The Macro Investor: Cash is Trash?

Higher US inflation is here. Cool.

As a reaction, market participants were selling stocks, bonds, gold, crypto, anything. To put their money where? You're guaranteed to lose purchasing power holding cash due to negative real rates, and even more so with higher realized CPI.

Let's screen the global macro landscape for investment opportunities.

Your money sitting in a bank account has been losing value for over a decade. The chart below shows US Fed Funds rate - realized inflation. Average -1% a year over the last 10 years. Compounded, that's a nice -10.5% purchasing power destruction in real terms.

It's gonna get worse soon. Today's real rates are a wonderful -4% due to the cyclical pick-up in inflation. My base case is that you'll have to endure this -3 to -4% real rates for several months to come. Ouch. So, where do we hide to preserve purchasing power?

Before we get there, let's have a quick helicopter view at the world and our monetary system. The nature of our system is credit-based: we don't cap the money supply or peg it to some real scarce asset, but rather expand and contract it as we deem fit. Actually, we mostly deem fit to expand the money supply because credit creation spurs (cyclical) growth and we like growth. Credit creation happens to also increase the private and public debt burden.

Please notice credit creation is NOT done by Central Banks. They can create bank reserves. Those get stuck in the banking system and can't get out. Credit creation is done mostly by commercial banks when they lend money or governments when they run deficits.

In order to reduce debt burdens, real growth > real interest rates you pay on your debt. You either record strong and structural real growth, or you reduce real interest rates to allow for an easier servicing of your debt costs.

Strong and structural real growth is impossible with a shrinking labor supply and poor productivity as a result of capital misallocation, hence guess what? As private and public debt increased all over the world, we have suppressed real rates into negative territory. The chart below shows US debt/GDP inverted (white) and 30y US real interest rates (orange).

Debt/GDP is inverted: the more it drops, the more debt/GDP is actually growing. The more leveraged the economy is, the lower real rates we impose. I expect this trend to continue.

Interestingly, you don't need -10% negative real rates to deflate away your debt. Due to compounding, -2% for few decades does the trick very well for debtors at the expense of asset owners which are basically ''taxed'' this way. Cool, no? No, it's financial repression.

Ok, this is the helicopter view, the structural backdrop. What about the cyclical one?

Inflation is the new kid in town, with US CPI YoY >4% and core inflation at 3%. I believe this is going to continue for 3-6 months before we perhaps revert back.

The US government has produced a gargantuan fiscal stimulus compared to the existing output gap. The graph below shows US families disposable income YoY (orange) versus US core inflation (white). The idea is that higher purchasing power for the average person somehow translates into higher demand for the same basket of good, hence some inflationary pressures.

US families disposable income YoY jumped to +31% (!!!) in April 2021 due to the stimulus checks. I'd expect that number to settle at around 8-10% YoY at the end of 2021, which means core inflation should stay on average around 3-4% over the next 3-6 months.

Red arrows for your own imagination.

So, 3-6 months of proper inflation prints on a backdrop of a monetary system which requires more and more negative real rates to deflate huge debt burdens. ''Patient'' central bankers advocating for transitory inflationary pressures and average inflation targeting.

So, we'll probably get even more negative (realized and implied) real rates. Which assets correlate best with very negative real rates and a strong cyclical nominal pick-up in economic growth?

Long Commodities: I like oil (WTI Jun Contract @65.16) as I expect a very strong summer travel season in Europe. Vaccination rates are likely to hit 60%+ by June already, which should allow for a proper airline season which is not fully priced. I also like gold (XAU/USD @1840) as it correlates well with negative real rates.

Long S&P 500: true, not all companies in the S&P 500 (SPX Jun Contract @4162) do immediately benefit from lower real rates especially if nominal rates rise a bit, just being outpaced by inflation break-evens. But still, you're buying an asset offering a large pickup in 12m forward Earnings Yield versus your risk-free real yield alternative and this pickup is about to get bigger as real rates drop further.

Long Selected EM: the drop in real rates is likely to happen faster in US than everywhere else as US inflation picks up more aggressively than peers. This should weaken the US Dollar on the margin, which is generally good for EMs. I'd focus my attention in countries with a good real interest rate pick-up and countries which are commodity exporters. Brazil (MSCI Brazil ETF, IBZL @23.7) and Russia (MSCI Russia ETF, CEBB @121.8) might be good examples.