Higher labor costs and "shrinkflation" - Inflation beyond the headlines

Forget about gas prices and food prices for measuring longer-term inflation. Those commodity prices will be volatile and can create inflation volatility. Focus on the hourly compensation paid to employees. This is where the rubber hits the road. 

Higher labor costs without productivity increases will squeeze business profit margins unless those costs are passed onto consumers. The question is whether firms have to market power to increase prices. The current answer is yes. Higher inflation leads to more pricing confusion and the chance for firms to increase prices. The pandemic has also created shortages which make consumers more willing to accept general price increases.

Additionally companies have become wiser about fooling consumers through "shrinkflation". Keep the prices the same but make the package smaller. This is the way that inflation is not always noticed. 

   

Stanley Druckenmiller on exiting positions

 

Stanley Druckenmiller: The other thing to me [that makes a good investor] is you have to know how and when to take a loss. I’ve been in business since 1976 as a money manager. 

I’ve never used the stop loss. Not once. It’s the dumbest concept I’ve ever heard. [If a stock goes down 15%] I’m automatically out. 

But I’ve also never hung onto a security if the reason I bought it has changed. That’s when you need to sell. 

If I buy X security for A, B, C, and D reasons and those reasons are no longer valid, [I sell]. 

Whether I have a loss or a gain, that stock doesn’t know whether you have a loss or a gain.

You know, it is not important. Your ego is not what this is about. What this is about is you’re making money. 

So, if I have a thesis and it doesn’t bear out — which happens often with me, I’m often wrong — just get out and move on. 

Because I said earlier: if you’re using the most disciplined approach, you can find something else. There’s no reason to hang on to any security where you don’t have great conviction.

He has an interesting comment on stop-loss. It sounds like a stop-loss at 15% down. The differences is whether it is hard-coded in a model. He does not have an explicit model, but he does have a rule. 

He makes the good point that if information changes for the negative so does the narrative, you exit. There is a no need for a stop-loss. However, it take a lot of self-discipline to make follow the Druckenmiller rules. You have to be true to your process and not live on the hope that you may be right.  

Pandemic consumption patterns and inflation - mismeasurement of inflation

Very interesting thesis by some researchers that the consumption basket changed with the pandemic relative to the existing basket used for the CPI. Given this consumption change, inflation was actually higher than measured by the CPI because the prices in the actual basket consumed grew much faster than the basket used for measurement. For many, it feels like inflation has been higher because the goods purchased were associated with greater price increases. See "Inflation with Covid Consumption Baskets"

There is a difference between headline and core inflation of COVID consumption baskets, and there is a difference between low and high income groups; however, overall, the inflation calculated across different countries has been generally higher. There is the potential for policy mistakes from mismeasurement. There is also a problem of misallocation of investments given there is a wrong display of inflation from the government versus the inflation associated with purchasing power of a consumption basket.

The next question is what will happen if consumption follows the old weights. This may lead to lower inflation against the COVID weights and another measurement problem. 

Inflation dispersion increases market opportunities and trading

Trading opportunities will increase with inflation uncertainty. When we say inflation uncertainty, we mean the spread of opinions concerning expected inflation across investors. The gap between the highest and lowest inflation forecast versus the median has grown with the debate between long-term and transitory inflation. The mean long-term forecast for inflation may still be relatively "behaved" at slightly greater than 2 percent, but all of the investment action will be associated with bets on the wings of the distribution and with bets on the inflation time path. 

Inflation uncertainty distorts price signals. Hence, there is less clarity on how to price products. This will lead to mistakes that impact investment decisions. Inflation dispersion will lead to larger allocation changes across asset classes. For example, inflation dispersion will create more switching between equities and bonds. 

Look at the time series of inflation surprises. The dispersion in inflation announcements will create more activity in the wings of  inflationary expectations even if the mean or median inflation look relatively stable.

Take the simple example of the relationship between bonds and inflation. Nominal yields are associated with a real yield, expected inflation, and term/risk premia. If expected inflation is more uncertain, then there will be a corresponding increase in nominal yield uncertainty. We will see this is the MOVE bond volatility index. It increased sharply earlier this in part with the unanticipated inflation shocks. We will also see a change in risk premia and flows as portfolios adjust based on changing inflation perception.

What this dispersion means for trading, across the board, is that rate options associated with sooner Fed action, higher inflation, a change in transitory inflation, and the potential for an extreme inflation move will offer strong return opportunities. Trades can be formed on multiple dimensions which are more complex than just saying that inflation is moving higher or lower.