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The Evidence is Clear – Inflation Has Peaked

Marion King Hubbert, a geologist who worked for Shell, posited in a 1956 paper that US oil extraction would peak between 1965 and 1971. He did not anticipate deepwater drilling, fracking, horizontal drilling, and the US shale revolution. Working with linear models, he failed to account for human ingenuity in a non-linear world. His Peak Oil theory has since been discredited (obviously) but the use of linear models to extrapolate the future continues to hold sway in the analyst/investment community.

The proliferation of inflation bulls in the hedge fund community is the outcome of the same form of linear thinking.

Let me make my stance clear: I think price inflation has peaked in USD terms and we are in for a period of rising living standards and abundance of goods.

“But a prominent hedge fund manager says oil is going to $300”

“The world is heading for a food crisis, according to a doomsday prepper I follow”

“My financial advisor told me to sell my bitcoin and buy energy stocks instead”

Ignore those guys. The evidence already suggests that commodities have entered a bear market. I’m not making a prediction – I’m stating a fact.

The collapse in wheat prices is even more striking given that Ukrainian grains still haven’t made it into the market.

There are a few agri/meat commodities like rice and live cattle that are still trending higher, but the parabolic up moves in prices that made headlines is a thing of the past.

Question for the inflation bulls: how is inflation raging if the price of palm oil and wheat, the staple food for even the poorest, has absolutely collapsed?

Ok Kashyap, I see your point. Maybe there will be no Arab Spring redux as a result of rising food prices and that’s a great sigh of relief for all the corrupt regimes fearing a revolution. But inflation is embedded in the economy. Aren’t prices rising due to shortages of everything from steel to copper to aluminum?

That used to be true, but no longer.

Copper is used in literally everything that keeps the world humming along. You would think the election of leftist governments in Chile and Peru, or the extortion of Oyu Tolgoi by the Mongolian government, would be bullish for copper prices, but nope.

Iron ore is collapsing because steel production is collapsing. Why is steel production collapsing? Lack of demand. A concept we will re-visit soon.

Think batteries and electric vehicles. There’s supposedly not enough copper and nickel to power the green revolution. Funny, you would assume prices would be much higher if that were indeed true.

I’ll end this chart storm with one last chart, which perfectly captures falling demand for housing.

Sorry, one more chart.

Just so I can say I have covered all of mankind’s essentials – food, clothing and shelter.

You would think the inflation bulls are capable of pulling up some longer-term charts and seeing the evidence in front of them, but no. That’s what happens when a narrative takes hold. Once the ‘inflation psychosis’ takes hold of someone’s mind, it is hard to let go of the idea.

I’m not trying to convince you that prices are going back to 2019 levels. No, the money printing since March 2020 has ensured that the world cannot return to the pre-covid era. I’m merely pointing out that the “to the moon” inflation doomsday fear porn being peddled by the media and hedge fund community flies in the face of reality, viz. the market.

Aren’t energy bulls the exception? No, they are actually the worst of the lot.

Gasoline prices decreased 28% during summer driving season. Isn’t it absolutely fantastic how the energy bulls disavow reality in favor of their fantasy world of $300 oil? Perhaps they get an orgasm when they imagine all the money they’ll make while their fellow human beings are feeling absolutely miserable and crushed. It’s not nearly as much fun buying a Hummer when the fellow next door is buying a Rolls-Royce – it feels a whole lot better when the repo man is re-possessing your neighbor’s Honda and he’s camped out on the front lawn while the movers pack up his stuff ahead of the bank foreclosing on his home.

The energy bulls absolutely hate that Biden released crude oil from the Strategic Petroleum Reserve (um, it’s called a strategic petroleum reserve, not a permanent one-way crude oil sinkhole). They don’t complain about the money they made holding shares in the refining companies that bought the crude, benefited from the crack spread, and delivered huge gains for shareholders. They aren’t uncomfortable with the notion that SPR oil ends up being refined and sent to other countries. No, their problem is that Biden used the SPR release to tame oil prices, which hurt their thesis of oil prices going to the moon.

“I’m a hedgie. I only care about my long energy book, and vehemently oppose any action that decreases my profits. If my fellow Americans can’t afford to drive to work or go visit their grandma, that’s their problem. Just don’t release SPR oil and bring down the crude price… But if you insist on doing that, I’ll profit from the record crack spread enjoyed by US refiners and still complain that the Democrats are ruining the country.”

The market brings out the worst of human tendencies. To be fair, it’s not just the energy bulls who cheer human misery. German politicians are equally worse – they would rather shut down all industrial production and have the populace freeze to death this winter than allow Russian natural gas to flow.

End of rant and back to peak inflation.

It’s not just falling commodity prices that make me believe inflation has peaked. It’s also the supply chain.

Price inflation was the result of a surge in post-covid demand meeting supply chain bottlenecks. The global supply chain shifted from a lean, just-in-time inventory model to building inventory buffers to account for longer lead times, wider fluctuations in demand, uncertainty of supply and good old-fashioned inventory build-up since inflation ensured profits from holding inventory exceeded the inventory carrying cost.

