Inflation, Money Supply, Debt, Commodities, ESG and Bitcoin
Summary of Horizon Kinetics Q2 2021 Commentary
Horizon Kinetics is an investment firm based in NY. It is owned by a publicly traded company called FRMO Corporation which trades on the OTC market under the ticker symbol FRMO.
Horizon Kinetics was founded by Murray Stahl who is an incredibly forward thinker and a smart investor along with his partner Steven Bregman. Both run FMRO Corporation as well.
I’ve learned a lot from them by reading their letters and I highly recommend you read their letters as well.
Horizon Kinetics was mentioning the huge upside for Bitcoin back in 2017, they were talking about the possibility of inflation and higher oil prices for over 2 years now, and they were talking about a company called Texas Pacific Land Corporation for many years also.
Many of their recent predictions have been coming true so they spend this letter going over everything now that the financial media can’t stop talking about these topics. The media coverage is resulting in Horizon’s investors to have many questions on these topics.
Here is my summary of the Q2 2021 letter which is a little old. It dates back to July 2021. It’s been a busy last couple of months and the Q3 2021 letter is out so I should have a summary of that one pretty soon as well.
Steve Bregman is a co-founder and President of Horizon Kinetics. He writes the letters and presents them to Horizon’s investors so for the purposes of this letter, I will be using Steve Bergman’s name as the author.
Steve says that the Fed prefers to use the Personal Consumption Expenditures Index (PCE) instead of the Consumer Price Index (CPI) to measure inflation, but they’re unsure why.
The PCE is up 16.8% in the past ten years and the CPI is up 20.6%.
When measuring inflation, Horizon Kinetics avoids both of these measures because they both understate the actual inflation rate.
Horizon Kinetics prefers the Big Mac index but with the help of Ed Harrison, they even realized that the Big Mac Index probably understates the actual inflation rate as well because it doesn’t include education and healthcare costs.
Here is a picture below that graphs the Big Mac index, CPI and 10-year Treasury real return together. The red line is most likely the nominal treasury rate, the blue line is probably the nominal rate of the 7-10 year treasury rate minus the inflation rate using the consumer price index (CPI), and the brownish line (it is brown right?) looks like it is the nominal rate of the 7-10 year treasury minus the inflation rate using the Big Mac Index.
Steve Bregman mentions that he never used shipping cost indexes before to measure inflation but they do have a significance because all of the goods that we buy in the stores are shipped there by truck or maybe even ship.
In almost 2 years from August 2019 to June 2021, flatbed truck rates are up 43% and refrigerated truck rates are up 44%.
Another shipping measure is the Cass Freight Index which is based on actual freight invoices from industrial companies. This index is up 25% since August 2019 and it’s up 12% from December 2017 – December 2019 (pre-pandemic).
In addition, the Baltic Dry Index is up 42% since August 2019 and 114% since August 2018 but on the other hand, it was lower in December 2019 than it was in December 2017.
The Baltic Dry Index measures global marine shipping freight rates for dry bulk goods like iron ore and grain.
Steve mentions that it is possible that these effects are from a rebound in demand and a bottleneck in supply resulting from the pandemic but Horizon doesn’t pay close attention to these indexes because they’re backward looking. They tell you what inflation was in the past; they are not causative factors that lead to inflation in the future.
The causative factors that will lead to inflation in the future that Horizon does monitor are the nation’s money supply, the nation’s debt, and the declining reserves of the handful of critical commodities that undergird the economy.
Excess money supply has been a cause of inflation going back 2,000 years. The Fed doesn’t mention excess money supply in their commentary.
The Bureau of Labor Statistics calculates that the CPI today is 15.9x higher than it was in 1925. According to Steve, that means that the dollar has lost 94% of its purchasing power (1/15.9=.06). Steve then debunks this 15.9 measurement from the CPI index used by the Fed by mentioning that a loaf of bread is 37.9x more expensive in Manhattan today than it was in 1925.
The U.S. money supply increased by $15.9 trillion in January 2020 to $20.4 trillion in May 2021, a 32% increase. The economy is only 1.4% larger though so it is very likely that this will cause inflation.
Steve doesn’t view inflation as transitory.
Debt is also up. Federal debt was 63% of GDP at the end of 2007, by the end of 2019 federal debt was 106% of GDP and as of March 2021 federal debt was 127% of GDP. The previous high for federal debt to GDP was in 1946, after World War II, when it was 119% of GDP.
