Why Inflation Might Return and Why You Need to Worry About It

Steve Johnson, Forager Funds Management

14 January 2021

Extraordinary. It is an overused word. It's also an odd word, to me at least. Why does something that is unusual or infrequent have an extra amount of ordinary? Anyway, we can safely use it to describe 2020 without being accused of hyperbole. Travel plans, living arrangements, schooling, workplaces and shopping were thrown into turmoil by a virus that spread around the world, caused governments to lock citizens in their homes and killed almost two million people. For those of us in financial markets, the March crash will sit alongside the 2008 Lehman-induced meltdown as a placemark in our careers.

At Forager, it was an especially extraordinary year. The Forager International Shares Fund returned positive 38.3% for the year. In absolute terms, that is an outlier. Relative to the MSCI AC World Net Index in $A, which returned 5.8%, it is the sort of result you hope for once every couple of decades.

The Forager Australian Shares Fund's 21.6% return is less of an outlier - you could argue it was overdue given the underperformance of the prior two years - but it was extraordinary nonetheless. That 21.6% encompasses a fall of 54% between 1 January and 23 March, followed by a 166% rise between that nadir and 31 December.

You should expect us to perform well in volatile markets. But the magnitude of the performance is particularly pleasing. My thanks go out to the entire Forager team for their outstanding work in a difficult year and our loyal Forager clients, who allow us to do our jobs in dysfunctional markets.

The game that never stops

One thing I like about marathon running is the well defined end-point. You train hard for a few months, eat well, dial it back for a week and then it's race day. Once the finish line is behind you, it's time for a cold beverage, a few weeks of rest and all the pies you can eat.

Running an investment portfolio in a year like 2020 is nothing like running a marathon. There is no finish line. Like a two year old child, it needs to be fed and monitored every single day. And the better your returns, the faster markets are moving, the more monitoring and feeding it needs.

If 2020 proved anything, it was that predicting the future is extremely difficult, if not futile. Look no further than my February blog Corona no virus for global stocks, two weeks before a market meltdown. That also shows that prognostications are not a prerequisite for above average returns.

When anything can happen, nothing is a surprise

We didn't predict the market bottom in 2020. We didn't anticipate the fastest bear market recovery on record. We simply tried to construct the best portfolios we could with the opportunities that were in front of us. We recognised that the best opportunities on the 23rd of March were very different from those on the first of January, and made quite dramatic changes to both portfolios.

In fact, writing a blog that looked foolish in hindsight was probably a blessing in disguise. It served as a timely reminder that great investment returns come from finding great investment opportunities. While many of those who predicted a market meltdown were wasting their time trying to identify the bottom, we were out there looking for stocks to buy.

We will take the same approach in 2021. Start with the view that anything could happen, and we won't be surprised.

A monetary epoch?

One thing that could happen, that most people think won't, is that we look back on 2020 as more than just a market crash. It may be seen as the end of an era.

Will inflation return? That was the question on the cover of the December 12 edition of The Economist. The answer will define the next decade, perhaps two, of returns on almost every asset class.

In September 1981, the 30-year US government bond was yielding 15% for an investor who held it to maturity. In the early 1990s, my parents were still paying interest rates of 18% on their mortgage. Today's yield on a 30-year US bond is less than 2%. A mortgage loan in Australia can cost you less than that.

For the past three decades, interest rates have inexorably fallen alongside inflation expectations. Today, central bankers are far more concerned about inflation never coming back than it ever getting out of control again. Investors are using low long-term interest rates, based on a lack of inflation concerns, to justify sky- high prices for property, infrastructure assets and Tesla shares.

There are theories, from ageing populations to technological improvements and low cost labour substitution, that explain low inflation or even deflation as a permanent feature of the developed world. I don't have a strong view that those theories are wrong. But I know that when the whole market thinks something can't possibly happen, the consequences of that assumption being wrong are significant.

Why might inflation return?

Some investors and economists - particularly of the pessimistic kind - have been predicting the return of inflation ever since the financial crisis of 2008/9. It hasn't happened, the argument goes, and therefore it won't.

Throughout the past decade, monetary policy was extremely accommodative. But it didn't have much help. The private sector - including consumers and banks - spent most of the decade in balance sheet repair mode. Fiscal policy wasn't helping, as politicians caved to austerity demands every time their economies started to recover. Just like the recovery from the Great

Depression of the early 1930s, this recovery was mired in fits and starts. This pandemic-induced crisis might be more akin to a war than a financial crisis, though. By the end of 2021, all three components will be surging in the same direction. Morgan Stanley estimates the four largest economies will expand central bank balance sheets by some 38% of GDP in 2020, almost four times the amount of purchases following the financial crisis.

And the same G4 economies will be running the largest fiscal deficits since the second world war at the same time. The US government deficit is expected to be 14.9% of GDP in 2020 and remain at 9% of GDP in 2021. Despite all of the bailouts in 2009, the US government deficit never exceeded 10% of GDP.

