Inflation and logistics - Potentially transitory but significant

 

Inflation is higher because of the surge in logistics costs. It is  not the only reason, but it is a key rationale for the transitory inflation story. The choices made last March are haunting a global economy that is now in recovery. The price of shipping as measured by different freight indices have exploded to the upside although there may be some evidence that the positive acceleration has slowed. 

The Fed is optimistic that these increases are temporary like the logistical price behavior after the GFC; however, a flattening of rate of change is not the same as a price reversal. Additionally, warehousing and inventory costs are increasing. Solving just-in-time shipping issues leads to other business costs. 

If you are tracking transitory inflation, these logistical indices should be front and center with any discussion.

Semiconductor inflation hysteria or something else? Follow prices, not the news

No chips! No chips! There have been recurring stories and a meme that the US and global economy is having a semiconductor shortfall. Shortages and supply problems exist. Farm equipment cannot be sold to dealers and framers because there is a chip shortage. Auto plants are closing because of chip shortages. Chip shortages are becoming described as a national security issue. 

If there is a chip shortage one would expect that semiconductor prices will increase significantly. The data show something else. Year over year price changes are still negative. A look at the semiconductor SOX index ETF (SOXX) shows a price decline from April highs and is at the same level as mid-January.

Follow the news or follow the price action. There may be logistical issues and bottlenecks, but it is generally better to follow prices.

 

Why value and momentum risk premia are a good combination - Different sensitivity to macro risk factors

A number of researchers have found that blending value and momentum is a good diversification strategy. Some have found that trend and value also work well together. The benefit from blending value and momentum premia returns comes from their negative correlation. Additionally, these two risk premia strategies have been proven to be the most consistent of all tested over long periods. These risk premia are time varying but have proven to be successful over long periods, across all asset classes, and across different countries. 

So, what makes this combination of value and momentum so special? We can find the rational of the value and momentum combination through looking a number of traditional global macro risk factors that have been long identified as useful. 

A useful set of global macro factors (variation of Chen Roll, and Ross 1986 factors) include: the term premium (identifies monetary policy and business cycle), the growth in industrial production (business cycle), unexpected inflation, change in expected inflation, and the default spread. The sensitivity of value and momentum risk premia to these macro factors are found to be the opposite signs. However, the sensitivities or strengths are different, so the macro factor effects do not cancel out return potential. These common macro risk factors will impact all asset classes and are associated with asset pricing anomalies.

 

A diversified portfolio that may include value and momentum risk exposures also has exposure to a set of global macroeconomic factors. An investor can change the tilt or mix between value and momentum based on their view to these macro factors. An investor that wants to hold different risk premia strategies should realize that he is holding different global macro factor exposures.

New inflation and the old descriptions

 

"Cost push inflation"

"Demand pull inflation"

When was the last time you heard those phrases? You may have to get into the way-back machine from decades ago. These inflation phrases are still taught in introductory macroeconomic costs, but little time was spent dwelling on the specifics especially given the sub 2% period post-GFC. Inflation was often discussed as a necessary evil to allow for policy flexibility.

We are certainly in a different inflation world than the 70's. Oil price shocks and union wage demands do not have the same potential impact for creating cost-push pressures. Globalization and output slack also does not allow for the demand pull reaction seen in the past. Yet, it may be time to brush up on inflation dynamics and their potential impact on the economy. 

Investors have to focus on two issues. 

1. What is the threat of pass-through from increases in input prices? If commodity prices increase, will there be an increase in end user prices? If there are increases in wages, will this translate into higher check-out prices? If supply chains are stressed, will prices increase? Given earnings have been high, profits can be squeezed without the failure of firms. Firms can choose to hold prices steady. Will they follow this strategy now?

2. What is the threat of price increases from excess demand? If incomes are higher, there can be stresses from higher demand that was not anticipated. We have already seen this  in the lumber market. Many lumber yards cut inventory in the spring of 2020 under the anticipation of falling demand. They were wrong and the cost has been demand-driven shortages. Again, firms have to determine whether to increases prices in the face of higher demand. Or, consumers have to determine whether they will pay higher prices to ensure delivery and reduce waiting times. 

The pricing game is simple - can firms adjust prices and get away with consumers accepting less at the same or higher price? If firms perceive that consumers will accept price increases, they will do it. We are seeing this with airfares. Prices are moving higher, and planes are being filled although load factor data are still not available for the current month. The increases are sticking, so demand pull price changes are happening. If this occurs across many industries, we have inflation.

"All inflation is transitory until after the fact."