On Inflation

Last quarter, within this portion of the letter we spoke of how investing is best done without emotion and even better done when it is for the long term. Moving forward, we will be discussing inflation in an attempt to open the conversation of why it is that we should invest some capital in the first place rather than save the entirety of all our money.

Those with a keen ear may have noticed how the whole financial sector seems glued to the idea of inflation as of late. Inflation itself is the general rise in price level within a specific domain over time. Oftentimes this is completely natural as an economy expands and is more profitable. After all, it only makes sense that the cost of goods and services would also increase alongside natural growth. To break it down in layman's terms, there are two primary ways inflation can naturally occur; cost-push or demand-pull.

Cost-push inflation is a relatively easy concept to understand. The overall supply of goods and services decreases, yet demand remains the same. In a free-market economy, companies with more available capital with the same demand are willing to exert more cash to maintain production. This then causes a highly competitive market for a finite amount of resources, wherein essentially a bidding war is taking place behind the scenes. To maintain the charade, companies must then pass these excess costs for goods and services to none other than the consumer. In terms of an example, you likely have noticed that gasoline prices have seemingly doubled within the last year. Nearly everyone has a stable consumption of gasoline in their day-to-day life. But when global policies, cyber hacks, or even natural disasters such as hurricanes hinder the production of petroleum, gasoline prices tend to rise in response as demand for gasoline remains unchanged.

On the other side of the coin, demand-pull inflation is a seemingly more viscous type of inflation. In an expanding economy, there is more money flooding the supply while the demand for goods and services remains the same. An increase in the money supply can stem from either lower interest rates, additional government spending, or even overseas growth which can, in turn, generate more exports and dump more money into the system. As more money falls into people’s wallets, the more affordable goods may seem. With more affordability, many begin to purchase more goods that were once unavailable to them. The increase in demand triggers an expansion of price. The clearest-cut example I can think of is after the first stimulus checks were dolled out in 2020, everyone wanted bicycles. With nothing to do during a lockdown and fresh with some government money in their hands, it only made perfect sense. Yet, with production also being shut down, the supply of bicycles was near an all-time low. As such, naturally, the price for a bicycle pulled nearly fifteen percent upward as a response in a relatively short amount of time.

Surprisingly, while we just mentioned the two primary ways in which prices can increase, the United States of America finds itself in a hybrid situation. “Cost-Pull inflation” has been slowly producing higher-than-average prices across the board. We find ourselves in a time where the global supply chain is still recovering, ineffective government spending runs abound, natural disasters ravage the nation, war looms, and yet there is still relentless demand. All of the above have played a role in the increased prices across the board at a higher-than-average rate.

Ironically, higher prices create a positive feedback loop. If we expect prices to rise soon, we would unashamedly rush to purchase goods today in fear that they would cost us more tomorrow. This phenomenon in turn creates even more demand for an otherwise finite supply, thus increasing pricing even further.

So then, the question that remains after we know the what and how of inflation; why does this matter to us as investors? The answer is directly related to the concept of purchasing power. We often hear older generations remark on how back in their day, they were able to purchase a can of Coca-Cola for five cents when they were children. Today, it costs us well over a dollar to purchase a can of Coca-Cola. The product is nearly precisely the same, yet stable inflation has slowly raised the cost of production, and therefore the cost to the consumer. In short, the purchasing power of a nickel has declined severely by this metric.

The challenge then for us as investors is to not only deliver returns but do so in such a way that we increase purchasing power over time. What is the point if we can double our money yet the cost of goods triples in the same period? No doubt this example is (hopefully) hyperbole, but the risks of inflation eroding purchasing power have been and will continue to be present moving forward. In this sense, it is well worth our time to be in constant pursuit of smart, well-thought-out investments which will generate returns above that of our average rate of inflation.

It is worth noting that in our personal opinion, the amount of inflation we are currently experiencing will come to pass. It is a hot topic of today’s culture, and while it is incredibly relevant, we hope that ten years from now it will simply be yet another story to regale about. So then, we shall continue to charge forth with our investment research and ideas all the while being mindful of this little concept that eats away at our purchasing power. As always, it is a pleasure for both Nathan and me to serve you and we recognize your support as an incredible blessing. For this, we cannot help but thank you.

Warmly,

Zach Terpstra

Principal