Inflation — QE Kryptonite

By now I’m sure most of you have read Bill Gross’s latest monthly commentary (link). He does an excellent job of summarizing the current investment environment and how heavy-handed central banks have inflated asset prices. I found myself shaking my head in agreement as I read his comments regarding monetary policy and its influence on financial markets. Without a doubt, Bill Gross is a great financial thinker and communicator.

While I strongly agree with his assessment of the current environment, I have trouble accepting his conclusion. Specifically, Bill Gross writes, “For now, investors must go with, indeed embrace this financial methadone QE fix.” It’s always hard to disagree with someone you respect, but as an absolute return investor, it’s important to think with an open and independent mind. With that being the case, I respectfully disagree with the bond king, and do not believe investors must go with or embrace the “QE fix”.

One of the things I like most about being an absolute return investor is I don’t feel obligated to be invested – it’s not a requirement for me. Instead of embracing central bank asset inflation and allocating capital into an overvalued opportunity set, I’m very comfortable rejecting it and watching it inflate from a safe distance. I feel fortunate to have the ability to remain patient and disciplined — many investors don’t have this option.

Intentionally sitting out a QE-induced bull market isn’t for everyone. I understand why so many are riding the wave of easy money. Investing in risk assets that are insured by central bank policy is extremely tempting. It’s more than tempting, it’s practically irresistible. Investors can enjoy the upside of asset inflation while being comforted and protected on the downside by unlimited central bank bids and forever expanding balance sheets. Can it ever get better than this? After watching stocks reach new highs again this week, apparently it can!

And I suppose Bill Gross may be right – in fact, he has been. Maybe free markets, capitalism, and investing (as I understand it) will continue to be suppressed. And maybe investors will be better served by playing along and embracing the monetary gift central banks have provided. Maybe.

As I’ve stated in past posts, there is a lot I don’t know when it comes to investing. I don’t know when central banks lose control and I don’t know when the current market cycle ends – I can’t time markets. But I do believe I’m capable of distinguishing and identifying value.

When I screen for stocks and perform valuation work on the companies on my possible buy list, I’m finding little if any value. In fact, I continue to believe this is the most expensive opportunity set I’ve ever seen. In my opinion, asset prices have been artificially inflated by monetary policy and are not supported by fundamentals or basic valuation math. Bill Gross acknowledges this, as he states the financial system is being distorted. Without continuous global QE, Bill Gross believes interest rates would be higher and we’d be in a recession. I couldn’t agree more. And I believe most investors agree.

In my opinion, the debate isn’t if asset prices are distorted. I think most investors acknowledge that without the trillions of dollars of asset purchases by global central banks, asset prices wouldn’t be where they are today. The debate is how long asset prices will remain distorted and how long investors can depend on central banks to backstop the markets.

Bill Gross believes the current investment environment will continue and states investors must embrace QE for now. But how long is “for now”? Until it ends? How will we know and how will investors – at once – be able to abruptly shift from embracing QE to running for their financial lives?

While it may appear safe to ride the monetary wave at this time, there are growing risks to embracing QE. One very important risk was noticeably missing from Bill Gross’s monthly outlook, but was apparent to me after reading Q4 2016 earnings reports and conference calls. That, of course, is inflation.

I’m not an economist, but I can get a timely and accurate view of the economy through the eyes of the 300 companies on my possible buy list. Currently, I see a deflationary mindset, turning inflationary. Even government data has picked up on this trend, with consumer inflation growing 2.1% year over year in December, according to the Consumer Price Index (CPI).

For investors relying on endless policy response and unlimited central bank balance sheets, maybe it’s time to reconsider the risk of inflation. For most of the current cycle, the majority of QE has flowed directly into asset prices. While asset prices continue to benefit, the inequality created by QE and central banks has attracted considerable attention. As a greater percentage of the population demands their fair share, will the inflationary consequences of QE spread from asset prices to the general economy? It’s possible. In fact, given current business trends and outlooks, it may be happening now.

It will be interesting to see if the CPI report replaces the jobs report as the most important economic press release of the month! If one is looking for a QE killer, rising consumer inflation would certainly be on top of my list.

In conclusion, while there are growing threats, it’s difficult to know exactly when the global central bank QE put will expire. Guessing its duration and demise is simply another form of market timing. Risk assets may continue to soar higher or they may decline sharply towards their historical averages. I really don’t know. However, based on current prices and valuations, I believe my opportunity set remains overvalued and is not adequately compensating me for risk assumed. As such, while I understand why many investors feel they must be invested and the current market cycle will persist, I haven’t altered my decision making or discipline.

Have a great weekend!