Perhaps most surprisingly, consumers around the world are in rude health. Unemployment has not risen as much as expected, and the large stimulus programs and a lack of things to spend their money on means consumers are flush with cash (see chart below). The lockdowns have hit a small percentage of the population hard but, as a whole, the savings rate in Australia soared to more than 20% of disposable income, a level unprecedented in RBA records.

Three-pronged inflation push

The aggregate picture is one of substantial pent up demand meeting more monetary and fiscal stimulus in late 2021 and into the following years. Perhaps we look back on this period as the monetary equivalent of the Second World War, one giant stimulus program that finally brought the economy to life.

Nonagenarian investor Charlie Munger once said "knowing what you don't know is more useful than being brilliant." Some of the brightest economics minds in the world have a patchy track record when it comes to macroeconomic forecasts. Perhaps demographics and technology do mean we never see inflation again. But the world is about to test the theory. And we won't be buying anything that assumes higher interest rates can't possibly happen.

LIGHT AT THE END OF THE TUNNEL - BUT WE'RE STILL IN THE TUNNEL

Marcel von Pfyffer, Arminius Capital

20 January 2021

• Coronavirus vaccines will help us return to normal, but there will be risks, obstacles, and delays through 2021.

• 2021 will bring a W-shaped recovery in the economy and the share market: two steps forward, one step back.

• The Australian dollar is headed toward USD 90c much faster than we expected.

After the grim events of 2020, the November news of three coronavirus vaccines set off a surge of investor optimism about the future. But the existence of coronavirus vaccines does not guarantee that life will automatically return to normal in the near future. For Australia and the world, there are many hazards to be avoided or overcome before we can find our way out of the dark tunnel of the pandemic.

First, there are the logistical complexities of distributing the vaccines throughout the world at very cold temperatures, followed by the administrative challenges of administering them to millions of people. In developed countries like Australia, the public health system will accomplish this task quickly and without difficulty. In poor countries with weaker healthcare systems, the task will be much slower and harder.

We should not underestimate the size of vaccine wary members of the population. Recent polls indicate that more than 40% of US citizens are unwilling to get vaccinated at present, and even in Australia a quarter of survey respondents have expressed reservations. These numbers are important because - depending on the complex epidemiological assumptions and calculations - herd immunity may only be achievable if 80% of the population is vaccinated. The US has a history of being very slow to adopt public health measures, and the failures of the initial US response to the 2020 pandemic raises doubts about the speed, breadth, and adequacy of the US vaccination program. Globally, the recent double-digit deaths of people who had just been vaccinated has not helped the smooth marketing plan that the drug companies' PR machines were probably hoping for.

Then there are the potential problems with the vaccines themselves. Although the clinical trials have been rigorous, they have not been large enough or long enough to remove all uncertainties about the vaccines. Therefore, as is obligatory with all newly approved drugs, the public health authorities in each country will track what happens to those who have been vaccinated. Clinical experience with new vaccines over the last century points to eight important risk areas:

• Manufacturing quality must be carefully monitored. In 1955, more than 200,000 children in five US States received a defective polio vaccine from bad batches manufactured by Cutter Laboratories. This mistake caused 40,000 cases of polio and 10 deaths.

• One or more of the vaccines may generate problematic side-effects in some classes of people. Minor allergic responses to vaccines and vaccine components are common, but none of the three vaccines triggered a pattern of serious adverse events during clinical trials. It should be borne in mind, however, that each of the Phase III trials only covered 40,000 to 50,000 volunteers. Administering the vaccines to billions of people expands the sample size by a factor of nearly one million, so there may be some surprises.

• Because of the timeline acceleration caused by "Operation Warp Speed", clinical tracking of the volunteers in the trials is less than three months so far. It is not unknown for new drugs to demonstrate negative side-effects in the longer term. For example, in September 2004 Merck voluntarily withdrew its osteoarthritis drug Vioxx (Rofecoxib) from the market, because evidence had built up since the drug's 1999 approval that it was associated with increased risk of stroke and heart attack.

• Because of the short follow-up period, it is not yet clear how long COVID-19 immunity lasts after vaccination.

• For safety reasons, children, the immunocompromised, and women who are pregnant or breast-feeding were excluded from the clinical trials, so we know little about the effects of vaccination on people in these classes.

• Vaccines are often less effective in the elderly because their immune systems no longer function as well as they used to. The complex and lasting symptoms observed in many cases of COVID-19 suggest that vaccination may not provide complete or durable immunity.

• Although the vaccines reduce or prevent COVID-19, we do not yet know how effective they are at preventing disease transmission to other people. If they do not prevent transmission, herd immunity will take longer to achieve.

• The normal mutation processes of the coronavirus may make some vaccines less effective.

