John Pattullo, Co‑Head of Strategic Fixed Income, shares his views on a question that is on many investors’ minds lately: “What about inflation?”
- There are lots of definitions of inflation: core/headline, cyclical/acyclical, wage/asset price, demand pull/cost push and, importantly, structural inflation. While the term is used rather loosely, an important aspect is often left out — the time horizon.
- Given the large demand shock experienced by economies during the COVID-19 shutdown, we expect low levels of both headline and core inflation going forward, though headline inflation will crater even more and is likely to be negative and more volatile because of the oil price crash.
- In our view, in the very short term, we expect deflation; in the medium term, we expect some cyclical reflation with price volatility. However, it is important not to confuse shorter‑term cyclical inflation with longer‑term structural factors, which could result from a possible and probable regime change.
Two crises (COVID‑19 and the oil price crash) within the existing global financial crisis … is now really the time for persistent inflation?
The most frequently asked question that Jenna [Barnard] and I receive currently is: “So … what about inflation?”
We always find this a particularly vague question, and I hope by highlighting some of the definitions and nuances, I can attempt to answer it properly in this article. I will also map out our shorter‑term cyclical thinking against longer‑term structural threats.
Last summer, I penned a piece titled Do You remember the Global Financial Crisis? (“Ahh – you mean the one we are still in… ?”). I wrote it slightly in annoyance to the junior – and rather overconfident –investment bank salesperson who seemed to be of the opinion that the Global Financial Crisis (GFC) was over. The article highlighted that most nations had accumulated much more debt than even before the GFC, that monetary policy used as a substitute for fiscal policy was broadly ineffective and hence, the malaise of low growth, low inflation and low bond yields would continue to persist.
I also stated in the article that we expected even lower bond yields, given the “Japanification” of the Western world. Some investors ridiculed this view and remained heavily underweight bonds, further choosing to overweight alternative investments such as exotic/illiquid/esoteric credit products – the so‑called “fool’s yield."1 I remember being invited to a “Finding Yield in Structural Complexity” conference, which I was wise enough not to attend! Unfortunately, much of this fool’s yield has performed very poorly recently, which was of no surprise to us.
That article also cited one of our heroes, the economist Richard Koo. In a book published in 2008, he made the point that the real solution to help the world to grow again was a wartime policy response (i.e., using substantial fiscal policy as a complement to loose monetary policy). Pre‑coronavirus, such a response was not politically justified, but fortunately, it is now, and various authorities around the globe have done a great job of bridge financing individual and corporate balance sheets.
We did not anticipate the COVID‑19 crisis and the lurch down in sovereign bonds and short‑term interest rates. But we were not surprised by the direction of travel, rather just the timing. Meanwhile, so many people seem to forget that we are in the midst of an oil crisis, which kicked off in late February just before the COVID‑19 pandemic broke out in Europe. The oil shock alone is a massive deflationary force as well as being destabilizing – akin to the events in 2016. Who could have ever imagined negative oil prices?
U.S. Oil’s Historic Fall into Negative Territory
So, Where Does This Leave Inflation?
There are, of course, numerous definitions of inflation, and people use the term rather loosely. We have core and headline, cyclical and acyclical, wage and asset price, demand pull and cost push inflation, and so on. More importantly, we have structural inflation. Also, what time horizon are we talking about?
The chart below shows the developments in the commonly watched inflation data – headline and core (not including volatile food and energy items) – in the developed economies over the last few decades.
Inflation in the Very Short Term (i.e., the Next Six Months or So)
Given the large demand shock experienced by economies during the shutdown, we expect low levels of both headline and core inflation going forward, though headline inflation will crater even more and is likely to be negative and more volatile because of the oil price crash.
Remember that inflation indices are 12‑month rolling averages; the negative and low oil price months will remain in the averages for many months until they eventually drop out. Thus, base effects matter a great deal. Demand has fallen off a cliff, while supply has adjusted with a lag. It is perfectly reasonable to argue the opposite as we open up again and supply is constrained in the short term.
Inflation in the Short to Medium Term (i.e., Nine Months to Three Years)
Given that supply chains and inventory builds/drawdowns are all over the place, we expect bottlenecks in food and various commodity markets, meaning the rate of change of consumption will outpace the rate of change in industrial production.
The pandemic has highlighted the desire to reshore certain industries for obvious reasons. Such deglobalization will mean things will cost more (known as cost push inflation). Most of the historic inflation in the U.S. in recent years has been in non‑discretionary items such as rent costs (called shelter costs), health care and education, while most goods inflation is actually negative or very low.
Another type of short‑term inflation is imported cost inflation, which the UK experienced rather nastily in 2011 when the consumer price index inflation rose to 5.2% in September 2011 due to the lagged effects of sterling falling materially post-GFC. Sensibly, the Bank of England looked through this imported inflation, which was a temporary phenomenon, and fortunately did not raise interest rates in response. That would have been disastrous for the economy at the time.
