, a lot of the builders were just in shock coming out of the financial crisis. And it was a sustained shock. Cullen Roche (00:23:24): I mean, inventories have remained low. And so, you’ve had this really unusual supply shock in the real estate market where there just aren’t nearly enough homes. And I think there’s probably a regulatory
component to a lot of this. I mean, having gone through this whole process, I mean, it’s crazy. I live a mile from the beach, and there is a five-acre lot directly behind me that’s completely empty. And I know the developer at this point because I tried to work with him
when I was going through our whole permit process because I was trying to tie into his sewage line. Cullen Roche (00:24:01): And this guy could not build, and California is a crazy, crazy example. But they made this guy do a six-month bird survey, a bird survey for six months. So, stuff like that that is just really unusual regulatory hoops that they’re making people jump through, combined with just the lack of building, I think, has created these big, big supply bottlenecks in the real estate market where there’s a huge demand for homes, and there’s just not enough houses out there. Cullen Roche (00:24:35): And so, going forward, I mean, the worrisome thing from an asset price perspective is that it’s hard to imagine that this is going to abate anytime soon, just because that supply-demand dynamic is it’s one of the things that’s so different now versus 2008. The other one being that the
quality of the demand is totally different. I mean, the average credit score right now, for instance, for buying is super high compared to what it was in the 2005 period. And so, there’s not a lot of this crazy speculative fervor that you saw going on in 2005, 2006.
Cullen Roche (00:25:15): And so, the real estate market is it’s really almost confusing right now because you have prices that, by any measure, appear really unsustainable but have these really, really big macro drivers that it’s very hard to imagine that those drivers are going to abate. I mean, gosh, they say location is so important to real estate, and of course, that’s so, so true. And so, this is different. I’m talking from mainly a US perspective. But from a global perspective, it’s similarly true. I have a Canadian buddy who always jokes with me.
Cullen Roche (00:25:58): He says, “Oh, you think there’s a bubble in housing, hold my beer.” It shows me what’s going on in Canada. And they’ve had basically this whole situation going on for 10, 20 years. I mean, they never really had a downturn in 2008 prices. And so, these things
can sustain for much, much longer than we expect. Real estate is just like you said, because of things like moving, there are so many factors that go into real estate. It is the ultimate macro asset class just in terms of how important it is to the economy and how complex it is.
Cullen Roche (00:26:35): I mean, that was one of the things that I found just astounding when I went through the whole process of building my house was just how incredibly complex a modern home was. Going back to our original comments about what inflation is and everything, I was really just amazed at the quality of the difference in homes. And this is one of the things that makes inflation so hard to quantify is that it’s so subjective, the way that we perceive our living standards, that it can be really hard, especially over very long periods of time. Cullen Roche (00:27:11): It can be very hard to quantify how our living standards are changing. But when you go in and you knock down a 40-year-old home and you look at some of the trash that was used to build that thing, you realize and then you go in and you buy modern materials. You’re like, “Holy cow.” A modern house is a huge
piece of incredible technology, whether it’s the fiberglass insulation that’s being used now versus 40 years ago or the drywall. Even the drywall is completely different than it was 30, 40 years ago. Cullen Roche (00:27:47): These little tiny things that you look at, I mean, the paint on the wall is a completely different thing. I put this paint on the exterior of my home that is virtually bulletproof. These little tiny things that we take for granted that we look at, that we say, “Oh that’s just a house,” it’s just completely, completely different than it was 40 years ago. And so, a lot of that makes it so hard to quantify. And the BLS, they try to do a good job with what they call hedonic adjustments.
