4 min read

Daily Dive #072 - The Increasing Risk of Stagflation

Daily Dive #072 - The Increasing Risk of Stagflation

Last week, we discussed the beginnings of a global energy crisis and the downstream effects on bitcoin mining in The Daily Dive #069. Today, we’re covering the latest developments in the skyrocketing energy costs, the risks of stagflation and how these pose increased risk for a future credit crisis.  

The Risks Of Stagflation

Last month, there were over 4,000 stories on the Bloomberg Terminal mentioning stagflation. It’s a growing economic concern in the market and one we’re watching closely. Stagflation refers to economic times when there’s rising inflation, a stagnation of economic output and a high rate of unemployment.

Historically, stagflation has often been accompanied by oil shocks. Now, we’re seeing the West Texas Intermediate Crude Oil price per barrel reach seven-year highs with a current global oil supply/demand imbalance. Along with the Europe and Asia natural gas and coal shortages, these factors are increasing the market chances of a stagflation scenario playing out.

Amidst the latest surge in energy prices, the Organization of the Petroleum Exporting Countries, Russia and their allies (known as OPEC+) met yesterday deciding to maintain their previously-agreed-upon production supply rather than raising supply further. The United States has called on OPEC+ to increase supply highlighting that rising gas prices are a threat to the global economic recovery.

For rising inflation, rising energy prices will affect gas prices, consumer heating bills and manufacturing production costs that can be passed onto consumers via higher prices and slow economic output.

We can already see this trend playing out through a rising surge in China’s Producer Price Index (PPI), up 9.5% in August while China Consumer Price Index (CPI) was 0.8% showing weak purchasing demand for Chinese consumers. Chinese manufactures can look to pass on increased costs to western, foreign consumers with both demand and CPI stronger post pandemic. For the United States, this comes at the same time when monetary policy is ready to tighten.

Source: Bloomberg
Source: Bloomberg, Holger Zschaepitz
Source: Financial Times
Source: Bank of America‌‌

What is often misunderstood is that the Federal Reserve cannot respond to the stagflation of today like they could in the 1970s, when Paul Volcker hiked rates all the way up to 20% to curb inflation. Volker could do this because of the relatively low debt levels across the economic system, but the situation today is much different.

Source: yardeni.com

With total domestic debt-to-GDP totaling 389.2%, nominal interest rates cannot be raised without collapsing the economic system, which puts Jerome Powell and the Federal Reserve in a challenging spot.

This is quite the paradox, because the current environment doesn't end happily for many participants. The current path of nominal rates held at the zero lower bound while real rates continue to plummet with ever-high inflation readings encourages borrowing at ever-lower real yields to leverage up and outpace the monetary inflation occurring. However, the music eventually comes to a halt when a certain feedback loop occurs:

  1. Monetary/fiscal policy stimulates demand, creating credit impulse
  2. Stimulus-enabled demand creates supply/demand imbalance between money and real goods and services in the economic system
  3. Use of financial engineering (leverage) to counter the increasing inflation
  4. Higher inflation and backlogged supply chains from monetary/fiscal stimuli squeezes profit margins for an extremely overleveraged economy
  5. Over-leveraged borrowers with little/no cash reserves face insolvency due to rapidly-shrinking profit margins; default on obligations
  6. Default affects counterparties, liquidity is withdrawn from markets, additional over-leveraged players face bankruptcy.
  7. Reflexive volatility spike/liquidity crises in historically leveraged financial/economic system

This is the series of events that occur as a result of a centrally-planned monetary system and cost of capital, and by the looks of it we are in the middle stages of the cycle. Make no mistake, central banks and governments will attempt to perpetually kick the can down the road, but the question that every investor needs to be asking is:

With the existence of a perpetual Fed put (socialized losses) in markets, how does the game ever end?

The answer to this question can be quite complex, but also quite simple. The game ends due to deteriorating credit quality of all balance sheets across the global economic system. After all, in a 100% fiat currency, debt-based monetary system, money is created through lending and destroyed through repayment and default. When the entire global economy becomes as systematically over-leveraged as it is today, the risk becomes the declining credit quality of fiat as an asset.

In simpler terms, the risk of holding debt securities has never been higher, yet the reward (yield) for holding these securities has never been lower. High risk, infinitesimally small reward.

The other side of this trade? Bitcoin.

A non-sovereign, decentralized, global store of value produced via a proof-of-work with an ultimate hard-capped supply and a difficulty adjustment to algorithmically limit over/under production. It is simply the most certain asset the world has ever seen, and in a world of ever-increasing economic uncertainty, bitcoin is your best bet.