Shelter Island Capital Management

When we were growing up in the 1970s and early 1980s, inflation seemed to be an exogenous problem that nobody could tackle. This problem was particularly acute in Spain as the Arab countries’ oil embargo of 1973 came just a couple years before Generalissimo Franco’s death. The early years of the great political transformation from authoritarianism to a democratic parliamentary monarchy were fraught with stagflation i.e. low growth and very high inflation rates, rising unemployment, and a relentless wave of terrorist violence. By the early 1980s, the misery index – the sum of the inflation and unemployment rates – hit nearly 30 and stayed above 20 for nearly 20 years. We still remember how very serious looking men, for they were all men at the time, would go on long TV interviews to discuss the problem of inflation. Yet none seemed to know the cure, notwithstanding the fact that the Bank of Spain held real rates negative or that it freely financed the Treasury directly. (No need for the highly choreographed Treasury auctions held today so that a few investors may pick-up a few basis points before selling newly issued bonds to their central banks). We would ask our parents and our teachers as well and while everybody agreed inflation was bad, nobody seemed to know what to do to make it go away. Luckily, we got the answer in a freshman Macroeconomics 101 class in 1984.

For a few weeks now, the Spanish media are having a field day reporting new record-breaking electricity prices on a daily basis. Power prices are going up and nobody is quite sure exactly why either. The marginal producer sets wholesale electricity prices in EU countries, including Spain. This has been the case for many years and yet we have not had such parabolic spikes before. Currently, combined cycle gas turbine power plants (CCGTs) set the marginal wholesale price for peak demand. The most common explanation is that gas prices have spiked as Russia holds back supplies to the EU and thus electricity prices soar. However, this is only part of the answer. The media are leaving out the real reason for this crisis because it is politically incorrect.

The real reason why prices are spiking is that the EU’s decarbonisation policies have led to the early decommissioning of most coal thermal power plants in Spain and elsewhere. There were 21 coal thermal plants in Spain in 2011, which generated 60TWH, which was 23% of total electricity demand for the year. Today only six such power plants are still in operation, they will all close by 2022 at the latest. Thus in 2020, coal was the source of just 5TWh, by the end of 2022 coal would account for 0TWh. Therefore, no matter how high gas prices rise; there is no possible substitution from other power sources for peak demand because for now, all renewable energy sources have dispatch priority and therefore at any point in time this source is at 100% capacity utilization. Demand substitution can only be achieved through higher prices that will destroy demand, especially industrial demand. Commodities’ spot prices are a reflection of activity levels. Currently, there is a supply deficit, inventories are near lows, and winter looms around the corner. Gazprom is rationally rationing gas volumes exports; this will be the winter of our discontent.

This self-inflicted new energy crisis is only the most recent example of the layover of costs to households and industry emanating from EU environmental policies. Let us not forget that in the early 1990s, the Spanish Government prioritized natural gas as a clean source of energy, at least compared with coal thermal plants. Although, reports form the US National Academy of Sciences and the Environmental Protection Agency had been warning about greenhouse warming since 1982, the local environmental movement was targeting acid rain stemming from sulphur dioxide emissions from coal thermal plants. Thus, Natural Gas, of which Spain has none, was the focus of a new National Energy Plan for the 1991-200 period. Conveniently, Spain had no connection to the gas pipeline network in Europe and was free to choose from whom and how it would get its gas supplies. We are sure that the gas pipeline from the Algerian fields that comes to Spain through Morocco was a great business opportunity for some, it turned to be a huge cost to all other Spanish households and businesses. The balance of imports is shipped in as Liquefied Gas Natural Gas and regasified at six terminals along the coast. (By the way, this is six more terminals than Germany has today).

Spanish utilities dutifully spent tens of billions in these new plants and infrastructure to no avail because the Government of Jose Luis Rodríguez Zapatero (also a socialist) decided that a middle-income OECD member country needed to be at the forefront of subsidizing the learning curve of new renewable energy technologies. The Green credentials of the Socialist party were long standing. In 1982, the Socialist party opposed nuclear power plants, then, they ordered the mothballing of those nuclear plants that were under construction when they came to power. The Spanish electricity consumer paid for that policy through a 3.17% surcharge on their electricity bill for many years. This was in fact a tax on which consumers paid VAT and other excise taxes, to boot. Sub sequentially; in the 2000s, Spanish households paid not just for the stranded costs associated with the no-longer green-enough CCGT plants, but also for some of the most generous subsidies for renewable energy sources anywhere on the planet.

