Dear Valued Clients and Friends,
Last Friday’s Dividend Cafe looked at five things I was concerned about in the present moment, as well as five things I was not concerned about. That second portion allowed me to dive into inflation a little bit, and try as best as space limitations allow to make the case that the inflation discussion today is actually three or four different discussions. When we talk about oil prices and the Strait of Hormuz closing, we are talking about a very important thing, and if/when oil prices go up/down because of it, it has practical ramifications for real people. That said, it is not the entirety of the inflation story. Likewise, the tariff impact on goods prices matters, but doesn’t cover the whole subject. And, of course, shelter matters a great deal to the inflation discussion – and where rent and housing prices are at a point in time has a big mathematical bearing on the monthly data, but also represents the largest monthly expense most people have. So as much as it feels good to talk about inflation as one thing, my point last week was that just those three topics mentioned here (oil/Hormuz, goods/tariffs, and shelter/housing) are three wildly different topics with different nuances and ramifications inside the broader inflation/prices subject.
Well, guess what. There’s more. Lucky you!
While Hormuz headlines and the immediate CPI data may speak to the above categories to some degree, beyond the political narratives, the short-term reality, and the immediate questions of what the Fed will or will not do, we have a bigger issue to ponder that goes beyond this month and this quarter. To put it as simply as possible: Is the era of disinflation over? That question will require us to ask another question: Is AI inflationary or deflationary? And in both of those questions, we are going to look for answers that are going to have profound consequences for investors. We intend to ponder these things cogently. And it starts today in the Dividend Cafe… Let’s jump in!
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Causation of Disinflation in the Last Generation
Dr. Lacy Hunt is a living economist who has had a profound influence on me over the years, particularly as it pertains to the interaction of debt, money, savings, velocity, and economic growth. His understanding of how excessive government borrowing crowds out productive investment and stunts long-term economic growth is remarkable, and the work he has done, in my opinion, in this domain is unparalleled.
Dr. Hunt has been a long-time proponent of the view (which I share) that the long-term inflation range has been compressed by the twin effects of fiscal and monetary policy interventions. I refer to this dynamic as “Japanification” and argue both from history and economic theory that excessive government indebtedness, followed by the elixir they use to treat it all (fiscal and monetary interventions), puts downward pressure on economic growth, and in that sense is either disinflationary (best case) or deflationary (Japan’s generational experience). Regardless of the outcome to the price level, the impact on both nominal and real growth is erosive, and undermines the economic potential of a country (such as ours).
Lacy has recently argued that the structural range of U.S. inflation is likely to move higher after 30+ years of this lower equilibrium range due to a “steady erosion of the disinflationary architecture that dominated the 1990-2020 period.” He frames his argument for a new inflation range around the death of globalization. Essentially, the argument is that:
- Globalization accounted for the prior period’s disinflation
- Globalization is dying
- Therefore, the prior period’s disinflation will be gone
The first premise – that globalization ushered in much of the disinflation of my adult lifetime – is connected to the fall of the Soviet Empire and the advent of China on the world stage. He rightly notes that this generated “one of the largest positive supply shocks in modern economic history.” The positive dynamics out of this were “falling capital costs, low-cost energy, and rapid technological diffusion [which] reinforced productivity growth and expanded productive capacity.” I believe both Lacy and I would refer to this as non-inflationary growth, and I wholeheartedly agree that it explains much of the 1990-2006 world we lived in. The aggregate supply curve did, indeed, shift outward, and this dynamic served to absorb excess liquidity all the while facilitating disinflation in the price of goods.
This globalization dynamic did not happen in isolation, though. Coincident with such global economic forces playing out, economic superpowers vastly increased debt at the same time. As Lacy has persuasively demonstrated, this “diverts income away from consumption and restrains aggregate demand growth.” This is not said as a positive thing! It is all at once distortive and contractionary. It is at the heart of what I have considered Dr. Hunt’s economic contribution to be over the last couple of decades – the cogent analysis of how excessive debt impacts prices, liquidity, and growth.
I want to suggest to Dividend Cafe readers that we can agree globalization contributed to disinflation (it is undeniable), and we can even agree that globalization has seen its peak (though I need to comment more on this shakier premise in a moment). But what I believe warrants further scrutiny is whether or not globalization explains all disinflation of the prior generation, and if it doesn’t, whether or not the other contributing factors are also seeing a paradigm shift.
I want to suggest that old deflationary factors still exist in spades, and that new deflationary factors may very well be coming – for good or for bad.
