Inflation 2021 w/Cullen Roche (TIP370)

Inflation 2021 w/Cullen Roche (TIP370)

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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 20:23

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