Cullen Roche (00:28:17): And I mean, frankly, it’s impossible to quantify the difference. I mean, how do you measure the difference in the quality of modern paint versus paint that was made 30, 40 years ago? I mean, how can you put a number on something like that? It’s so subjective to some degree. And the BLS tries to do a good job of it. It just ends up being a super imperfect measure because, frankly, it’s all so subjected. So, yeah, it’s interesting mainly because coming back to the real estate market, housing is so complex. Cullen Roche (00:28:50): There are so many great big factors that work into it that it makes it very, very difficult to imagine that a lot of the current trends are going to change anytime soon. Stig Brodersen (00:29:02): Let’s zoom out a little here. We see
in the news, obviously, the US inflation numbers are very prevalent, but you also see inflation creep up in European Union. Japan is like a story in itself for a bunch of different reasons. But if we talk about the regional differences, let’s just say Japan or Europe and America here, do we have technical differences between how inflation is measured like the actual numbers that are being published? Or it’s just a question of, say, America just has more inflation than the other regions? Cullen Roche (00:29:37): Yeah. There are technical measurement differences. But I would argue that the big lesson coming out of COVID and really the COVID recession versus the financial crisis is that fiscal policy makes a huge difference. And the response from the United States was so much bigger than almost every other major developed country. I would argue that the main driver of the current inflation, I mean, in addition to all the unusual supply chain issues, I mean, what we basically had happened was in March of 2020, it looked like we were going to have a massive deflationary collapse in the economy.
Cullen Roche (00:30:24): And so, what you had was a situation where businesses basically went through a couple of quarters where they expected for the absolute worst. And so, they’re selling inventories off, they’re not reinvesting and producing a lot of these things. And used cars are such a good example. I mean, you had Hertz and companies like that that was about to go bankrupt or ended up going bankrupt, and they ended up selling off their entire fleets. And so, used cars now and rental car prices are just crazy, crazy expensive because there aren’t that many cars.
Cullen Roche (00:30:59): These perpetual buyers of cars were suddenly liquidated. And so, you had this really acute supply issue. I mean, the amazing thing about what the United States government did was that they basically maintained aggregate demand. They actually overshot it. I mean, looking at a lot of different measures, personal incomes, personal consumption, consumption expenditures, and things like that, everything is higher than it was in the pre-COVID period. Cullen Roche (00:31:32): So, you have demand that, because of government policies, is actually higher than it was pre-COVID, combined with this really unusual supply shock where now the supply is lower. And so, a lot of the inflation just comes down to this basic supply/demand dynamic where we did, for all practical purposes, print a ton of money coming out of the pandemic and during the pandemic. And you have just unprecedented demand for all this stuff now. And compared to the rest of the world, the numbers just aren’t really that comparable.
Cullen Roche (00:32:08): I mean, the EU did put together, surprisingly, a fiscal package. It was amazing that they even got any fiscal package. I mean, coming out of 2008, I’m sure you remember, austerity was the name of the game. And so, it was amazing that they even put together a fiscal package at all. But the United States, I think, was very, very proactive. I think the one thing that policymakers seem to have
learned is that, and this is the big bazooka with a lot of inflation discussions is that the Federal Reserve is not as powerful as you think it is. Cullen Roche (00:32:43): And they increase their balance sheet by trillions of dollars coming out of the financial crisis. And they implemented all these lending programs, and they supported the banks, all the bailouts, all this stuff. And we got barely sustained one and a half percent inflation from all of this. And that was the big lesson of the financial crisis was that, the central bank, and this is not to imply that central banks aren’t extremely powerful.
