Inflation Investigation (Part 1) — Intro to Inflation and Why Common Leading Indicators Aren't Always Reliable
Voss Capital is a Houston hedge fund founded by Travis Cocke in 2011, running value-oriented, bottom-up strategies focused on underfollowed small- and mid-cap special situations through long/short and long-only funds, increasingly turning activist.
In plain words
This report asks whether inflation is coming back and what it means for stocks. The author says that while CPI data looks calm, the Fed allowing inflation to overshoot 2% and some early indicators (like Google searches for 'inflation' hitting all-time highs) are flashing warning signs. But here's the twist: history shows these indicators are often unreliable. Instead, watch real drivers like loan growth and falling savings rates. If inflation does rise, it would hit long-duration stocks (companies like unprofitable SaaS firms that depend on future cash flows) hardest, because higher interest rates shrink their value.
Voss Capital explores the possibility of inflation returning and its impact on the stock market. The core view is that although CPI has not yet shown inflation, the Fed allowing an overshoot of the 2% target and leading indicators spiking could change the situation. If inflation expectations push up
Theme and Background
This chapter explores whether inflation is returning and the potential profound impact this could have on the stock market. The report notes that while CPI data has not yet shown inflation pressure, the Federal Reserve's allowance for overshooting the 2% target, combined with surging leading indicators, could change the situation. The author believes that if inflation rises significantly, it will severely hit "long-duration stocks" that rely on cheap capital (such as loss-making SaaS companies), as the discounted value of their future cash flows declines.
Core Thesis
The author's core judgment is that the United States is unlikely to repeat a Weimar Republic-style hyperinflation, but inflation significantly higher than the past 40 years (especially if new fiscal stimulus is implemented) is a real risk. Key factors to monitor are loan growth, the savings rate, and government spending, which may push up the velocity of money. Counterintuitively, although the money supply (M2) has expanded massively, inflation has not yet materialized because a large portion of funds remain "idle" in savings and Treasury coffers rather than in circulation.
Key Arguments and Data
- Inflation Definition and Measurement: CPI is based on the 1982-1984 benchmark (index=100). Core inflation excludes food and energy (more stable), while headline inflation includes all items. Over the long term, the two are not vastly different, but short-term fluctuations are evident (e.g., 1986, 2007/2008, 2014).
- Historical Inflation Levels: Inflation has been extremely low over the past few decades. In February 2021, core inflation stood at only 1.3%, the lowest since 2010. However, historically, there have been periods of twenty years with average monthly inflation above 6% (e.g., the early 1980s).
- Drivers of Inflation: Inflation is jointly determined by changes in the money supply (M2), changes in the velocity of money, and output growth. Currently, M2 has expanded dramatically, but velocity has plummeted; the two have a near -1 correlation, preventing inflation from emerging.
- Current Status of Idle Funds:
- Of the $3 trillion printed by the Federal Reserve, approximately $1.6 trillion remains idle as U.S. Treasury cash balances (as of end-February 2021).
- The U.S. savings rate has surged due to the pandemic, currently at 13%, far above normal levels.
- Comparative Cases: The report compares Weimar Republic hyperinflation (the direction warned about by Michael Burry) and Japan's prolonged deflation (where stimulus failed to reach the 2% inflation target), to calibrate how history might repeat.
| Indicator | Current Data | Historical Comparison |
|---|---|---|
| Core CPI (February 2021) | 1.3% | Lowest since 2010 |
| High-inflation historical period | Average monthly inflation >6% | Early 1980s |
| M2 expansion | Massive growth | Near -1 correlation with velocity |
| Treasury cash balance | ~$1.6 trillion | 53% of Fed's money printing |
| Savings rate | 13% | ~7-8% pre-pandemic |
|---|
Companies/Assets Involved
- Long-duration stocks (e.g., loss-making SaaS companies): The author is bearish on these assets. If inflation expectations push up long-term interest rates, the discounted value of their future cash flows will decline sharply, based on the "Finance 101" principle—higher discount rates reduce present value.