Any setbacks in the global vaccination program would cause temporary damage to investor sentiment. In the longer term, other more effective vaccines will be developed - there are currently 18 candidates in Phase III trials. In the short term, travel and tourism stocks, as the sectors worst affected by COVID-19, would give up much of their recent gains.

For these reasons, we continue to expect a W-shaped recovery in the Australian economy and share market. We forecast this sort of recovery back in June, when it became obvious that COVID-19 would have recurrent outbreaks until herd immunity was achieved. The subsequent outbreaks in Melbourne and Sydney have confirmed our forecast. The additional possibility of setbacks in the vaccine rollout reinforces our belief that two steps forward will often be followed by one step backward.

For Australian investors, we recommend riding the Australian market up, buying the dips but avoiding risky sectors. Over the next six months, economic recovery will propel the Australian share market upward even if there are minor corrections. In the second half of 2021, however, the risks will increase as any vaccine problems emerge. In addition, the Australian government needs to find its way to a truce, if not a peace treaty, in the trade war with China.

While the broad market will keep rising in the long term, some sectors will become over-priced as optimism outruns reality. As noted above, the longer herd immunity is delayed, the longer it will take the tourism and travel sectors to return to profitability. Speculative stocks, e.g. in fintech, mining, and biotech, have floated upward on a tide of stimulus money, and the withdrawal of stimulus payments means that the tide will go out and leave many investors stranded.

Back in June, we forecast that the Australian dollar (AUD) would rise against the US dollar (USD) over the next three years, reaching at least USD 84 cents and possibly USD 90 cents. Since then, our prediction has been coming true faster than we expected. The AUD has risen 11% against the USD since end-June, and it could rise another 10% to 20% within twelve months, thanks to the US mishandling of the pandemic, debt-funded multi-trillion dollar stimulus packages en route in 2021 and the ongoing dysfunctionality of US politics.

GameStop

Michael Frazis, Frazis Capital Partners

31 January 2021

Well, that was one of the more engaging weeks in finance I can remember!

I recorded some views on iTunes and Spotify. Slightly new format so please have a listen and let me know what you think.

Here is one of the original posts on r/wallstbets outlining the case before the stock went up over 100x. 

This story had everything, including the juicy villains of SAC/Point72 (caught multiple times for insider trading), Citadel and Robinhood.

Robinhood marketed themselves as by the people/for the people, while cynically selling their order flow to Citadel for the express purpose of front-running their own clients. Robinhood indeed.

They largely got away with this, but will never by the same after they halted purchases of heavily shorted stocks last week, severely harming their users who were net buyers. 

It's uncertain whether this was due to pressure from their real client Citadel, or whether they were simply running out of cash, which given the emergency cap raises late last week, is almost certainly true. As politicians from all sides are sensing opportunity in the moment we may well find out. 

There are also some new heroes, specifically the hive mind of reddit. There are 7 million people on r/wallstreetbets. If they have $5k each, that's $35 billion of dry powder. That's more than enough to push around a heavily shorted stock.
 
We've noted before that when bearish investment professionals heavily short a widely loved company, the love tends to win out. This has happened time and again across our portfolio with Tesla, Afterpay and Carvana et al. The r/wallstbets crowd was generally very bullish in 2020, again forming an opposing view (and position) to the 'smart' money. We know how that played out. 

We were observers the Gamestop saga, rather than participants, but before you ask, January went OK. The rotations that ripped through the long/short community were largely neutral, though whether the short losses trigger a market sell-off remains to be seen.

The long term consequences are profound. Long/short funds may never be the same. Certainly, institutions should think twice about allocating pension money to long/short funds that:
- did not perform in the crisis of 2020, and
- can toast billions of dollars in days with a single misjudged trade. 

It's a familiar irony that long/short strategies sound like sensible risk-managed approaches, but so often prove the opposite. 

This is all very positive for cryptocurrency: people will long remember the manipulative moves of Citadel and Robinhood. 

One final point: it's important thing to remember that all short squeezes end in the same way: a collapse in price. Once the forced buyer folds at the top, there is no reason for anyone else to buy. Best keep that in mind.

Having said that, this may not be over. The memes and use of language over the past week has been second to none. In fine form comes the phrase: 'is the squeeze squoze?' 

According to the website, with Gamestop short interest still at over 100% by some measures, the squeeze has not, in fact, yet been squozed.

Michael

Disclaimer

The information in this note has been prepared and issued by Frazis Capital Partners Pty Ltd ABN 16 625 521 986 as a corporate authorised representative (CAR No. 1263393) of Frazis Capital Management Pty Ltd ABN 91 638 965 910 AFSL 521445. The Frazis Fund is open to wholesale investors only, as defined in the Corporations Act 2001 (Cth). The Company is not authorised to provide financial product advice to retail clients and information provided does not constitute financial product advice to retail clients.

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