Cullen Roche (00:33:11): But I think we tend to have this view that the central bank is the money printing entity, and that the central bank has the big bazooka. And I think what we’ve learned in the post-COVID period is that it’s actually the treasuries that have the big bazookas. And a lot of what the central banks do, and I discussed this in a lot of my papers on the operational dynamics of things like the monetary system and quantitative easing, that the central bank, to a large degree, is a secondary actor in all this. Cullen Roche (00:33:43): That the real money printing, if you want to call it that, is done by the Treasury. And so, to use a concrete example,
when the Treasury runs a deficit, meaning that they spend more than they actually take in in tax revenue and they end up having to borrow, you could call those bonds. They’re printed from thin air. They’re completely net financial assets. If the government was to finance their spending by dumping cash on the ground, for instance, rather than dumping bonds on the public sector or the private sector, they would literally be printing cash. Cullen Roche (00:34:18): They would literally be printing money. And so,
of course, we don’t do that in the modern era. We finance spending by printing bonds, basically. But those bonds are net financial assets. And what the Federal Reserve does, to a large degree, is they come in after the fact. And when they implement something like quantitative easing, they’re just changing the composition of the financial assets that the private sector then holds. So, they’re printing a reserve deposit and they’re exchanging it with the bond. Cullen Roche (00:34:49): And if you think about this from the order of operations, well, they’re just exchanging the different types of financial assets. They’re adding a deposit and they’re taking the Treasury bond out of the market.
So, where did the real money printing occur in this order of operations? Well, it occurred at the Treasury level. The Treasury’s deficit was the net financial asset. It was the balance sheet expansion that really matters. The Fed technically expands its balance sheet. Cullen Roche (00:35:13): But in the process of doing so, the way to think of it is that, yeah, they expand their balance sheets to create reserves and they buy the bonds with them, but then they remove the bond from the private sector. And so, what impact does that have? From a consumers’ perspective, it’s a lot like swapping a savings account, which is basically what a treasury bond is for a checking account. And ask yourself,
how does your financial situation change when you swap a checking account with a savings account? Cullen Roche (00:35:44): It doesn’t really meaningfully change at all, except for the fact that you actually have a lower income now. So, I think you could make an argument that something like quantitative easing is marginally deflationary because it reduces the private sectors’ income. But that’s the big lesson from the post-COVID period versus the post-financial crisis period is that fiscal policy has a much, much bigger impact. You have to look at it comprehensively. Cullen Roche (00:36:12): You can’t just look at the Fed’s balance sheet and say, “Oh, look, we’ve printed all this money because”… let’s say we were Europe in the post-financial crisis period and we were running basically budget surpluses or negative or flat balance sheet expansion from the Treasury level. Well, who cares if you’re doing quantitative easing in that environment, because then, there really is no meaningful balance sheet expansion at the Treasury level. And the Fed or the European Central Bank is just swapping those bonds for deposits.
Cullen Roche (00:36:48): And so, you’ve got to look at things comprehensively. And to make all of this even more confusing in the case of something like Japan, you have to consider all these other factors like demographics. And so, all else equal, fiscal policy is hugely, hugely important. And the degree to which those policies are implemented and then sustained will have a meaningful impact on aggregate demand and future inflation.
Stig Brodersen (00:37:15): So, Cullen, let’s transition from the first part of the interview where we talk a few definitions of what inflation really is, and then into the second part where we’re going to talk a lot more about the investing piece, how we as investors should take action according to inflation. So, students worldwide in business schools learn about interest rate parity. So, for those of you who are so lucky, as opposed to me who haven’t gone to business school, it’s like a non-arbitrage condition under which investors can’t make a higher return by investing in the country with a higher interest rate. Stig Brodersen (00:37:51): So, you might hear about this is the interest rate in Turkey or this is the interest rate in Argentina. And so, you might be thinking, “Well, why don’t I just invest in those countries and then make a lot more money than I would in the States?” But that is assumed to be inflated away and that inflation would be reflected in the change in interest rates. So,
that’s why we have this interest rate parity. This is like an assumption we say would hold true in the long run. But first of all, we can discuss the validity of the parity. Stig Brodersen (00:38:21): But I guess right now, I’m curious about the difference in inflation across the globe and all the changes we’re seeing right now.
Does it provide investors with opportunities to bet against the interest rate parity temporarily? Cullen Roche (00:38:35): Boy, I mean, you talk about a question that really gets into a ton of different risk variables and macro factors. My basic view is that interest rates basically reflect the future expectations of Fed policy. And Fed policy reflects their future expectations of inflation. So, to me, when you think about interest rates and the amount of risk that exists across different countries, what you really need to consider is the central bank’s position versus the outcome of potential likely inflation.
