Inflation, Deflation, Elon, and Cathie

A breakdown of the discourse between Cathie and Elon and some thoughts on the flations

This is one of my macro pieces. I publish ~1-2/month, as well as several stock deep-dives. I also publish on TikTok, Youtube, and Twitter!

This is a broad macro piece on my thoughts around inflation, deflation, and the conflicting forces. Please note, I am not an economist by trade, simply an observer.

I’ve been thinking a lot about this thread between Cathie Wood and Elon, and inflation in general. Elon Musk asked Cathie, the CEO of ARK the below question:

Elon Musk @elonmusk

@CathieDWood @wintonARK @ARKInvest What do you think of the unusually high ratio of S&P market cap to GDP?

Her response thread was pretty interesting.

I respect Cathie and her company, but have mentioned before my worries on the ARK’s risk cluster. I also don’t entirely agree with her thesis on deflation.

Cathie’s thesis seems to be that the stock market isn’t that expensive now (compared to the early 1900s) because of the deflationary impact of technology. Because of that, supports current valuations, and gives the market more room to run.

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The Thread: GDP and Productivity

Click below to read her whole thread if you would like. I don’t have every tweet included.

Cathie Wood @CathieDWood

GDP statistics evolved during the Industrial Age and do not seem to be keeping up with the digital age. Thanks to productivity, real GDP growth probably is higher and inflation lower than reported, suggesting that the quality of earnings has increased significantly.

Elon Musk @elonmusk

@CathieDWood @wintonARK @ARKInvest What do you think of the unusually high ratio of S&P market cap to GDP?

GDP statistics evolved during the Industrial Age and do not seem to be keeping up with the digital age.

Cathie is saying that both real GDP growth and inflation are mismeasured. Because of this, things are actually better than they seem to be.

Productivity, which is referenced as a driving force for economic growth, is equal to the ratio between output volume and input volume - so how efficiently labor and capital are used to produce something.

She states that GDP growth is higher than expected and inflation is lower - which doesn’t make a ton of sense (how can you get more for less or less for more, and numbers not capture that?) But if we do have increased productive capacity, she is right - that raises potential GDP and can have a deflationary impact.

So how do we measure productivity - a few different ways:

• GDP / hours worked

• Flow of productive services that can be drawn from past investments

• Multi-factor productivity

Source: BLS

According to data from BLS, productivity hasn’t increased (on paper).

But Cathie’s thesis is that things are actually different - that all of the above are potentially not the correct way to measure productivity. A big driver behind her argument is that earnings quality has improved - that GDP stats aren’t capturing the fact that companies are better.

You can look at earnings quality from a few different angles:

1. Non-GAAP vs GAAP EPS: See below for some Non-GAAP magic, partly from pandemic impact. Is productivity higher or is accounting just easier to play around with?

2. Profit Margins: Profit margins haven’t improved as much as earnings have. With the fluctuations in the PPI (to be discussed later) profit margins will likely continue to contract. This doesn’t mean that companies aren’t “productive” - but it does work against the idea that earnings quality is higher.

Source: Factset

3. Corporate profits as a % of GDP: Corporate Profits are now ~10% of GDP, after hovering much lower for most of the last century. This feels like a chart crime too, but it shows that companies are *earning* more relative to GDP.

Does this mean that companies getting more productive? Maybe.

But the flows towards unproductive assets (pre-revenue SPACs, potentially some of the meme stocks, and other stagnant goods) more shows that there is just a lot of money around right now. This isn’t a bad thing - but just because earnings have increased doesn’t mean that they are all going towards productive assets.

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The Thread: Good Deflation

This is a big part of the narrative. Good deflation is supported by tech, and tech inherently is deflationary. That is true.

Cathie Wood @CathieDWood

The technologically enabled innovation evolving today is dwarfing that during any other period in history. It is creating “good deflation” and explosive demand. Battery technology is a good example. In @ARKInvest’s view, EVs will scale 15-20 fold in the next five years.

• Demand and Deflation: Explosive demand and deflation are inherently contradictory. The mismatch between supply and demand does create some inflationary headwinds, at least in the short term. However, over time, this will result in deflation.

