Inflation, Deflation, and Separating the Signal from the Noise
Heavyweight economists are making bold and assertive claims on which direction the economy is moving. The evidence they are presenting is strong and their arguments are sound. The only problem for those trying to look at their diagnoses and make sound investing decisions from them is that the various experts are taking seemingly opposite sides as to whether the current market is facing inflation or deflation.
Michael Burry and many others are predicting hyper-inflation, pointing to increasing consumer prices and lack of action from the federal reserve. Burry has gone so far as to call the Fed and those speaking for them liars. The main argument from this point of view is that growth and price increases resulting from pandemic recoveries will compile enough to create run-away hyper inflation that continues to fuel increasing prices until the bubble inevitably pops.
On the other side of the spectrum, inflation sceptics like Cathie Woods and Lacy Hunt argue staunchly that in fact deflation is taking place. The argument here that we are currently experiencing a low in terms of velocity of money and a reduction in the velocity of money is, by definition, deflationary, and has been a leading factor in recent economic changes.
Where to Look Next
With fairly compelling arguments from both parties, it can be helpful to look at the positions of each to try to glean more insight into what they actually predict will happen.
Michael Burry is short on Bonds, an appropriate position given he expects runaway inflation. He’s effectively betting that government spending will reach a point that it devalues currency. What makes less sense given this prediction is an even larger short on growth equities, specifically TSLA and ARKK. This second position could be explained in either of two ways, he is hedging the shorts against each other as the payout from the bond short would dwarf his TSLA/ARKK position. Or he is putting his money where his mouth is, after publicly criticising ARK Invest and their speculative funds.
Woods’ position makes slightly less sense given her current market diagnosis. She is heavily invested in equities, but equities are usually considered to be a safe haven in times of inflation, so why go all-in on them when you believe the market to be deflationary, especially the speculative equities Woods is so heavily invested in? This again has two possible explanations. First is that she actually believes that equities are no longer that safe in times of inflation and the aftermath, In much the same way that large financial institutions leading up to and immediately after the financial crisis of 2008 didn’t prove to be as unshakeable as was thought beforehand. However, most of the people making that argument have reversed tack and are describing large caps as an asset class that can provide protection from inflation over long time horizons. A more likely explanation for Woods’ position is that she predicts current deflation to end and simply sees the current landscape as an ideal buying opportunity. This aligns with the fact that her argument generally discounts the effects of the Fed using their repo/reverse-repo facilities to tip the bond yield curve. This might seem suspect because it makes the fundamental data she points to more robust, but it’s arguably fair to discount in this way if you truly believe recent inflation to be near-entirely transitory. Essentially she is saying “sure, we’re bending the rules now, but just watch what happens after we stop.”
The real predictions
Given their respective positions – Burry short on bonds, Woods long on equities – Burry is predicting the price of debt to plummet while Woods predicts the price of stocks to soar. This argument amounts to little more than one saying “The sky is blue.” and the other responding “No, it just looks that way.” While the causal mechanism may be different from one to the other, the ultimate outcome (or at least the desired outcome in this case) is the same. The juxtaposition between the opposing arguments of Inflation and deflation vs. the aligning positions of short on bonds and long on equities shows how world class asset managers can position themselves to be correct on outcomes even when their causal diagnoses may differ.
What we can learn
The key takeaway from this should be that investors need some agility for the short and intermediate term as current factors that make large caps attractive now may not always be the case.
In the short term, current levels of inflation are likely to benefit asset classes that are both valued in dollars and able to take on lots of debt when said currency is valued low, a.k.a most domestic public large caps.
Also in the short term, disruptive/speculative industries are still sorting themselves out. The gains realized by those who do win out in the long run will be massive, but speculating on which individual entities are capable of surviving the financial storms of a new sector until the industry establishes itself presents too much of a risk to account for more than a small amount (i.e., ~1%) of one’s net worth.
The agility comes into play as the current scenario begins to shift. Just because domestic large caps are attractive now doesn’t mean they always will be.
Investors should keep their head on a swivel, try to understand the implications of economic factors at work, and once articulately formed, give their thesis time to play out (short term pricing fluctuations usually mean little in the long run) while simultaneously not “marrying” any particular idea when evidence to the contrary starts to pile up.