Uncertainty Wednesday: Valuations and Inflation Risk

Today’s Uncertainty Wednesday is about the risk of inflation. I spend much of my time thinking about company valuations, both as we make new investments and also as we try to mark valuations in existing companies. Of course valuations for private companies are influenced by available public comps and those have been trading at high multiples, including the current crop of IPOs. Now there are two countervailing views in the market. One view is that valuations will return to lower historical multiples and the other view is that current multiples are the new normal.

Why could multiples have expanded permanently? Well there are two possible explanations (which are not mutually exclusive). First, that due to pervasive network effects successful companies can grow faster and have stronger ultimate positions in their respective markets. This is to say the higher multiples are justified on fundamental grounds. Second, that there is so much money sloshing around causing low interest rates and thus driving up present value of growth companies. This is to say the higher multiples reflect a changed monetary landscape. The place to look here is the Fed’s balance sheet which expanded massively during the 2008 financial crisis and again in 2014 as can be seen on the following graph.

Now what that graph also shows is that for about a year now the Fed has had some success in bringing that money back in by shortening its balance sheet to the tune of a few hundred billion dollars. That’s a huge amount of money but still pales compared to the roughly $3.5 trillion expansion.

What does all of this have to do with inflation you may ask. Well, the multi trillion dollar question is where we go from here. Can the Fed successfully continue to shorten its balance sheet, or is the following projection from JP Morgan Asset Management correct?

This basically suggests settling in with an extra $3 trillion or so and growing from there. It reminds me of what someone said as the Fed started with quantitative easing: “The Fed’s balance sheet is like toothpaste – easy to squeeze out, impossible to put back in the tube.” (I can’t find the quote right now to attribute).

If that’s indeed the case then it is true that asset valuations may stay as high as they are (to the extent that the monetary explanation for high multiples applies), but it also means that there is the potential for an inflationary shock across all prices, including everyday consumption items. I have written a lot about inflation before where I keep making the point that technology is deflationary. But that doesn’t rule out inflation from a loss of faith in purchasing power.

There is a small but nonzero chance that’s where we could wind up, especially if the collective belief suddenly shifts to concluding that we will use inflation exclusively to finance government spending. Now I should be clear that I am actually a fan of using the money supply to finance a Universal Basic Income, but that requires a shift to full reserve banking and the addition of some kind of wealth tax to rebalance the system. It could all be done, but only if we are willing to change a lot of things instead of just printing more money.