• EV and battery technology: This is a reason that some of these SPACs can go on and SPAC at absolutely wacky valuations - because of the promise of growth and explosive demand, backstopped by the idea of deflationary pressure. Is this “productive”? Only time will tell.

Cathie Wood @CathieDWood

If deflation limits the long term Treasury yield to low single digits, the discount factor used to present value future cash flows probably will fall to surprisingly low levels during the next few years, a massive head fake in the face of higher inflation expectations.

• Rates: rates will remain low forever - if we do have deflation. So inflation expectations will be unfounded - giving support to higher valuations.

She came back a few days later to explain some of the “good vs bad deflation” and references the S&P / US GDP as a source for anchoring market valuations.

Cathie Wood @CathieDWood

In the late 1800’s and early 1900’s - as telephone, electricity, and the automobile were emerging - the US equity market cap relative to GDP appears to have been 2-3 times higher than it is today. We need to verify this difficult-to-get data but, if true, I have a hypothesis.

Elon Musk @elonmusk

@CathieDWood @wintonARK @ARKInvest What do you think of the unusually high ratio of S&P market cap to GDP?

Here is what she is referring to:

Source: Longterm Trends

The whole thesis is that the market is underpricing growth right now, relative to history. The idea is that the market was more expensive in the late 1800s and early 1900s (2-3x higher) so the market today has more upside. This is bizarre.

I think she means that we are in a similar space now - and that equities have more room to run because of that (go 2-3x higher).

There are some parallels that she draws between now and then - the Roaring 20s was fueled by technology-enabled platforms, primarily:

• Telephone

• Electricity

• Automobile

She cites learning curves (the infamous Wright’s law) as creating the deflationary impact (tech makes things cheaper), coupled with the gold standard.

Cathie Wood @CathieDWood

As deflation pressured an increasingly difficult-to-measure nominal GDP (the denominator), exponential unit growth and rapid productivity gains increased the quality of earnings while low interest rates boosted their capitalization (the numerator).

The idea is that deflation leveled the nominal GDP, with general growth and productivity boosting the quality of earnings. Add in low interest rates = companies have a higher market cap.

Today, we have more tech (the deflationary forces and the learning curve):

• Genomic sequencing

• Robotics

• Energy storage

• Artificial intelligence

• Blockchain technology

She also refers to Bitcoin as today’s gold standard. So things are similar to the 1800s, 1900s - but the stock market is lower now, so there is more room to the upside.

Cathie Wood @CathieDWood

Deflation should lower the velocity of money, a mirror image of the seventies. If consumers and businesses expect prices to fall, many will defer spending. As a result, the rapid growth in global money is unlikely to unleash generalized inflation, except perhaps in asset prices.

Deflation should lower the velocity of money, a mirror image of the seventies.

Seems like we are already there.

The theory is that people will not spend, because they expect prices to fall. The only inflation that we would see would be in asset prices. I am not sure if this theory entirely holds up - velocity is already so low.

I don’t think we are in a world where tech allows us to wait. There are so many products, service, etc released instanteously - waiting cost is outweighed by FOMO.

Cathie Wood @CathieDWood

“This time is different” are dangerous words in forecasting markets. Most forecasters use post World War II history as their guide. On that basis, never has the equity market been higher relative to GDP. In the late 1800’s, however, it seems to have been 2-3 times higher.

Overall, I see what she is saying. I have immense respect. But I think it’s tough to compare now to the early 1900s, and say that equity markets are cheap relative to then.

It was a completely different time. For 4 main reasons (MarketDog has a good recap):

1. The stock market wasn’t as important then as it is now. Most of the economy was centered around mom-and-pop shops, not large cap corporations

2. There were fewer companies. There were fewer investors. Most people had no idea how to invest (because of lack of access).

3. The economy wasn’t centered on tech like it is now.

4. There wasn’t the same level of fiscal support and monetary policy intervention

She highlights at the end that

“This time is different” are dangerous words in forecasting markets.

And she is right. Markets are forward looking, but they have a memory. I think the argument of deflation is interesting - primarily because of all the short-term inflationary pressures that take precedence to the long term deflationary impacts.

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So, do we have inflation?

I don’t know (a terrific conclusion).