So generous indeed, that the Government had to lower these subsidies retroactively a few years later. This became the source of significant ill will from foreign and domestic investors and countless lawsuits in international courts of arbitration. Shutting down thermal plants before having cost effective storage for renewable source electricity is going to prove very expensive as well. For the time being, the Government has yielded to the public’s outcry by reducing or eliminating taxes on electricity generation, which is very heavily taxed with activity taxes on top of VAT. This is the case as well for other industries and services that cannot relocate abroad and are easily taxed through monthly invoices. The government has again retroactively established a windfall tax and other charges that the utilities will fight in court for years. Not a single press article mentions the impact on the fiscal deficit of any of these tax cuts either. Some people may be led to believe that the Government has fixed the problem, but not it is not likely to be many.

As you may conclude from the chart above, Spaniards are a pretty hardy bunch. Notwithstanding the fact that they have endured for decades with one of the highest misery indices of any OECD country, most still believe that there is no better place to live anywhere in the world. May this be the result of lack of information?

We were looking forward to Thai food for dinner as a most welcome break from months on end of a very healthy and wholesome yet bland Mediterranean diet. We were told there was a very decent restaurant on the townies’ side of the resort. Minutes after we sat down for dinner in a pleasant courtyard, we started panicking as the place was packed and there was only one lonely and overwhelmed waitress. We managed to grab her attention and placed our order knowing all too well that it did not look as we would ever get it. Nearly an hour later we were still waiting for our main courses. We decided to leave. The waitress turned out to be the owner as well. She apologised profusely, apparently, the surge of customers was unexpected as they only had two bookings for the evening and therefore she did not have enough staff. We ended up getting main courses at a sure bet in the marina where we ran into another table of refugees from the Thai restaurant.

This anecdote is not exceptional. The managers of many service companies are having difficulties staffing for peak demand as the ebb and flow of each contagion wave runs havoc with their best-laid plans. In addition, there are labour shortages in many markets a result of generous government transfer payments. The net-net of all of this is that successful restaurants are raising prices, as they are always full and because food prices are surging. Many of them do not even answer the phone anymore. The old Yogi Berra aphorism “nobody goes there anymore, it’s too crowded” no longer works.

For central bankers the current spike in inflation is a transitory issue. The Fed sees the problem in the rise of durable goods prices, a temporary phenomenon explained by supply chain bottlenecks and generous Government transfer payments. There is also a marked increase in food and energy prices, but policy makers who typically focus on core inflation often ignore this “more volatile” component. For decades, durable goods have been a deflationary component of the price index for personal-consumption expenditures. Consumer prices rose at a 1.8% rate for the previous 25 years driven by services, which prices rose at 2.6% annually, while prices for durable goods declined at a rate of 1.9% per year. Many take comfort therefore that inflation will soon decline driven by the same forces of globalization and technology improvements that have kept inflation in check since China joined the WTO.

This Fed analysis is, in our opinion, the root cause of much malaise and political dissatisfaction and its course may have run out. Arguably, the Fed has paid very little notice to the price inflation of housing, healthcare, or education, which are the three chapters that arguably most matter to American families. In the US, property developers observe the beginning of a new housing cycle. Prices are rising and rents are skyrocketing, bringing on more inequality. There will certainly be a pause in durable goods inflation as fiscal consolidation makes its way. The container shipping industry went through its own wave of consolidation, this coupled with capacity problems at container ports, suggests that shipping costs will remain high for the foreseeable future. It will take time to take delivery of new ships and maybe even more time to sort out the logistics problems at many ports. The WSJ reports that 30 very large container ships are usually anchored outside of the port of Los Angeles waiting for days to unload. So far, we may conclude that we could have a deceleration of growth as fiscal tightening makes its way and continued supply bottlenecks. This perverse combination is more suggestive of stagflation than of “goldilocks”.

Most economists also incorporate into their forecasts the supply shock caused by disruptions to supply chains stemming from the recent delta variant wave. Nearly all agree with the Fed that this is a temporary phenomenon and therefore the recent spike in inflation is self-correcting. But not Nouriel Roubini of the Great Financial Crisis fame. He stands out as a lone voice suggesting that the threat of stagnation is all too real. We tend to agree with some of his analysis this time around (https://www.project-syndicate.org/commentary/mild-stagflation-is-here-and-could-persist-or-deepen-by-nouriel-roubini-2021-08). This is a most unpopular stance in a financial community where once again the Pollyannas have trounced the Cassandras thanks to their amazing recent performance. Needless to say that this was the case as well in 1999-2000. The euphoria that characterized the prelude to that Minsky moment was unprecedented. E-Trade, the original online broker, captured the Zeitgeist brilliantly with their Super Bowl XXXIV commercial where a patient is wheeled into the ER and the doctors discover that he has money coming out of his Wazoo!