Inflation in the Longer Term (Three Years+)
In the very short term, we expect deflation; in the medium term, we expect some cyclical reflation with price volatility (in various guises), subject to the local constraints of the respective countries, which could well be stagflationary.
However, it is important not to confuse shorter‑term cyclical inflation with longer‑term structural factors, which could result from a possible and probable regime change.
We feel there is a pretty good case to be made for a longer‑term paradigm shift. Many, often elderly, commentators (who had experienced the inflation of the ’70s and ’80s) forecasted inflation as a result of money printing by the authorities post-GFC – and were fantastically wrong.
We were also wrong with a short-duration bias in 2010‑11, agreeing with the consensus view, which would have necessitated hikes in interest rates. Then we read Richard Koo’s book and have been long duration ever since – up until the recent pandemic crisis hit the markets – as we saw a world trapped in a low interest rate environment.
Back then, most of the money printing was either trapped in the banking system or found its way into financial markets, resulting in asset price inflation but not Main Street inflation. This time, it is a little different, so we remain open minded. Nowadays, banks are well capitalized and willing and able to lend money (much of it underwritten by the government – or should I say taxpayers!). There has also been fiscal and monetary stimulus on an unprecedented scale. Further, there does seem to be genuine demand for corporations to borrow money, in both Europe and America.
This is where it gets quite nuanced.
The explosion of corporate borrowing in America is intended to build a safety net/cash buffer. Some of the biggest and safest companies are raising longer‑term “bond” money to repay shorter‑term revolving credit lines. More precarious companies are simply terming out short‑term debt.
Time will tell what happens to the excess cash raised. Optimists say the money will tide the companies over and may get invested. It may be returned to bondholders or it may even be used to buy back shares; it all depends on confidence and the economic outlook, of course. In the same way, will the U.S. government’s gifted checks be used to pay down debt, consumed or invested? That is a tougher argument.
Too Much Personal Savings Are a Drain on the Economy
Again, Koo economics suggests this surplus should be captured and spent by the government via fiscal policy. Along these lines, there is much discussion on the “velocity” of circulation (i.e., how quickly money turns over in an economy in a given period of time) in the MV=PT monetary equation.2
In theory, the amount of money in the economy multiplied by how fast it turns over is a proxy for aggregate demand. Simon Ward believes that velocity has fallen, for a number of structural reasons. He argues that the trend decline in broad money velocity reflects a rising wealth-to-income ratio – in other words, money has outpaced nominal gross domestic product (GDP) not because of “hoarding” but because of an additional demand for money due to rising wealth.
The current money supply explosion is massive in a historical context. Mr. Ward feels that the velocity decline is unlikely to fall enough to offset the money supply expansion and hence, this could be inflationary. Again, if this is correct, the longevity of this impulse is up for debate.
Mr. Ward’s longer‑term growth and inflation argument is further supported by some of his economic cycle work (in relation to the inventory, capex and, most pertinently, the housing cycle). Other commentators dismiss the potential for excess demand out of hand. You could argue that it is hard to have excess demand (demand pull inflation) with a massive output gap. It is difficult to find businesses that are short of capacity, apart from the short‑term bottlenecks discussed earlier.
Remaining Pragmatic and Open Minded
Thus, on this point – inflation in the longer term – we remain open minded, or at least try to be. We have remained very skeptical of other mainstream economic folklore such as the Phillips curve for years now.
We do have serious concerns about the now-apparent and broadly accepted monetization of fiscal deficits and an emerging Modern Monetary Theory paradigm shift and yield curve control. Complete currency debasement and helicopter money for all could certainly bring excess demand inflation (by closing the output gap).
Moreover, this could change inflation expectations as well, especially as the credibility of central banks wears thin. We have written on this before. We expect yet more financial repression with negative real yields all over the developed world. Post‑World War II, financial repression was very common in trying to shrink government deficits relative to GDP.
The gold bugs are loving this debasement of money. Why? Gold correlates well with falling real yields. Also, in a relative sense, gold is quite “yieldy,” as we have negative real yields in most countries (and it is in short supply, unlike paper money).
In our view, this is not an ideal environment for sovereign bond investing. Beware cyclical inflation pops and price volatility for now, but do not confuse that with a paradigm shift – not yet, anyway.
1Dan Rasmussen, Portfolio Manager, U.S.-based Verdad Advisers. “Fool’s yield and the wild west of private credit” interview on Real Vision, January 22, 2020.
2MV = PT: Fisher Equation, Quantity Theory of Money. M = Money supply, V= Velocity of circulation, P = Price level and T = Transactions.
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