If you didn’t get that, don’t worry. I’ll explain using a story.

Wal runs a local supermarket named Mart. For the last couple of years, he has had trouble getting shipments on time, so he went to the credit union and took a loan. Because of his creditworthiness, the friendly loan officer gave him a working capital loan at 3% APY. Wal leased some warehouse space next door to his Mart, increased his order quantity, and kept excess stock at the warehouse. No more shortages, happier customers, increased sales, and everything was hunky dory for Wal and his Mart.

Sometime in early 2022, Wal started to worry. The average spend of his customers remained the same, but he noticed that he was running out of two-ply toilet paper while the four-ply rolls weren’t selling. Inflation had forced his customers to make cuts, and demand had shifted from higher-value products to lower-value products. Wal changed his product mix to account for this, and things hummed along. The only problem was that lower-value products translated into lower gross profits, which hurt his pocketbook. So, he scaled back on his ordering.

Meanwhile, his distributor had cut down the time it took to deliver on his orders, so Wal found that he didn’t need to stock up as much excess inventory. His margins were down, but at least he needed less working capital, which meant less interest expense. The credit union had raised his interest rate from 3% to 6%. The bank manager said something about the Federal Reserve Board raising their Fed Funds Rate and how that meant higher borrowing costs for business owners like him. Wal couldn’t understand banker-speak but astute businessman he is, he did understand that he now had to pay double the monthly interest.

Wal took a hatchet to his inventory, figuring it was better to lose some sales than to pay double the interest just for goods sitting in a warehouse.

Wal’s distributor Carl noticed that Wal had reduced his order quantities. Worse, every other customer seemed to be imitating Wal. First, it was lower orders for higher-value items. Then, it was lower overall orders. Just when Carl had become more efficient in delivering orders too. What was he going to do with all the goods he had stocked up? His bank had just told him that they were raising his borrowing cost. And the trucking company was raising rates citing higher gasoline prices and lack of qualified drivers.

So Carl cut down on his orders to the chief importer in LA Long Beach, figuring he would work off his excess inventory first before committing more cash to new orders. Port congestion had eased, and delivery time had dropped, so he figured he could handle the same volume of business with lower inventory levels. Worst case scenario, he would expedite an order if it was profitable to do so. Beats paying double the interest on goods that are just sitting in the warehouse.

Importer Paul is in a deep funk. For nearly two years, he had over-ordered goods from China. He had made unimaginable profits as his inventory had been bid up by distributors competing for early delivery. The Chinese manufacturers had been unable to keep up with soaring demand and had started rationing. So Paul had to order 200 widgets when he needed 100 widgets, in order to be assured that he would at least receive 80. Whatever excess inventory he received, he had managed to sell it at a premium in the spot market, so this had been quite the lucrative trade.

Now, Paul had the reverse problem. Transit times from Shanghai to Long Beach had been cut in half, plus he was receiving his entire order. Paul shares his thinking with his purchasing manager sitting in Shanghai. The purchasing manager tells him that the Chinese had seen this coming and had cut production already. Chinese imports of all raw materials had shrunk as they had foreseen the demand destruction and didn’t want to end up holding overvalued inventory when prices dropped. Paul didn’t have to worry about upsetting his Chinese vendors. They had been one step ahead all along.

Paul is pissed that he seems to have been the last one to get the memo that the inflation trade was over, but being a trader at heart, he knows that the first loss is the best loss. He had made good money from holding inventory while prices rose, now he would get out before the bottom fell out of the market. He cuts prices to work off the inventory bloat.

Few weeks later…

Wal’s customer Hank is happy. He just bought a jumbo pack of four-ply scented toilet paper and paid less than what he had paid for the two-ply roll earlier.

CNBC talking heads are screaming something about inflation and how Biden destroyed the economy by selling American oil to the Chinese, but Hank doesn’t care for CNBC anymore. Economic pundits still worried about the massive US government debt, but the worry-warts had been wrong in their dire warnings ever since the national debt first crossed $1 trillion in 1981.

A colleague of Hank had put him wise to RealVision, a financial media channel run by a guy named Raoul Pal. Raoul had said buy bonds, and Hank had taken the advice to heart, buying short-term investment-grade bonds paying 6% interest. He was saving more of his paycheck now and planned to construct a CD ladder, just like his father had done.

The energy bulls had shut down their hedge funds, just like Amaranth and at the end of previous bubbles. Not surprisingly, they had defended the long energy trade all the way until the bitter end, refusing to believe the evidence of the charts.

The trend following CTAs had shut down their funds too, swapping client meetings and shirtsleeves for flip flops and beach front property in Nassau. They had played both sides of the inflation trade, made more money than God – and kept it.

At the Eccles building in DC, a wizened old man sat alone, lost in thought. He had achieved the seemingly impossible – a soft landing – and nobody cared to acknowledge it.

“If a tree falls in the forest and no one is around to hear it…”

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