Energy Constraints Will Hamper Near-Term Productivity Gains: Inflation to Persist

In our last few letters, we discussed our view that inflation would remain higher and “stickier” than most were forecasting and well above the Federal Reserve’s 2% target. We anticipated this would force the Federal Reserve (the “Fed”) to keep the federal funds rate higher for longer as it tries to contain inflation.

At the start of 2023, the federal fund's effective rate stood at 4.3%. A resilient economy coupled with persistent inflation led the Fed to implement three rate hikes during the first half of the year, culminating in an effective 5.33% by year end. Despite higher rates and inflation exceeding expectations, the economic resilience defied many predictions of a US recession in 2023.

During recessions, inflation and the economy weaken, and interest rates and corporate earnings decline, resulting in lower bond yields and declining equity (i.e., stock) prices. In 2023, however, the widely predicted recession never occurred, while Inflation remained above estimates, catching many investors off guard. Despite significant volatility throughout the year, the bond and equity markets ended the year with positive returns. The positive returns continued through the first quarter of 2024.

Looking Ahead

Fundamentally, economic progress and productivity gains are driven by the efficient conversion of energy to goods and services demanded by the populous. In turn, country-level prosperity also occurs with the increasing efficiency of energy conversion. Conversely, when the efficient conversion of energy is disrupted, productivity declines and inflation increases.

A country's prosperity occurs in small increments month over month and year over year. Still, progress is usually upward-sloping as technological improvements drive productivity gains through the economic system. However, there are periods when productivity stalls or reverses.

One of the significant trends we are witnessing today is the shift from high-density fossil fuels to lower-density green energy. Over the past four decades, the high-density fossil fuel industry has been a key driver of productivity gains, leveraging technology to reduce the overall energy cost to consumers. This high-density, low-cost energy has been efficiently distributed. However, this trend is now changing, and it is crucial to understand its implications on productivity and energy constraints.

As we shift from a fossil fuel-intensive economy to one powered by renewable energy, we face the challenge of simultaneously constructing sufficient power and distribution infrastructure to accommodate this transition while also accounting for future growth. This shift from high-density to low-density energy sources, coupled with the transition from high-efficiency distribution systems to lower-efficiency ones, leads to reduced productivity and heightened inflation.

Several additional factors further complicate the much talked about energy transition and will also likely add additional costs:

Anti-fossil fuel sentiment has significantly reduced investments in fossil fuels and, therefore, future supply of the highest-density forms of fuel, even though demand for these fuels continues to rise, pushing prices higher.
The drive for renewables increases the demand for industrial metals (e.g., copper, lithium, titanium, rare earth elements, etc.), many of which are severely capacity-constrained relative to the demand required to build out the renewable infrastructure that is needed.
Technological advancements have consistently led the way throughout history by boosting productivity and lowering inflation rates. Ironically, the next major leap in technological innovation poised to drive substantial productivity gains is artificial intelligence (AI). However, harnessing AI's potential necessitates significant investments in power-intensive infrastructure to facilitate the next wave of productivity growth.
Globalization has also played a role in productivity as the free flow of information, goods, and services worldwide has created efficiencies for all countries, increasing productivity and reducing inflationary friction. The recent deglobalization trend has limited the free flow of goods and services and requires the new construction of localized infrastructure and manufacturing capacity. The initial start-up phases of these new supply chains will come at a higher cost of production.

We anticipate heightened inflation in the initial phases of the energy transition, artificial intelligence infrastructure development, and reshoring as industrial capacity expands. Moreover, we only expect technological productivity gains to balance out the increased energy demands on our progressively constrained energy infrastructure as these substantial infrastructure investments come to fruition and as artificial intelligence becomes more integrated into various sectors.

On the Issue of Power Demand

Over the past few decades, US electrical power demand has grown by about 1% annually, with power infrastructure capacity investments sized appropriately. According to J.P. Morgan’s Michael Cembalest, “McKinsey, BCG, and S&P Global expect US power demand to grow by 13-15% per year until 2030.” This level of growth would likely stress the US electrical power infrastructure and quickly expose the inadequacy of the US baseload power and grid capacity.