I am writing this because I think we have inflationary pressures - the long end of the curve is pricing in an expectation of inflation and the expectation of tightening. But I also agree with Cathie that there are longer term deflationary forces that will price out some of the short term inflationary pressures.

Shorter Term (?) Inflationary Pressures

• The CPI is set for tomorrow at ~2.5% expected for Headline CPI and 1.5% for Core. A lot of the gap between the two is driven by increased energy prices.

  • CPI has remained “low” for the past several months. And note, this is a very large gap - 1% is definitely not a nonfactor in the inflationary world.

• US Producer Price Index climbed 1% on a seasonally adjusted basis in March (~12% annualized)

  • There are severe supply chain bottlenecks and increasing commodity costs. Aluminum, copper, oil, and lumber have all surged in recent months.

  • Rising air and freight costs to ship its goods

  • Eventually, some of these costs will get passed off to consumers. Or companies will eat the cost - which will bite into margins, and presumably impact their performance (doesn’t bode well for their stocks)

• Stimulus and pent-up demand

  • The idea that we can expect ~7% GDP growth and not have inflation seems strange. I understand that y-o-y everything will seem outsized - but surely the gap up of demand will drive some pressure.

• Jump in the 10Y: It’s calmed down quite a bit, but the pace of the move upward was concerning. It shows that the market is expecting inflation (or at least doesn’t trust the Fed as much as it used to).

  • The 10-year break-even rate, climbed to its highest level since 2013 last week, at 2.36%

• Asset Inflation: The stock market seems expensive. Home prices are on an absolute rip.

  • However, Jamie Dimon highlighted in his recent letter that economic growth could support where markets are currently at. “While equity valuations are quite high (by almost all measures, except against interest rates), historically, a multi-year booming economy could justify their current price.”

  • Continued growth could support these valuations - but that requires a “booming” economy - which could be weighed down by the above

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The Dual Mandate: Unemployment and Inflation

Part of the reason that the Fed hasn’t pulled back on QE is because there is still a real economic gap in employment - all the numbers are skewed because of the pandemic.

• This is why it would potentially be a bad move for the Fed to move now. Many are still unemployed (or are just now getting their jobs back).

Things have to normalize (whatever that means) before we can get a true sense of what things mean. Even if we do have outsized inflation, we still have to reach the Fed’s target - which will take some time. That is a whole other can of worms to unpack.

Source: Claudia Sahm

There are broader macro risks that can send the market into a tailspin - and that will create outsized pressure that the Fed won’t be able to maintain.

• Leverage (looking at you, Archegos). Consumers are also trading with incredible margin - which is concerning for if/when the market does pull back

  • “Investors had borrowed a record $814 billion against their portfolios... up 49% from one year earlier.” That’s a lot of margin!!

  • The massive unwinds and the liquidation that was the Archegos debacle could be a warning sign of what could come.

• Concentration risk: This is my main problem with ARK (circling back to Cathie). I wrote about it a little bit in my Stonks piece, and I have some quick videos on it (here and here). There is illiquidity, volatility, intercorrelation, just general reflexivity from fund flows. That creates an ARK bubble, which is going to be painful if it pops.

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Conclusion: There is some sort of Flation

In conclusion, I am uncertain. A lot of market movement is expectations and companies that can play into growth opportunities (tech companies as highlighted by Cathie’s thread) are going to price based off expectations, not so much current fundamentals.

Tech is deflationary. But supply chain risks are inflationary. In the long term, I think we will experience deflation as tech will expedite so many processes and create so many efficiencies - but in the short term, it does seem like that there are inflationary headwinds that the Fed and other policymakers *could* be underpricing.

What to do?

• Luxury goods: Someone will always pay for something. Fashion never dips out of style for some - also, these brands (LVMH for example) have a lot of pricing power

• Crypto: Time will only tell here, but for now, crypto seems like a gold-like hedge against inflation and the potential valuation compression that can come from a rise in real rates

• Hard goods: The supply and demand nature of commodities makes them decent investments. I think that their inflationary headwinds should be short lived (hopefully) but companies with energy exposure could be interesting.

Disclaimer: This is not financial advice or recommendation for any investment. The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.