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New Theme: Real Income Destruction

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Stockholm (HedgeNordic) – Michal Danielewicz and Jens Larsson, the founders and managers of thematic-focused long/short equity fund St. Petri L/S, had warned about the re-emergence of inflation well before inflationary pressures started creeping up all around the world. And indeed, an inflationary surge is evident and the word “inflation” is on everyone’s lips, fueled by Russia’s invasion of its neighbor, Ukraine.

Josephine Cetti, Portfolio Specialist at St. Petri Capital.

“When we started discussions about inflation some time ago, we would talk about seeing re-emerging inflation in certain areas only,” says Josephine Cetti, Portfolio Specialist at St. Petri Capital. “Then at some point during the beginning of the year, one could hardly keep up mentioning the places experiencing increasing prices because inflation has been everywhere,” she emphasizes. “There is actually not a single space where you do not see inflation.”

The portfolio behind thematic-focused St. Petri L/S, which usually houses between eight to 12 themes, had featured “inflation-protection” positions for several years now in anticipation of higher inflation and rising interest rates. Most recently, the team added a new “real income destruction” theme populated with short positions in consumer-related companies expected to “face material headwinds going forward because the consumer is so squeezed now due to rising prices.”

Easing Deflationary Structural Changes

In the decade after the financial crisis, the world embarked on a big cycle of money, credit and debt creation driven by both monetary and fiscal stimulus. With interest rates hovering around zero for many years, seemingly all effort has been undertaken to get individuals, businesses and governments loaded up with the maximum amount of debt. Yet, contrary to what any formal theory of economics suggested, inflation remained subdued. The deflationary effects from structural shifts kept inflation in control, argues Danielewicz.

The St. Petri Capital team’s early warning about the re-emergence of inflation stemmed from their observation that the deflationary effects from two powerful, decades-long structural shifts have been easing and thereby will let loose inflationary pressures. “Three of the main structural changes that Jens and I have observed over the last years include globalization, technology revolution and demographics,” starts Danielewicz. At least two of them have had deflationary effects over the past few decades.

“Aside from the many benefits of globalization on economic growth and well-being, globalization was actually extremely good for low inflation with production being offshored to cheaper locations,” argues the co-founder of St. Petri Capital. “The second structural change, technological revolution, has led to massive productivity growth for all of us, which again, was tremendously deflationary,” he continues. “These structural tailwinds that created a very good environment for equities and kept inflation under control could potentially become future headwinds.”

“These structural tailwinds that created a very good environment for equities and kept inflation under control could potentially become future headwinds.”

Globalization – a phenomenon that has defined the world’s economy in recent decades – appears to be taking a step backward due to the Covid-19 crisis and more recently, Russia’s invasion of Ukraine and the associated economic sanctions inflicted on Russia. “This subtle deglobalization process is not having a positive effect on global value chains and pricing,” warns Danielewicz. Global trade as a percentage of global economic output had been increasing since China joined the World Trade Organization (WTO) in 2001, but this share reached a peak a couple of years ago before embarking on a downward slope. “The current geopolitical tensions will further limit any benefits of globalization on global price deflation.”

“The slope of change in the technological evolution may no longer be as steep as it used to be.”

The technological revolution, another deflationary structural shift, has also been slowing down in recent years, according to Danielewicz.“The slope of change in the technological evolution may no longer be as steep as it used to be,” he acknowledges. “Don’t get me wrong, I am still a great believer in technology and technology accounts for a big part of our portfolio,” he emphasizes. Yet, one has to remember that “the technological revolution has been ongoing for 60, 70 years, and the slope of change cannot be as steep as it used to be,” according to Danielewicz. “The technological revolution has been a significant contributor to productivity gains and has been deflationary.” These deflationary effects are starting to wane in magnitude.

More “nascent” structural changes such as the fight against global warming and climate change, as well as increasing defense spending in response to Russia’s invasion of Ukraine, are adding to inflationary pressures. “If you combine the continuation of green energy and the recent focus on defense spending, which all compete for the same resources, with slowing demographics, maybe slowing technological revolution and global disintegration, everything points to higher inflation.”

St. Petri’s New Theme: Real Income Destruction

Danielewicz and Larsson usually build the portfolio of St. Petri L/S around eight to 12 themes, with the allocation to each theme depending on the maturity of the theme. Unsurprisingly, the “inflation wave” represents the team’s largest long exposure. “We very much like companies with pricing power that would be anchored within basic materials and industrials,” explains the portfolio manager. “These two sectors are associated with increased pricing power and can withstand higher inflation. The common theme here is the inflation wave.”

“On the short side, most of the exposure is still allocated to the “low volatility exuberance” theme.”

“On the short side, most of the exposure is still allocated to the “low volatility exuberance” theme,” says Danielewicz. This theme mainly features “highly-valued companies that tend to underperform when interest rates are increasing due to inflation,” explains the portfolio manager. “The low volatility theme continues to be the largest pool of short ideas.”

“Prices are going up everywhere, so we started to discuss a lot about demand destruction.”

As inflationary pressures continued unabated after Russia’s invasion of Ukraine, the St. Petri team added a new theme to the portfolio that is “100 percent connected to inflation,” according to Josephine Cetti. “Prices are going up everywhere, so we started to discuss a lot about demand destruction,” she continues. “Ordinary consumers are seeing their energy bills going up, their grocery bills going up, their commute and other bills all going up.” To add a layer of protection to St. Petri L/S’s portfolio, the team built a theme solely comprised of short positions in consumer-related companies that are expected to suffer due to real income destruction.

“We don’t yet see this real income destruction on the micro-level, but we already see it on the macro level.”

“At the micro-level, we don’t see the squeezed consumer just yet after reviewing the earnings reports of many consumer-related companies,” says Cetti. “The reports don’t reflect the demand destruction or the real income destruction, but we are confident that this inflation-biting problem will feed in the coming quarters,” she emphasizes. “We don’t yet see this real income destruction on the micro-level, but we already see it on the macro level where the more recent macroeconomic figures from April, both from the Eurozone and the US, are already showing some evidence of the consumer beginning to get hurt now,” Cetti adds.

“We are 100 percent sure that over the coming quarters, we will see many of these big consumer-related companies being hit on their top line but also their bottom line because they are also facing increasing input costs.”

“It is just a matter of time before it will translate from the macro-level down to the micro-level,” says Cetti. “We are 100 percent sure that over the coming quarters, we will see many of these big consumer-related companies being hit on their top line but also their bottom line because they are also facing increasing input costs.” The “real income destruction theme” is now the second-largest theme on the short side after the “low volatility exuberance” theme.

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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