Monetary Phenomena
One of the things that Lacy has been relentless about for years is the impact of excessive government spending on money velocity. Using Irving Fisher’s Quantity Theory of Money (MV=PY) – that money supply multiplied by its velocity is equal to the price level multiplied by economic output – Lacy has pointed out using simple algebra that the price level has not gone up because velocity has gone down. As we evaluate potential changes in globalization and their impact on inflation, it is worth questioning if the monetary phenomena that has been at play is also subject to change. Lacy notes that “money velocity fell almost continuously during the era of globalization,” and he is certainly correct. However, the correlation and causation are very important here, because if declining velocity was less about the “expanded productive capacity, cheap labor, and excess industrial capacity” of globalization, and more about resources being diverted from spending and investment to debt service, we have to ask whether or not that dynamic has changed. Indeed, we may even assert that that dynamic is worsening.
I think it is fair to say that credit growth and excess debt can be offset in a healthy economy by enhanced productive capacity (dare to dream!), but even in a stale, dull, non-productive economy (see: Japan), the monetary phenomenon of diminished growth coming as a result of debt overhang remains the elephant in the room. No one should take this as a positive declaration – it is actually quite bad. But a slowing money turnover is anti-inflationary, and a slowing money turnover (suppressed loan demand and diminished opportunities for capital deployment) has been the consequence of excessive indebtedness for over two decades. I would suggest that we do not appear to be on the verge of reversing our love affair with government borrowing.
The Other Premise
For my purposes today, I am taking for granted the second premise – that all of these forces of globalization are rapidly waning. I don’t actually believe that – or put differently, I don’t think we can assume it all to the degree many seem to be doing. The assertion that changes in supply-chain management, semiconductor fabrication, our relationship with China, tariff protectionism, and other such shifts all create structural increases in the cost of production is a projection or prediction, but it is not a description. Many believe, and I am sympathetic to this belief, that current administration flirtations with industrial policy are half-hearted, poorly implemented, anything but structural, not codified into law, erratically enforced, and lacking in the substance needed to suggest that they will become perpetual and embedded. It is undeniable that there has been a dramatic increase in rhetoric towards less globalized supply chain efficiencies, but do we really see increased structural costs as it pertains to manufacturing, logistics, and inventory management? I would suggest that it is market discipline keeping those things from happening, and restraining the political impulse. I would not suggest there has been no marginal movement here, but I am not ready to claim that a generation of enhanced productivity from improved efficiencies is obsolete.
There are plenty of things to consider as to the future direction of U.S. trade policy and global production realities, but I do not believe the domestic political winds tell us the future. In fact, to the extent we can read tea leaves from short-term political forces, I would suggest that following through on dramatic intentions of industrial policy has proven much harder to do than the speeches that precede the policy. In short, campaigning is easier than de-globalizing.
The AI Conundrum
Regardless of where one sits in the debate about what caused the last generation’s disinflation, or where we are headed in the global economic order, one has to question whether or not we are on the verge of some technological disruption that, one way or the other, impacts this current discussion. It is here that things get complicated.
Lacy acknowledges the potential for productivity gains from AI (which would be disinflationary), but points out that before such gains occur, “AI is extraordinarily capital and energy-intensive, requiring massive investment in data centers, semiconductors, electrical transmission infrastructure, cooling systems, and high-performance computing hardware.” This is all undeniably true. So the argument goes as follows: Before we might get to the good stuff, the capital demand, energy demand, and resource demand to feed this boom substantially exceed available supply, which is intrinsically inflationary. So an AI optimist would say that the infrastructure buildout is temporarily inflationary but long-term deflationary as costs per unit of output fall substantially. This seems to be the consensus view – inflationary pressures first, followed by deflationary benefits later.
Demand for capital is most certainly rising faster than our domestic supply of saving. Monetary expansion will not create the resources needed for capital formation. There is a genuine risk in how the infrastructure investment for AI will be funded. As a disciple of Michael Milken, I happen to believe that “capital is never the scarce commodity.” A lot of good and a lot of bad can happen in how AI capitalizes itself, but I am on Milken’s side that, ultimately, human capital outweighs financial capital, and if there is a productive use for dollars, the dollars will be found. But the demand for energy, labor, and resources needed in the current moment absolutely exceeds supply, and that generates short-term inflationary pressures specific to certain sectors. The impact, magnitude, and timing can all be debated, but that directional thesis seems cogent to me.