Cullen Roche (00:39:18): And so, for instance, like I was saying, in the United States, I think that there’s still a risk that inflation could overshoot the Fed’s targets for longer than they expect. And so, compared to someplace like Europe, I would argue that Europe has the opposite situation where they’re much more likely to experience a sustained lower rate of inflation. Because in large part, their policy expectations are a bit different. I think that the market does a fairly good job of
pricing the risks of these different interest rate parodies, I think, for the most part, very well. Cullen Roche (00:40:02): And it’s very hard to capture the existing, I think, arbitrage between these because what you end up essentially making is the future inflation prediction about what’s going to transpire in the future. You’re not really able to capture an existing current arbitrage because the future risks are so unknown. I think trying to utilize a strategy like this is somewhat, I don’t want to say counterproductive, but it’s much harder to capture those interest rate differentials than I think it is just looking at it from a nominal perspective.
Cullen Roche (00:40:37): And the largest contributor to that is mainly that the main reason why higher interest rates exist in some parts of the world than others is because there are just unusual risks. I mean, if you look at it from a corporate level using a dumbed-down example, the reason junk bonds have higher interest rates is because there are just a lot more unknowns versus an investment-grade bond in that area of the world. And so, when you look at it from a global macro perspective, the same basic thing exists. Cullen Roche (00:41:06): An interesting real-time example is cryptocurrencies. I mean, if you look at cryptocurrencies right now, there’s a lot of these high yielding cryptocurrency accounts that people say, “Oh, well, why would you keep your money in a 0% interest bearing bank account when you can go in and earn 10% per year in X, Y, Z cryptocurrency?” And the real answer there is that you could wake up one morning and that cryptocurrency might not even exist.
Cullen Roche (00:41:33): So, there is an embedded risk component that’s priced into that market that is, I don’t want to call it efficient, but it’s accounted for, to a large degree. And you’re not going to wake up one morning and find that your Bank of America just doesn’t have your deposits. It’s just the likelihood of that is zero. The FDIC has literally never lost a single penny in FDIC-insured deposits. And so,
that’s why, to a large degree, you don’t earn interest in an environment like this on a deposit because there is no risk. So, the risk is fully priced in, it’s fully accounted for. Cullen Roche (00:42:09): And so, to me, to make a longwinded answer really short, I do not think it’s possible to find these interest rate differentials and really benefit from them without making a future inflation prediction. And that’s, ultimately, what this comes down to on a country by country basis is, you have to look at the interest rates as a measure of risk in some degree. And looking at like Turkey, for instance, would I feel comfortable buying a 10-year or 30-year Turkish bond just because it has a higher interest rate? Cullen Roche (00:42:44): Well, absolutely not because the risk of hyperinflation in that situation is just through the roof. And so, the interest rate reflects a certain degree of risk in that. This is a really interesting theoretical concept from a country perspective because the interest rate does, to a large degree, reflect the credit quality of that specific country. And I think that a lot of what you’re seeing
in the developed world where interest rates are very low is really a reflection that inflation, to a large degree, is a reflection that the demand for that money is so high that the perceived future credit risk is perceived as extremely, extremely low. Cullen Roche (00:43:33): And from a country perspective, the interest rate and the inflation rate, to a large degree, which tends to correlate to a large degree over long periods of time, it reflects the credit quality of that specific country. And so, we think of sovereign governments as being risk-free. But the reality is that a 10% yielding sovereign bond is really, for all practical purposes, it’s like a junk bond. It’s a really junky bond compared to something like a 10-year Treasury, which in today’s environment, even though it’s yielding 1.3%, the reason that’s like that is it’s not just the Fed.
