Winter (Inflation) is Coming

There are many times in life where I notice something is happening, I make a mental note of it and schedule time to think about that noticed “thing” at some point in the future. One of those things came back and really hit me in January — why was the U.S. dollar so weak in 2017? The U.S. Dollar Index, which measures the value of the dollar against a weighted basket of currencies, recently slipped to its lowest level in more than two years.

As it was happening last year, it surprised me. At first glance, the U.S. has much more lucrative yields for its bonds than Japan or Europe, which is a factor in the currency. The German bonds are yielding 0.70% and Japan’s bonds spent much of last year in the negative (an investment that structurally costs money). The U.S. economy is doing better than most economies around the world. So why is the U.S. dollar falling in value?

There are several factors that go into answering this question of what affects the price of a currency. One is the country’s overall economy. Another is how much the country’s debt yields in returns. Better yields attract money. Another factor, still, is the trade surplus/deficit. And yet, another factor is how much outstanding debt the country has, relative to GDP, and whether the rate of the deficit is expanding or contracting.

As Mr. Wonderful (Kevin O’Leary) says, “ Money goes where it’s treated best.” So, we have to ask the question — why is the U.S. dollar continuing to fall against other currencies? In 2017, the U.S. dollar lost 11% compared to a basket of currencies tracked by the $DXY index. Why did this happen? To answer that question we need to look at who is treating money the best.

On the surface it would seem that the U.S. would be the best place for money. Its bonds are yielding 2.8% on the 10-year treasury in contrast to countries like Germany or Japan which are yielding near 0%. So why would the U.S. be experiencing outflows of money if it gives the highest return compared to other countries? The answer ultimately comes down to an investor’s belief that they are going to get paid back in the same amount of purchasing power as they lent, plus interest. I think the calculus right now is showing that most people do not believe the government of the U.S. will pay its debts in the same amount of purchasing power as when lenders’ lent the money. Borrowers will get paid back the dollars they lent; it’s just that each dollar will not have the same purchasing power at bond maturity as at the time it was lent. More deficits lead to more inflation will outpace yield.

Governmental Policy

There are several factors, and the most recent is probably the most compelling. The Trump tax plan, on the surface, looks good to companies. However, if you look a few years out, it is going to wildly add to the U.S. deficit and overall debt. That is going to reduce purchasing power for each dollar because more dollars, because more dollars are going to need to be printed to service the debt. This is the reason why the U.S. Dollar continues to slide in value in 2018.

When you see the dollar falling against other currencies, you see the mechanics for how we import inflation from the dollar. This means we have to buy foreign products for more dollars because the value of each dollar is dropping in relation to the foreign currency. If the prices for foreign products are increasing, that is inflation. The market is seeing this and, as the dollar falls, our chances of getting high inflation here in the U.S. rise. I suspect we will see good to moderate inflation in 2018.

Inflation

To watch for forecasted inflation, look at 3 criteria:

• Money Supply (M2) — Currently Expanding
• Price of Copper — Above $3 and slightly rising
• Treasury Yield (10-Yr) — 2.8% and rising

As of now, M2 Money Supply has been steadily rising, even with the normalization efforts from the Fed. This creates the potential for inflation because more money in circulation means each unit is worth less. Checking in on the price of copper, it’s over $3. That means a base commodity has an increasing price, and that leads to inflation. Many investors call it “Doctor Copper” because the price of copper is a very good leading indicator. Finally, the 10-Yr U.S. Treasury rates are producing a yield of 2.8% and they are rising. These signs all point to rising inflation in 2018.

The Case for Anti-Inflation (Stagflation)

There is work done by Harry Dent who outlines a case that inflation is not correlated to the money supply, that it’s directly correlated with demographics. He explains, with an aging economy, there is no way to get inflation. He is predicting a deflationary bust. You can check out some of his work, here.

Winter is Coming

I think indicators are pointing to some inflation in the medium-term. Some of the best investments in a rising inflation environment are: emerging markets, commodities, materials, industrials, real estate and precious metals. I would be focusing my research in each of these areas. All the heavy global government debt is having an impact on the financial markets. It’s time to consider this possibility in your investment plan. I tout some recommendations in my 2018 Investing Themes post.

Based on how the foreign currency markets are reacting, traders think there’s going to be more inflation in the U.S. than expected. This is surmised from the fact that the U.S. dollar keeps losing value. It lost roughly 11% of its value in 2017 and roughly 2% already this year. Traders think the deficits are going to be a lot greater than what’s being projected by the U.S. government. Many make a case for the deficit to blow up to over $1T per year starting in 2019, so an additional data point to watch is the projected deficit number for 2019 and beyond. That add $1T every year to the national debt. If that widens to over $1T, we can assume there will be more inflation because it’s one way to get out of debt faster (by inflating the currency, paying off debt with dollars worth less and reducing purchasing power per unit of currency).

My prediction over the next two years? Winter (Inflation) is Coming.

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Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Please do your own homework.

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