The focus on expanding renewables while decommissioning baseload nuclear, natural gas, and coal from the power supply runs counter to the need for increasing 24/7 baseload power required to support increased demand from reshoring manufacturing, new semiconductor plants, electric vehicles, AI, and population growth.

We find it hard to argue that the US will escape the next five years without significant energy shortages and, thus, will face continued inflationary pressures.

Debt Crisis

With record levels of US government debt and rising fiscal deficits, the US faces significantly higher interest expenses as a percentage of the budget.

According to Congressional Budget Office (CBO) estimates, interest expense on US government debt held by the public will total $870 billion for fiscal 2024, equal to 17.6% of the 2024 budget receipts, up from just 10% a few years ago.
These CBO estimates assume the weighted coupon rates on US government debt will average only 3.33% over the next five years.
However, over the next three years, approximately 47% of the outstanding debt must be refinanced at rates that are likely to remain higher than the CBO forecasts. While the CBO forecasts annual deficits well into the next decade, we believe deficits will be much larger than the CBO envisions.
This will likely force larger than projected debt levels, with interest expense eating up an alarming level of the US federal budget.
At the current forecast, interest expense already exceeds military spending and is quickly encroaching on other mandatory spending programs. The current path is unsustainable, though given the existing dysfunction in Washington, budget discipline is unlikely to address the problem.
In our view, without spending discipline, rising deficits and debt levels add further fuel to the inflationary pressures we see ahead.
We continue to expect elevated economic volatility as the Fed battles inflation, which we anticipate will remain stubbornly above its target.

As for our investment portfolios, we believe…

It will be prudent to continue our focus on companies with pricing power, sound balance sheets, and those that we believe are better suited for the next three to five years and the current higher interest rate and inflationary environment, rather than on what has been favored over the past decade.
An overweight position in energy should remain a core theme —not futures contracts but integrated, exploration and production, and service-related companies. We believe all forms of energy will be necessary to meet growing traditional needs, as well as the energy requirements of an ever-increasing and upgrading power grid, and the energy demands required to provide the constant power needed for the build-out of artificial intelligence, data centers, crypto-currency, and semi-conductors fabs.
It is appropriate to have a portion of the portfolio in gold. Currently, we are targeting between 5% and 7% for most portfolios.
Additionally, many industrial names present good opportunities.
Selective financial companies should also benefit from the current interest rate environment.
Technology-related companies, especially those focused on automation, robotics, semiconductors, and artificial intelligence, show great promise.
Importantly, unlike the past 15 years, interest rates now make holding cash or equivalents a reasonable option in the absence of other values.
For our fixed income accounts, we offer a variety of strategies, including cash management and laddered income portfolios. For cash management accounts we roll very short-term US Treasury bonds. For our laddered income accounts, we roll short-term Treasuries but currently also include higher coupon corporate bonds, with an average duration of less than 5 years.
We continually monitor macroeconomics, industry, and company-specific data and will make appropriate portfolio adjustments when we believe they are warranted.

It is important to remember that the US has overcome many significant challenges throughout its history. While today’s economic environment is challenging, the US remains armed with substantial and durable attributes, giving us confidence that it will overcome the challenges ahead.

Century Management ("CM") is an independently registered investment adviser with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Century Management is also registered as a Portfolio Manager in the Province of Ontario. A full description of our Firm’s business practices, including our Firm’s investment management services, wealth plans and advisory fees, is supplied in our Form ADV Part 2A and/or Form CRS, which are available upon request and also at www.centman.com.

Past performance is not indicative of future results. The discussions, outlook, and viewpoints featured are not intended to be investment advice and do not take into account specific client investment objectives. CM reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. Forward-looking statements are not guaranteed.

Positions held within each individual account may not be the same from one account to the next. Individual securities may be traded at different times as well as receive different execution prices. In addition, individual accounts may be pursuing similar objectives but may have different investment restrictions. All investments involve risk and, unless otherwise stated, are not guaranteed. CM-2024-05-08