Cullen Roche (00:44:15): To a large degree, it’s the perceived expectation that the credit quality of the United States is not going to be in jeopardy anytime soon. And that the likelihood of you losing a nominal amount on that bond is extremely low. So, it reflects the demand for money and the demand for money is a reflection of risk, to a large degree.
Stig Brodersen (00:44:38): Let’s use that to transition into the next question because I wanted to talk to you about how we as investors should position ourselves if we are worried about rising inflation. And one of the things you hear a lot is that you should take on debt with a fixed rate and a long maturity. In which situation, if at all, is it a good idea for us as investors to do that? Cullen Roche (00:45:01): Yeah. I mean, this is a pretty personal question. But I mean, going back to what we were talking about before with whether the debt is good or bad, a lot of it depends on the rate of interest that you’re able to get. I mean, for instance, is it better to go out and
binge on a bunch of things that you consume that, on a credit card, might end up costing you? Let’s say, the interest rate on your credit card is 25%, just to use a crazy example. Cullen Roche (00:45:34): Versus is it smart right now to leverage up your balance sheet a little bit and purchase a home that you can get a mortgage rate on that let’s just say is two and a half percent? And compare that to the rate of inflation. Well, now think of it in real terms, well, what’s the likelihood of generating a real return on that credit card debt versus the two-and-a-half percent mortgage? Well, obviously, the risk-reward dynamics are completely different, but it’s also a question of relative asset class returns.
Cullen Roche (00:46:14): When someone comes to me and says, “Hey, should I refinance my mortgage,” well, you ask yourself, “Well, what can you borrow at?” If you can borrow at let’s say, two and a half or 3%, well, what’s the expectation of what you might otherwise be able to do with that cash? And that’s the big kicker is that, are you going to take the cash that you would have to, say, put into either a refi or a new purchase of a home? What’s the rate of return that you’re likely to be able to earn on that portfolio if you weren’t to borrow the money? Cullen Roche (00:46:45): And if you can lock in a fixed rate that you believe is on a risk-adjusted basis, it basically, allows you to earn a superior risk-adjusted return by holding on to that cash, in essence, well, yeah, then you should borrow. It’s a good risk-reward analysis. The thing that makes real estate so tricky these days is that when you look at something like a 30-year mortgage, I mean, typically, housing prices are pretty boring over long periods of time. So, you can make a pretty good projection over very long periods of time about what a house price is going to do.
Cullen Roche (00:47:28): When you get into these really funky environments where real estate prices go up 20% year-over-year and stuff like that, well, you’ve now introduced a whole different type of risk into all of your analysis where you can’t just look at the risk of, actually, the mortgage versus all of the relative asset classes like stocks and bonds. You now have to consider your ability to stomach the potential for, say, a 25% decline in home prices. And what would that do to your balance sheet? And how would that play out over the course of a 10 or 20-year period? Cullen Roche (00:48:03): And how would that impact your personal balance sheet? As a very sloppy general rule of thumb, you want to analyze what your expected rate of return on using the cash versus borrowing is. If you’re someone who has a really good credit score and you’re able to get a really good interest rate, well, yeah, on a relative basis, a lot of the time, it can make a lot of sense to be able to borrow because you’re essentially able to utilize your existing cash in a manner that allows you to earn a higher rate of return than you otherwise would. Cullen Roche (00:48:41): And so, what you end up with is you end up with basically a much higher ROI, return on investment than you otherwise would if you were to just pile all that cash into the house itself or something in a situation where you can borrow to buy the house. And you can put the money into a diversified portfolio of stocks and bonds and earn a rate of return that ends up actually being higher than the house would.