So then, where does it go post-buildout? Assuming the capital, resources, and energy are found to facilitate this technological transformation, are we looking at a deflationary (or at least dis-inflationary) conclusion on the other side?
This is where it gets real. Because I would suggest there are a couple of possibilities, both biased toward deflationary forces, but one of them quite good and one of them quite not.
Should the production of goods and services experience cost reduction because of the efficiencies of AI, this is an undeniably deflationary force in the economy. More output per unit of labor is the definition of productivity – the very productivity that Lacy rightly points out globalization helped foster in the disinflationary period of the 1990’s and thereafter. Cheaper labor costs and enhanced competition should push prices lower, and if this does not happen, the whole AI thing will prove to be a joke. As critical as I am of much of the froth, excess, and irrationality in the AI investment story of the here and now, I have always been bullish on this eventual outcome in AI potential.
Now, with the glass half-empty, let us assume it never materializes. Let us assume that trillions of dollars are invested towards a failed end. That would be awful for the investors exposed to it, and it would certainly be recessionary for a season. And I should point out the obvious – it would be about the most anti-inflationary thing any of us have seen in a long time. And I do not mean that in a good way.
Conclusion
Lacy writes in his recent piece that “absent a sustained recession, a favorable supply-side shock, or a prolonged period of monetary restraint, the broader structural backdrop … suggests inflation and Treasury yields will trend upward.” I added the bold-faced emphasis myself, because I think this is important. Let’s discard the possibility of a prolonged period of monetary restraint. Neither Lacy, nor myself, nor any of you believe that is in the cards. Now, I would like to believe a favorable supply-side shock is possible, and that caveat Dr. Hunt offers is very important. More supply is always and forever therapeutic to the economy, both in terms of standard of living and how we think about the price level.
But I believe the setup is embedded on the other side of this scenario, too. AI’s investment either pays off, which proves deflationary in the end, or it doesn’t. And if AI investment does not pay off, anyone who believes that would not prove recessionary is far, far more optimistic than I am. We are living in the midst of the biggest investment boom any of us have ever seen. The stakes are that high and that inter-connected. A total swing and miss carries a bad recessionary outcome, and that is called deflationary. A malinvestment period/need to purge/moment of excess before we get it right – I would call this the Bahnsen Base View – is also contractionary before it course-corrects. And on the other side of the course correction are the healthy parts of disinflation.
Sometimes the hard part about history is that it tells you what you don’t want to hear, and what you want to hear. I think this is one of those moments. The good and the bad are both foreseeable, and they are certainly evident in the lessons of history.
Summary:
The structural dynamic of the U.S. economy is still one of excess debt and government spending, a dynamic that has proven to put downward pressure on nominal economic growth for nearly twenty years. I do not believe that has changed. The potential for change out of the current AI moment is opportunistic on one hand, and recessionary on the other. And in both cases, for good or for bad, disinflationary.
Chart of the Week
I found this chart entirely fascinating, though it should be less surprising than meets the eye. It turns out that when a financial crisis comes, and you have to sell off your best assets to stay alive (Citigroup with Smith Barney, for example), it is very hard to grow in the two decades that follow. But it also turns out that when you are in a solid state entering the crisis, and get to use the distress to ADD core assets (JP Morgan with Bear Stearns and Washington Mutual, for example), the results will separate you from the pack. No one will accuse Morgan Stanley, Bank of America, and Wells Fargo of entering the financial crisis in the position of strength that JP Morgan had, but Morgan Stanley fortifying their balance sheet with equity from Mitsubishi and subsequently buying the crown jewel of Smith Barney, BofA taking on Merrill Lynch, and Wells Fargo taking on Wachovia, all, over time, facilitated a high return on that invested capital. No one benefitted like JP Morgan because no one deserved to benefit like JP Morgan. No one suffered like Citi because no one deserved to suffer like Citi. But seeing this chart reinforces a lot of pretty expected things over a long period of time.
Quote of the Week
“In the midst of winter, I found there was, within me, an invincible summer.”
~ Albert Camus
More to Chew on
- The White House acknowledges a lower tariff is needed on aluminum as the higher rate isn’t working
- For all of the focus on increased debt on the balance sheets of the hyper-scalers, it may be the debt not on the balance sheets that is most noteworthy!
- You’ll be shocked to hear that American AI companies are really worried about the threats of Chinese AI companies, and are looking to Washington for help
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A lot to chew on in this week’s Dividend Cafe, and I could have written 10,000 words. Feedback welcome. And may your weekends be peaceful and joyful. I can’t wait for Monday.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
