Inflation Or Deflation?

The Iran War is causing energy prices to spike world-wide.  Energy is the most important cost element in consumer price inflation, since it effects everything from transportation, heating/cooling, fertilizers, food, chemicals, to building materials and pharmaceuticals. 

Therefore, cost driven CPI will inevitably go higher if things do not normalize in the Persian Gulf in the immediate future.

• Inflation for Goods: A spike is to be expected in consumer good prices, particularly for staple necessities such as fuels, natural gas, food and housing costs.  Let's call these "inelastic" expenses, although consumer behavior may shift after a few months of prolonged high prices (this may happen faster than before because in the US, particularly, a very large portion of households live hand to mouth and will have to cut spending even for necessities (the K-economy).

But what about assets such as equities, real estate, private credit and equity, junk bonds, precious metals, cryptos, collectibles?  Prices for these depend on spending and saving patterns by the top 10% of US households who control 80% of wealth.  How will they react to a war that drags on?  I make the following assumptions:

1. Risk premiums will re-adjust across all markets.
2. Short term interest rates may go higher, putting downward pressure on equity and precious metal valuations, on top of risk premium adjustment.
3. A squeeze in disposable income will lower discretionary spending for luxury goods and services, including travel, vacation homes, collectibles. Valuation for their respective assets will be marked down.

• Deflation for Assets: As risk appetite recedes, asset prices will be marked down.  Coming into an already highly elevated market for all risk assets, markdowns may be very substantial.  

Therefore, Inflation for consumer goods and Deflation for risk assets (if the Gulf War drags on).

One final possibility: the US may have to rework its tax policy in order to raise revenue to support the "bottom" 80% part of the K-society.  I will not be surprised to see President Trump announce a "temporary, wartime" wealth tax.  After all, the war is already costing around $1 billion per day and the tariff window has been firmly shut by the Supreme Court. Mr. Trump may, in fact, be the only President who could propose and pass such a tax (he is a populist, after all).

 The negative effect of a wealth tax on all risk assets is easy to predict, while long Treasury bonds and the FX value of the dollar may benefit.

The Danger Of “Passive Investing”

Warren Buffet is unquestionably the greatest value investor of all time. Yet, he may have unwittingly recommended the worst investment strategy to individual investors: buy and hold index funds.

It was done with the best intentions, of course, since most active money managers routinely underperform broad indexes and charge high fees. 

His advice, among others, led to a massive influx in index funds which now amount to $14 trillion in US equities alone (ETFs plus index mutual funds). That’s 25% of the market capitalization of S&P 500. 

Combine this with algo trading and we now live in a world of “passive investing” - an obvious oxymoron and the very antithesis of Mr. Buffett’s own strategy. 

Index investors trust that markets will always perform as usual. They are akin to warriors who use “fire and forget” weapons, sure that their missiles will find the target no matter what. That’s a grave mistake at a time of global fundamental changes:

1. Geopolitical power is shifting East.
2. Climate change.
3. Energy transitioning from fossil fuels to renewables challenges the dollar’s supremacy.
4. Consumer spending, and therefore GDP growth, is limited by the K-economy.
5. The US may finally deal with its fiscal problems and raise taxes, particularly by imposing a wealth tax plus a VAT-type consumption tax.