As investors are doing exceptionally well and Wall Street is firing on all cylinders nobody want to listen to a spoilsport. Roubini points out that there are persistent negative supply shocks stemming from several sources including de-globalization and protectionism and a Sino-American cold war. He fears as well that the loose monetary and fiscal policies may result in a de-anchoring of inflation expectations unleashing a wage-price spiral, which will result in a stagflationary environment worse than the 1970s. There is of course a growing number of people, including many economists, who believe that Modern Monetary Policy is a panacea with no ill effects. This raises an interesting point, if printing money is the solution to all problems, why has it worked so poorly in the past.

There are a number of important differences between QE today and early-days QE as Governments are currently running very large fiscal deficits even as the economy expands. In addition, there is no regulatory drag on credit creation today. Banks do not face higher capital requirements today as they did in the aftermath of the GFC. On the contrary, many supervisors allow or encourage forbearance including capitalizing interest on missed payments and extending the tenor of non-performing loans, as there is no requirement to set any provisions for these restructured loans. Thus, whereas total credit to the non-financial sector declined from its peak in 2008 to a post crisis trough in 2011, credit expanded by 9.1% in 2020 in spite of the economic implosion. In addition, once US Congressmen got a flair for their new God like powers, most cannot get enough. They are currently debating additional expenditures in the trillions, which they want to fund with higher taxes on personal incomes above $5 million, raising the capital gains tax to 28.3%, and the corporate tax rate to 26.5%. We shall soon see how this all ends up. (Note to EU politicians: the progressive Biden White House does not want taxes to be raised on the middle class people who earn up to $400,000. Quo Vadis Europa!)

The usual suspects, including Brazil, Turkey, and Russia, are already seeing a dangerous rise in inflation and fast declining GDP growth rates. Turkey tops the charts with an August print of 19.25% for CPI. Brazil comes in second with the most recent CPI print running at 9.68% while core inflation is at 6.1%. Some central Banks e.g. Korea’s have started raising rates. The Fed and the ECB are debating a reduction of the size of their asset purchases. The moment the Fed stops buying credit we should see a repricing of all risky assets but not according to some economists that see ample liquidity and a decline in new issuance as the harbingers of rates markets stability and therefore asset prices stability.

We may agree that, on the one hand, a continuing supply shock and higher energy and food prices are leading inflation higher, and on the other hand tapering and some fiscal drag as fiscal deficits will trend lower over time, may dent aggregate demand and credit creation. In any case, it is always a question of risk reward. Let us start by saying that those whose bullishness derives from their belief that inflation has peaked and that we will see a prolonged period of disinflation may underestimate the perverse effects of disinflation at a point in history when the global ratio of credit to the non-financial sector to GDP is at an all-time high. The disinflation that we experienced in the wake of the GFC only exacerbated the problems in the credit markets.

Many people agree that the response to the pandemic has accelerated many trends and the rate of adoption of new technologies. Few trends more so than the rise of e-commerce. In the voluntary confinement desired by those who prefer to work, eat, exercise, and be entertained at home rather than venture into the dangers lurking in the world outside their walls, ecommerce is their tether to the outside world. This brave new lifestyle is not exactly The Matrix, but it seems to be a move in that direction.

XMBO, who stoically leads the Middle Kingdom into the future, is doing his outmost to control the pace of the digitalization of lifestyles and to curb the growing powers of the platforms. Soon we will have access to a version of OASIS and there will be no reason to leave the house ever again. This is of great concern to China’s leader as “lying flat” is one of the few successful protest movements in that country. Many young Chinese are disillusioned by long work hours, conspicuous consumption, and very high housing prices and are doing the bare minimum. This movement is organized in social media platforms. This is apparently a major source of concern for the authorities as it is a direct threat to their targets of national rejuvenation.

XMBO is doing his own tightening of financial conditions by increasing the cost of capital for Chinese companies even as some very large companies are going belly-up and Chinese banks trade at large discounts to stated book value. Like most authoritarian rulers, XMBO is a moralist. He now demands that algorithms should “orient towards mainstream values” and “actively transmit positive energy”. These marching orders could be driven by nostalgia for a bygone era or a desire to recreate a more wholesome society, but also by fear of the organization capabilities that stem from social media. The machine learning algorithms behind Artificial Intelligence, ultimately seek to obtain knowledge about all things past, present and future from data. Thus, a strong government needs to have effective control over that data. The machine learning algorithms may not necessarily develop a moral compass that suits XIMBO’s social engineering plans. Indeed, human intervention is necessary to ensure certain outcomes for automated content selection algorithms. In other words, for You Tube or Tencent Music to suggest to you the Osmond Brothers instead of The Rolling Stones, we may need a Deus ex machina intervention which we used to call “the censor” when we were growing up in Franco’ Spain.