Cullen Roche (00:49:05): So, it’s a situation where you have to perform basically a relative risk analysis on the asset classes and consider for your personal situation how risky is the debt and the interest rate applied to it relative to all of your other options? So, this is a super personal question. But I mean, as a general rule of thumb, it can make a lot of sense to borrow because there are prudent ways to borrow, especially if you’re investing and I mean, really investing, as in basically spending for future production and producing something that’s going to be very productive. Cullen Roche (00:49:42): Going back to my original example of something that’s a world-changing innovation versus going out and binging on consumer goods that are literally going to disappear the second you consume them. So, the answer is it depends. Stig Brodersen (00:50:01): I like that. There are so many other things here in investing, in finance, it depends. Cullen, last time you were on our show on Episode 331, you
praised value stocks because they, by nature, have more predictable cash flows. And one of the things you mentioned was that a company like Facebook could potentially become a lot less attractive in the high inflation environment because the cash flows are somewhat unpredictable. You mentioned that they’re not necessarily based on the real economy but based on the internet-based economy.
Stig Brodersen (00:50:33): And so, one of the reasons why I wanted to bring this up and one of the reasons for my previous question was that I’ve been thinking a lot about how to position my own stock portfolio due to my own concerns about inflation. And I would be the last person on this planet to say you shouldn’t invest in value stocks. That’s not what I’m saying at all, but one of the things that do concern me is that companies that are referred to as value stocks very often have capital expenditures. Stig Brodersen (00:51:01): So, think about the Union Pacifics of the world. They are companies who you might not or perhaps you do, I want to throw that to you in a bit here because they have to spend old dollars to pay for the high maintenance CapEx in new inflated dollars. And so,
could you please talk to us about the whole value versus growth stocks in the time of inflation? Cullen Roche (00:51:24): This is pretty timely. I want to point the audience to a paper that came out May 25th that is called The Best Strategies for Inflationary Times. And that paper goes into really granular detail about all of this. And so, you can get really granular inside of this discussion. And so, going specific to what you were talking about, for instance, value has done really well in the last six to 12 months relative to growth. And a big part of that is that when you look at the granular drivers of that, you find that, for instance, energy stocks have had a huge resurgence. Cullen Roche (00:52:04): And so, if you go and you look at this paper, you can find the performance summary in exhibit two. And what they do that’s cool in this paper
is they get very granular on the exact equity factors that perform really well. And they go into sector factors as well. So, they find, for instance, that consumer durables are just about the worst thing you can possibly own in a high inflation environment. They find that energy stocks and commodities are extremely, extremely good. And so, you have to get more granular. Cullen Roche (00:52:41): What I loved about this paper was that they didn’t just study the equity factors, they studied all the different asset classes. So, they took a super
zoomed-out macro perspective. And they found that energy commodities are the top-performing sector in high inflation. They found that trend following does really well. Trend following commodities does really well. Industrial commodities, industrial stocks, obviously, like gold and precious metals, do really well. But trend and momentum actually performed really well. Cullen Roche (00:53:15): And this is especially interesting compared to the value factor because there have been so many studies in the last 10 years to find that combining trend or momentum with value is a really profitable long-term strategy because they both tend to exhibit sustained outperformance in the long term. To some degree, they tend to
counterbalance each other to some degree. So, from a pure value perspective, again, what’s cool about this paper is that it does a deep dive into the exact factors that drive a lot of this. Cullen Roche (00:53:51): So, yeah, it depends on the specifics of the sector. But I mean, during high inflation, yeah, Exxon Mobil or Union Pacific, they have to update their infrastructure. But the commodity price increases in their underlying sector are so
dramatic that they’re able to pass on. They have a huge amount of pricing power where they’re able to pass along those increased costs to their end consumers and so that’s a lot of it. Whereas something like consumer durables, they just don’t have the same degree of pricing power. Cullen Roche (00:54:27): It’s really tricky. I mean, from a high inflation perspective, I actually, even though I say that… as a general rule, I tend to fall into a market cap weighting, a boring old-school market cap weighting perspective. Where
I think if you’re trying to assess the risk of the market, you generally are better off combining non-correlated assets to the equity markets. Because finding the pockets of specific risk protection within the equity market is just so, so difficult to do. Cullen Roche (00:55:07): I mean, for instance, people often ask me, “Instead of buying bonds these days, why don’t you just buy defensive stocks?” I say, “Oh, you mean defensive stocks, like the ones that… defensive stocks that fell 50%, 60% in 2008?” There was nothing defensive about defensive stocks in 2008. And so, in my mind, when you often find that stocks are stocks are stocks are stocks, and all of these stocks tend to, to some degree, reflect just huge amounts of principal risk.