- Michael Burry: As the proponent of the comparative case, he warns that the U.S. could head toward Weimar Republic-style hyperinflation. The author believes this extreme scenario is unlikely, but rising inflation is a real risk.
Investment Implications
- Monitor key indicators: Investors should closely watch loan growth, a decline in the savings rate, and government spending levels, as these factors could raise the velocity of money and thus trigger inflation.
- Avoid long-duration assets: If rising inflation expectations lead to higher long-term interest rates, reduce holdings or short "long-duration stocks" (e.g., loss-making tech/SaaS companies) that depend on future cash flows, as their valuations will be compressed.
- Prepare for inflation scenarios: Even without hyperinflation, inflation levels of 5-6% (as in the 1980s) could have a major market impact, so portfolio adjustments should be made in advance.
Theme and Background
This chapter focuses on multiple leading indicators of current market inflation expectations, exploring whether these indicators suggest the U.S. may enter a "higher for longer" inflation environment. The author points out that despite synchronized surges across several indicators, historical data shows these indicators have had limited predictive power for actual inflation over the past three decades, particularly in accurately forecasting inflation magnitudes.
Core Viewpoint
The author's core judgment is: Inflation expectation indicators are universally pointing upward, but historical evidence suggests these leading indicators have significantly diminished predictive power for actual inflation. The counterintuitive aspect is that although the market is widely focused on the surge in inflation expectations (e.g., Google search volume hitting an all-time high, breakeven inflation rates reaching their highest since 2009), the author believes these signals reflect short-term sentiment rather than reliable inflation forecasting tools.
Key Arguments and Data
The author demonstrates the rise in inflation expectations across four dimensions while highlighting their predictive limitations:
| Indicator Category | Current Data | Historical Predictive Performance |
|---|---|---|
| Google Search Trends | Search volume for "inflation" at all-time high; gap between inflation and deflation searches at historical extremes | No data provided on historical predictive validity |
| Commodity Prices | Energy leads, implying strong demand environment | Was a leading indicator for core inflation in the 1970s–1980s, but predictive power has declined significantly since then |
| Survey Data | University of Michigan 12-month inflation expectation at 3.3% (highest since 2014); ISM Prices Paid index at the 98th percentile | Systematically underestimated actual inflation in the 1970s–1980s, but has consistently overestimated actual inflation since then |
|---|---|---|
| Breakeven Inflation Rate | 5-year breakeven inflation rate at its highest since 2009 (near 2010–2011 levels) | Fed purchases of TIPS may distort this spread |
Key Historical Comparisons:
- The University of Michigan survey systematically underestimated inflation in the 1970s–1980s (e.g., expected 8% vs. actual 13% in 1979), but has consistently overestimated since 1990 (e.g., expected 3% vs. actual 1.5% in 2020).
- The correlation between commodity prices and inflation weakened after 1990 due to "heterogeneous shocks" (e.g., geopolitical events), no longer reflecting underlying economic fundamentals.
Companies/Assets Involved
- TIPS (Treasury Inflation-Protected Securities): The author notes that the Fed's ongoing purchases of TIPS may artificially depress yields, causing breakeven inflation rates to be exaggerated. Investors should be cautious about the distortion risk in this indicator.
- Commodities (Energy): Served as a leading indicator for inflation, but current price spikes reflect supply shocks more than demand-driven inflation.
Investment Implications
1. Be wary of over-interpreting inflation expectation indicators: Current market panic over inflation (e.g., Google search volume, breakeven rates) may already be fully priced in, but history shows these indicators have limited predictive power for actual inflation. Investors should avoid aggressive position adjustments based solely on them.
2. Focus on structural changes rather than short-term signals: The author suggests that inflation and indicators were highly correlated in the 1970s–1980s, but factors such as globalization and central bank independence after 1990 altered the transmission mechanism. If inflation does return, one must verify whether structural changes resembling the 1970s wage-price spiral or fiscal dominance have emerged.
3. TIPS market carries distortion risk: Fed purchases may distort breakeven inflation rates. Investors should cross-validate using other indicators (e.g., real interest rates, money velocity).