And this new debt accumulation didn’t fund new productive capacity in the nation’s factories and research facilities and it didn’t produce robust economy growth. This is a cause for concern according to Steven because the amount of new debt being created is exceeding the growth rate of the U.S. economy.
There is also the $120 billion a month the Fed has been printing to buy bonds in order to keep interest rates down. The printing of this money to buy bonds and keep interest rates down is also inflationary.
The Fed has discussed tapering, or ending their program that buys bonds each month, but this will cause interest rates to rise back to what a normal market interest rate would be. This higher rate will result in higher interest expense for the Fed to pay on their $28 trillion in Federal debt.
Commodity prices are increasing in the same way that prices for all other goods increase – an imbalance between supply and demand.
Supply isn’t going up much for commodities because of the cyclical price collapses of nearly 10 years ago and also because producers decided to reduce spending and not develop new reserves.
On the other hand, demand for commodities is going up because the global population increases each year and the living standards of emerging economies increases as well.
There is also an add on effect resulting in an increase in the demand for commodities due to renewable energy projects and the electrification of the economy.
Renewable energy may reduce the use of fossil fuels in the future but until the energy output coming from renewable energy is sufficient to power the economy, fossil fuels will continue to be in high demand in order to extract the raw materials (lithium, cobalt, nickel, silicon, neodymium, copper, silver, steel) from the ground in order to build the renewable energy projects and to electrify the economy.
Stated reserves for the oil companies are now lower today than they were in 2006 meanwhile global consumption is 15% higher which could mean more increases in the price of oil.
There are asset-light companies and asset-heavy companies. Asset-light companies benefit from rising inflation because their input costs don’t rise as much as asset-heavy companies. This results in higher free cash flow for the asset-light (inflation-beneficiary) companies than for the asset-heavy companies.
The images below draw comparisons between companies that benefit from inflation vs companies that don’t benefit:
(The companies on the left don’t benefit much from inflation due to a more asset-heavy business model meanwhile the companies on the right benefit more from inflation due to an asset-light business model)
Here is Steve Bregman on the stark differences between the common advantages of the asset-light businesses:
“They can generate more dollars of revenue per dollar of assets invested. In an inflationary environment, that means that less of the operating assets on the balance sheet are vulnerable to replacement-cost increases.
- If less employee-intensive, the business is less subject to inflation in compensation or benefits. There is less risk of non-debt obligations, such as for pensions and post-retirement health care. - With less physical operating assets required and less in the way capital expenditures, there’s more free cash flow available to distribute or reinvest.
- Also shown was the highest form of asset-light business, which is a hard-asset company, like Mesabi Trust or Texas Pacific Land Corp: their revenues come directly from the asset itself, as processed by third parties. With no operating expenditures required, they are passive beneficiaries of any increase in the price of the commodity and any increase in production volumes by the third parties that bear the capital investment and operating costs. No other business model can replicate that level of profitability.”
Steve sees only 3 reasons to invest in companies or funds with an ESG focus:
1. Wanting to be involved in the intentions of what environmental and ethical are trying to accomplish.
2. Profit making.
3. An externally imposed policy decision like when a manager is restricted on which funds or companies he can buy.
The measures of ESG can vary and aren’t perfect. For example, Berkshire Hathaway has a 6.7 out of 10 ESG rating compared to the average S&P 500 company who has a 5.8 out of 10 rating. But Berkshire Hathaway is the 4th largest emitter of greenhouse gases in the U.S. Berkshire emits more than 2x the greenhouse gases that Exxon Mobil emits.
Berkshire Hathaway is one of the largest owners of private utilities which need to use fossil fuels to power the electric grid and delivery electric power to households. Steve mentions they aren’t attacking Berkshire but are just observing that there might be a more effective way of identifying companies that are truly consistent with the aims of ESG investing.
Steve makes an interesting and contrarian case for Bitcoin being an ESG investment because the amount of bitcoin being mined gets cut in half over time.
This halving results in less energy being used for mining. He also mentions there is an incentive for miners to cut power usage because if they’re using the same servers that they were using before the halving, then they would be losing money because the electricity costs from server usage would exceed the dollar value of the bitcoin received from mining.
Steve says there has already been a 70% reduction in power use per terahash in just the past 3 years.
To read more from Steve Bregman and his partner, Murray Stahl, you can follow the links below:
Horizon Kinetics: https://horizonkinetics.com/whats-new/
FROM Corporation: https://www.frmocorp.com/index.html