Cullen Roche (00:55:37): And so, if you want really uncorrelated protection from certain things, you need to go outside of that asset class. And in the case of inflation, I think that to a large degree, and this is largely consistent with what this paper concludes, is that you need to go into things like commodities or you need to go into completely uncorrelated strategies like trend following. And trend followers use… predominantly, they’re using derivatives and they’re using commodity derivatives.
Cullen Roche (00:56:08): And so, they’re using things that are really, truly uncorrelated to the equity market itself. But as a basic rule of thumb, the stock market is a pretty fantastic inflation protector. Going back to all these boring periods of inflation, I would argue that, yeah, it’s nice to have inflation protection when inflation is really high. But really, it’s a lot more important, in my mind, to have just very sustained inflation protection. I mean, you don’t think often of needing protection from 2% inflation. Cullen Roche (00:56:42): But the reality is that I think that those boring inflationary environments are much more important to protect yourself against because they’re just so much more likely to occur. I mean, the likelihood of the Weimar Republic occurring in the United States or something like that, or Zimbabwe, in my mind, it’s just super low. And so,
if you’re going out planning for some environment and you’re building your whole portfolio around something like that, you’re building your portfolio around a really low probability, asymmetric bet that, yeah, it might have a huge potential upside. Cullen Roche (00:57:17): But the likelihood of it actually coming to fruition is just not very high. And so, it’s a lot more important to build your portfolio around the more likely outcomes, which is just that inflation, yeah, it’s always going to go up from the bottom left of that chart to the top right, and you have to protect yourself from that. And that means that the risk of a two and a half percent or 3% inflation is much higher. It has a much bigger impact on your overall quality of life than sitting around worrying about a Weimer Republic or a Zimbabwe.
Cullen Roche (00:57:49): And so, the equity market as a whole has been a fantastic way to protect yourself and generate a real return, regardless of whether or not there was ever going to be hyperinflation. And so, from a pure purchasing power protection perspective, stocks as a whole are a wonderful way to protect yourself from inflation. And so, you’ve got to get really comprehensive about it. But from just a very boring macro perspective, thinking of stocks as a continual purchasing power protector is, I think, a useful mental model, a good framework to start with when you’re considering your purchasing power protection. Stig Brodersen (00:58:34): Let’s talk a bit more about it. Very practical about it because it’s often said that we should invest in real assets and not financial assets in a time of inflation. And so, your real assets,
that could be precious metals, commodities, real estate, land equipment, natural resources. And to some people, including myself, some of that can sound quite intimidating because you want to have the actual physical asset. Do you want to store gold in your own home? Stig Brodersen (00:59:02): What do you do with those 100 barrels of oil, or whatnot, that you’re going to put somewhere in your garage, right? So, many investors, therefore, prefer to buy paper assets due to the convenience of not having to go through transactions with real assets. And this might sound confusing, since you can have paper assets, for instance, stocks where you own a company with many real assets. And so, could you clear that up for us, Cullen? What is the relationship between a paper asset and then this hedge against inflation through real assets? Cullen Roche (00:59:38): We call what we do investing. And a lot of
what people do in the financial markets, it’s not from an economic perspective, it’s not technically investing. It’s really, we’re just reallocating our savings. And so, what I mean by that is that when a firm goes out, when an oil company goes out and they buy a million barrels of oil, well, they’re not going to do what you just described. They’re not going to take those barrels of oil and just stick them in their backyard and hope that the price changes. Cullen Roche (01:00:07): No, they’re typically going to do something with that oil. They’re going to literally spend for investment on it. So, they’re buying the barrels of oil, and then they’re doing something. Who knows, they’re turning it into gasoline or they’re reselling it to someone who is going to be able to purchase it to turn it into, who knows, tires or some other product that is actually useful in the long run. And so, what they’re doing is spending for future production.