Even external ranking algorithms may not provide the desired outcome without much human guidance. It is very difficult to decide that an algorithm gives the “wrong answer”. It is also difficult for many people to understand that it is not computationally possible to know why a machine-learning algorithm is doing something in real time. If regulators insist on “explainability”, we will not get the outcome. This “uncertainty” principle is one more reason why most people prefer Science Fiction to actual science. If XIMBO were American, he would likely be one of those Republicans who believe that the 1950s saw the apex of Western Civilization and are quite uncomfortable with the complexities of modern societies. In any case, one thing is clear, it is probably not the algorithms but rather the people who run the companies that have benefitted from the initial policy response to the pandemic that will be more closely regulated going forward, not just in China but everywhere. This is the case because many more voters work in the retail and hospitality industries than for Amazon, for now.

Technophiles such as Kathie Woods, whose Ark Investments may well be the Janus of the current technology cycle, believe that new technologies will deal a lethal blow to inflation. Certainly, some technology developments in financial services and other industries are disinflationary. True as this may be, as Roubini points out there are countervailing forces coming from supply disruptions that may last longer than generally thought and more importantly protectionism, de-globalization forces, and demographics which will push wages up.

Also importantly, as Milton Friedman pointed “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”. Certainly, credit to the non-financial sector is growing much faster than output today. Output growth in fact remains constrained and may remain constrained by future waves of contagion. It is remarkable that used cars is one of the product categories suffering the highest rates of inflation in the US and that this recovery in the demand for personal transportation is not seen as conflicting with the notion that people will stay put at home instead of going back to work. Many families will no longer be able to spend the money they saved on commuting and meals outside the home during the pandemic.

Risk reward is the overriding litmus test of our investment process. Thus, what we are we are trying to assess here is what is the downside if the consensus on inflation is wrong. For example, German Government bonds with 30-year tenors yield 0.154%. If the ECB meets its inflation target investors in these bonds will lose nearly 60% of their investment in real terms. Thus, it is far more likely that a pension plan may meet its required rate of return objectives being short than long these bonds at today’s prices. Current rules on matching the duration of liabilities force these plans to invest in long dated fixed income securities. They have become sitting ducks waiting for the Big Kahoona, which they may actually welcome as quick solution. Absent such a sudden repricing, these managers will just bleed a little bit every year for years. Conversely, the consensus 2022 ROE for the Nasdaq 100 Index (NDX) is 49% (Bloomberg). It would appear that this is a much better risk reward until one is reminded that the last time that this index traded at 5x EV/Revenues was in 2000. Subsequently, it took 16 years for the Index to recover its highs of March 2000. We may soon discover that the E in that ROE estimate is a bit too aggressive just as we did back then.

Our stance therefore is that the risks that matter are to the upside for inflation and to the downside for activity as markets already discount a low inflation, reasonable growth, and taper immune scenario currently. Clearly fixed income in many regions, especially in the euro zone, will be a poor investment, as will be credit in general except for special situations. In such a worst-case scenario, cyclical stocks will not do well. The current enthusiasm with European stocks should be tempered by the fundamentals of most EU companies. Remark that sales per employee for the Eurostoxx 50 have been declining since 2008. Analyst consensus for 2022 earnings may be too optimistic as the index has not had a double digit ROE since 2007. Also importantly, the greening projects that the EU leadership encourages are not very good investments in many cases as the rush for yield in the euro zone lowers most projects’ expected returns to the very low single digits. We are thus reducing our exposure to cyclical stocks, as we reduce our exposure in general. We are uncomfortable with the current environment of unusually high complacency.

Yet, as one of the best technology investors in the world often reminds us, the great thing about tech for an investor is that dispersion is consistently very large. Year in and year out, there are many winners and many losers. The best stock pickers can do exceptionally well in such a market consistently. Having vast research resources is key for his success. Not every manager has such a deep bench of talent. Do ask your money manager what is their budget for their investment team, as it may matter a lot going forward. If there is a turn for the worst scenario, indexing may not be a good strategy for a sometime either as indices can go lower for years even as some companies fare well. In our thirty-three year long career in finance, we do not remember too many less inviting environments to have risk on.