Inflation Threat?

Everybody’s talking about inflation. The classic cause of inflation is “too much money chasing too few goods.” Noted economist Milton Freidman studied inflation and concluded that “inflation is always and everywhere a monetary phenomenon.” By this he meant that all episodes of inflation stem from the government expanding the money supply beyond the needs of the economy. Given that 20% of all dollars ever created were created in the past year, it is reasonable to expect that such a surge in the money supply will lead to inflation.

But will inflation actually come?

The inflation conversation often begins with noting price increases on specific items. For example, our local donut shop has increased their prices for the first time in five years. Gasoline prices have nearly doubled in the past year. You can likely cite your own examples of rising prices. However, inflation requires an increase in prices across the board. While the prices of some goods have indeed gone up, the prices for other goods and services have gone down. For example, hotel rates have fallen drastically. That’s why the government’s goal of getting to 2% inflation has been frustrated. In fact, instead of increasing, inflation has actually fallen to 1.4% in the past year.

Covid is the culprit behind the surge of money. The government has proactively spent money to offset the impact of Covid-induced lockdowns. With the large expansion of money, inflation seems a likely prospect. However, the impact of money on the economy depends on the money multiplier. This multiplier reflects the relationship between economic activity and the “money” which the government prints (actually added reserves to the banking system). Unless banks make loans with the added reserves, the reserves will not impact the economy. The Fed’s attempts to “goose” the economy have been frustrated in recent years as the ratio of GDP to bank reserves has been declining. Prior attempts to expand money have been offset by the declining desire of both consumers and businesses to spend money. If the multiplier continues to decline, the surge in the money supply will not lead to much inflation.

Analyst and demographer Richard Hokenson argues that the reason for the decline in the multiplier is an aging population. In the early years of life people spend on new cars, new homes, and a growing family. Currently, a significant portion of the population is older. They have moved beyond their early spending years. Older people have a diminishing appetite for possessions. They no longer need to acquire goods, and they often are actively trying to downsize their spending. They sell large, high-maintenance homes to move into smaller, low-maintenance condominiums. So, while an abundant supply of dollars has been created, the impact of these added dollars is being offset by diminished demand for them, as reflected by the declining multiplier. Translation: We may not actually have too much money.

What about the other element required for inflation: Do we have too few goods? As I write this, I am looking out the window at a record number of container ships waiting to enter the Long Beach port. Normally, there are two or three ships. Today I see more than 30 massive ships awaiting their turn to unload. That’s a lot of cargo! Many people are still working from home. Spending more time at home, they notice some things that need to be fixed or improved. A home office? A new deck? Many have used their government support checks to pay for these goods that are coming to the US from overseas. That’s why I see so many container ships waiting to unload. When goods expand along with money, then we should not expect inflation.

INFLATION AND INTEREST RATES

Not only is there talk of inflation, there is also talk of rising interest rates. Inflation and interest rates are related in a complex way. Mathematically, we can say:

Interest rates = (f) inflation

Inflation = (f) interest rates

What does this mean? Interest rates are a function of inflation because lenders want to grow their purchasing power. If rates reflect only the cost of money, lenders will earn only that base rate. They will get their dollars back, but will have lost some of the purchasing power of these dollars. The only way lenders can maintain their purchasing power is to lend at a rate that compensates both for the cost of money and the loss of purchasing power. So in a time of inflation, lenders will charge rates that are high enough to offset the impact of inflation on their purchasing power.

But inflation is also a function of interest rates. Rising rates act as a damper on the economy because the long-term cost of taking out a loan becomes too steep. A good example of this was in the late 70’s when inflation was running at a near 15% rate. To combat this inflation, Federal Reserve Chair Paul Volcker cranked interest rates up to 20%, bringing the economy to its knees. GDP growth, which had been around 5%, fell into negative territory. It took four long years of subdued economic activity to bring the inflation rate down to less than 3%.

LOOKING FORWARD

Unless there is Volcker-like intervention, interest rates and inflation tend to move hand in hand. Currently both are rising. For example, from the lows in 2020, the interest rate on 10-year treasury bonds has more than doubled, rising from 0.7% to 1.6%. Similarly, inflation is now starting to rise. Regardless, I do not expect a return to an inflationary era. While interest rates and inflation may rise, I don’t expect a dramatic increase. Further, I expect any increases to be short-lived. I believe the deflationary impact of an aging population is sufficiently strong to offset the efforts of the Fed to increase inflation.

SCA NEWS

While the dance between the inflation and interest rates continues to play out in the economy, Seven Canyons believes that investing in small well-managed companies can reward investors in the long run. As we search worldwide for these companies, we are grateful for the many investors that continue to invest their money alongside ours. Your confidence adds wind to our sails, reaffirming that our investing strategy is valued in the marketplace. Thank you for your trust.

It has been a good start to the year at Seven Canyons Advisors. The last twelve months (the Covid year) have been a wild ride for us. We’ve grown from $97M in assets at the bottom of the 2020 sell off, to $307M at the 2021 Q1 end—attributable to both new investments and strong fund performance. Our ability to travel and visit in person with management of the companies we research has been severely limited over the past year, compelling us to become even more expert in international online meetings. We are grateful for strong relationships with brokers around the world who have kept us abreast of their local conditions and have been our surrogate boots on the ground. As vaccines are more broadly administered, we look forward to picking up our travel schedule again and interacting on-site with prospective companies.

Finally, we are very pleased that, once again, Investor’s Business Daily (IBD) recently recognized the Seven Canyons World Innovators Fund (WAGTX) as one of the top five International Mutual Funds. It is worth noting that of the five top funds, WAGTX is the only small/mid-cap fund, and the only one with an exclusively international portfolio. The IBD Best Mutual Funds Awards go to funds with at least $100 million in assets that have outperformed their benchmarks for the past one, three, five, and 10 years. WAGTX qualified for this same IBD award in 2019. We hope it becomes a habit!

Sincerely,

Sam Stewart,

Partner

This letter is for informational purposes only and does not constitute investment advice or a recommendation of any particular security, strategy, or investment product. The expressed views and opinions presented are for informational purposes only, are based on current market conditions, and are subject to change without notice. Although information and statistics contained herein have been obtained from sources believed to be reliable and are accurate to the best of our knowledge, Seven Canyons Advisors cannot and does not guarantee the accuracy, validity, timeliness, or completeness of such information and statistics made available to you for any particular purpose. Past performance is not indicative of future results.

Chairman's LettersSam StewartMarch 31, 2021