Cullen Roche (01:00:36): And that’s one of the things that, I think, people have to be cognizant of when they’re analyzing all this. And it’s one of the reasons why I generally if you’re going to apply like a macro rule of thumb to inflation protection, it’s nice to own the financial assets in large part because the financial assets reflect what the underlying spending for future production is actually resulting in. So, for instance, when you buy Exxon Mobil, you’re not just buying some piece of paper that reflects the craziness of what people think on Robin Hood.
Cullen Roche (01:01:16): To a large degree, you’re buying a piece of paper that reflects the underlying value of what Exxon Corporation does with their spending for future production. And so, you’re getting embedded inflation protection in there, not because of just the underlying commodity, but really, you’re making a bet, to some degree, on how innovative Exxon Mobil is able to be with their barrels of oil and what they end up ultimately doing with those barrels of oil. Corporation is really… it is a real entity. Cullen Roche (01:01:51): To a large degree, you’re buying the real assets of that corporation and what those real assets are likely to be worth in the future.
And so, that’s why things like stocks, they much more reflect the real asset world than just buying the pure-play like a commodity, because you’re getting embedded inflation protection. Going back to my example of the house, one of the reasons that houses end up being at least fairly good inflation protectors over the long term is because, for instance, when I bought my house, yeah, I knock the thing to the ground, but I was able to rebuild. Cullen Roche (01:02:30): I was able to reinvest in land and I was able to do it, I mean, granted my timing was lucky, I guess. But I was able to do so at a time when the cost of building was low. And now, the cost of building and the price of housing reflects the cost of replacement is much, much higher. And so, I made what is, to some degree, an investment in the underlying real assets
that exist on my property. And so, a corporation that issues financial assets to fund all of these, like stocks or bonds, well, they’re doing something that’s very similar. Cullen Roche (01:03:12): They’re doing something that’s, frankly, it’s a lot smarter than buying a home because the ROI is generally so much higher. You can get at it both ways. But the question you have to ask yourself is, if you’re considering buying a lump of gold versus buying something like a company that actually uses that gold and is able to break it down and put it into technologies that actually have a positive return on investment. Well, you have to ask yourself which better you more comfortable with?
Cullen Roche (01:03:44): Are you more comfortable that that commodity is just going to increase in value because of underlying macro factors? Or do you feel better buying something that uses that commodity in a way that ultimately is going to make it generate a higher return on investment in the long term? And that’s why, ultimately, you come back to the basic rule of diversification. I have nothing against owning blocks of gold or real estate or physical assets. In fact, I think that roughly it makes a lot of sense to own something that’s pretty close to the global holdings of all of these things. Cullen Roche (01:04:22): I mean, the market may not be efficient, but the market isn’t stupid either. And so, I think it makes sense to diversify across a lot of these things. But certainly, it’s practical to think of things like stocks as real assets because you ultimately, if you were to strip away and use a really strict Warren Buffett type of methodology to analyze all this, what you have left when you sell a company is all of the real assets and everything that it’s worth at a real level. And so,
that’s why the stock market is a wonderful inflation protector in the long term. Stig Brodersen (01:05:00): I can’t help but ask you, Cullen, with all of this being said, how do you position yourself? Cullen Roche (01:05:06): It’s getting harder and harder. Obviously, I own real estate, I own stocks and bonds. I think that it’s interesting, people often ask me why I own cash and bonds and the quantities that I do. I think people tend to have this hyper-focu
2021-08-18