Real story of inflation
Bitcoin and crypto markets have seen a high correlation with tech stocks. Bitcoin still doesn’t seem a mature asset that can play its original role — ‘an inflationary hedge and a store of value’. In the short term, bitcoin seems to be driven more by the macro-economic factors than anything else. A key macro-economic factor that is is driving the current ‘bearish’ sentiment is ‘inflation’.
Off late, media seems to circulate a narrative that ‘inflation’ is close to its peak. Markets are factoring a 2.75–3% fed funds rate by end of year and an inflation rate of ~5%. This is consistent with the Fed narrative of a ‘soft landing’.
Second order effects
As Howard Marks writes in his book ‘The Most Important Thing’ — it’s not the obvious things that matter. It’s the second and third order effects that cause significant shifts to the ‘expected path’. Predicting such second and third order effects is where the real ‘alpha’ lies.
By looking at the data we have from various sources, I have a thesis that markets are hugely underpricing the price shocks heading our way. Such shocks can lead to overcompensation by Federal Banks which can in-turn lead to a deep liquidity freeze in financial markets (and maybe a collapse of few large institutions)
My thesis is that we can see a huge inflation spike by September-October that can trigger market shocks and a potential liquidity freeze
Here are some data points that drive me to this thesis.
1. Food crisis
Russia-Ukraine war started in the first week of March. At the time of writing this article, the war appears to be heading for some sort of a stalemate.
However, apart from the initial spike in oil, commodities & the collapse (and recovery) of ruble, I think we are yet to see the real ramifications of this war. To begin with, let’s look at food production in Ukraine.
Ukraine is a major producer of corn and wheat — its major spring crop is corn, barley and sunflower that is sown in February/March and harvested in September/October. As per this Reuters report, spring crop sowing area is cut down to 7 million hectares from 15 million hectares. There is uncertainty even on how much of the harvest can be exported (there is a lot of fighting happening close to the ports).
It is highly likely that 2022 will be a washout year for Ukraine food exports. Looking at the numbers, a total of ~56 million metric tons of food is exported, largely to Europe, Asia and African countries. Europe, already reeling under energy crisis, gets 14% of its grains (~12 million metric tons) from Ukraine.
Over 7 million hectares of farmland that produced corn, barley, sunflower seeds, soybeans every September (spring harvest) will not do so in 2022. It is very unlikely that market has factored in the implications of this shortfall in its 5% inflation estimate.
2. Fertilizer crisis
An even more serious problem is a global shortage of fertilizer (nitrogen, phosphorous and potassium), again thanks to Russian embargo and supply chain disruptions due to Russia Ukraine war. This article on Bloomberg gives a bleak picture of how global crop yields are set to drop because of high fertilizer prices and rampant shortages.
Fertilizer prices have risen almost 70% in the past few months making it untenable for farmers to use at large scale. International rice research institute predicts a reduction in crop yields by ~10% because of insufficient fertilizer.
Massive increase in fertilizer prices coupled with Ukraine crisis means that the September-October harvest will see a sharp reduction. Expect massive food shortages, export controls by individual countries leading to massive price hikes in the last quarter of 2022.
3. Supply chain crisis
While this is happening on the food front, there is another epic event unfolding in China. Thanks to its zero Covid policy, China is witnessing a shutdown in key cities such as Shanghai, Shenzhen, Guangzhou and 70 other cities. Windward, a maritime intelligence and analytics company, in their blog have cited massive congestions at Chinese ports.
Report says the number of container vessels waiting outside of Chinese ports in April is 195% higher than it was in February.
A look at the illustration below shows that number of vessels stuck in the port have increased to 506 in April from 260 in February. Note that this blockage has a ripple effect globally — clogging at one place leads to a chain reaction of clogging at all ports. Unclogging these ports usually takes 6–8 months (or more) leading to massive supply chain disruptions.
Report goes on to say that 20% of all ships worldwide (1826 vessels) are stuck at ports right now (506 of them in China itself). This effect is also exacerbated by the ongoing Russia-Ukraine war.
The effect of clogging of these shipping lines will not be felt immediately. ‘Docking’ at port to ‘Stocking’ at stores takes 50–60 days during normal times — in such extreme conditions, this can easily stretch to 100–120 days. Consumers will start to feel the pinch 4–5 months from now. That again takes us to the September to October horizon.
Food shortages from Ukraine, global fertilizer shortages & supply chain disruptions, all seem to converge with a devastating lag-effect that will show up somewhere in September-November time window.
Worst case scenario
While I certainly hope we avoid this, I feel there is a non-zero chance that food and supply chain shocks could trigger flashpoints in emerging markets.
This can trigger panic actions by governments and central banks — ‘export controls’, emergency imports coupled with policy rate hikes and currency devaluations etc. Export controls imposed by countries to secure food for their own citizens will compound a local problem and make it global.
This can suddenly spike inflation rates in the US and can drive the Fed and markets off-balance. Fed will try to overcompensate (as always) and something breaks a few months down the line that can cause a deep liquidity crisis. And we will most likely be back all over to Quantitative easing again— and the story goes on...
Conclusion
I think market is expecting things to go smoothly — this could be a hangover of a 10 year bull run. Sure, there seems to be pain in the market but there is also a feeling that things are largely in control. Never before have we had a hawkish fed, an ongoing war, massive supply chain issues and food crisis of epic proportions hit us together.
A lot of bad events are likely to converge in the August-October period that could break an already fragile market and economy. A single trigger event can lead to corporate defaults, mortgage price crash and systemic liquidity crisis. And we can end up again with another round of quantitative easing.
Thankfully, unlike in 2008–09, we have a new weapon in our arsenal — Bitcoin. I hope Bitcoin emerges as a true inflation hedge and protect us from future debasement of currency and loss of our savings.
