Financial Market Flash of March 4, 2021 -
What to make of the current debate on whether inflation is back (or not)?
Deputy Chief Executive Officer,
Chief Investment Officer
Inflation occupies a dark corner of savers’ collective unconscious, with several painful episodes in our recent memories as citizens and investors. Without going all the way back to 1920s Germany, the latest bout with inflation occurred in the late 1960s and early 1970s, driven by the double shock of a run-up in US federal debt to fund the war in Vietnam, followed by a spike in oil prices during the 1970s. These are indeed very painful memories for investors, and after hitting 1000 points in 1966, the Dow Jones did not surpass that mark again meaningfully until 1982, after radical economic and monetary measures had been taken, precisely to get out of the inflationary spiral!
With all that in mind, what are we to make of the current debates over the desired return of inflation?
Central banks are enlivening this debate by maintaining massive monetary creation policies and 2% inflation targets in the US and the euro zone, targets that are having a hard time being met. In the euro zone, for example, inflation has not exceeded 2% since 2011. Meanwhile, given the massive debt that both governments (and companies) have piled up over the past several years, and which is being aggravated seriously by the Covid-19 crisis, higher inflation would help reduce debt/GDP ratios more rapidly by providing an extra boost to nominal GDP.
So, inflation is once again a hot topic. At first glance, this seems to be at odds with an underlying feeling that Western economies have plunged into a sort of “Japanisation”, i.e., a prolonged period of deflation.
But there are, in fact, several factors now pointing to a resurgence in inflation:
- In the short term, a robust, vaccination-driven economic upturn is expected, and that is pushing commodity prices up. Meanwhile, the energy transition is squeezing some sectors and pushing up costs for manufacturers; demand for semiconductors is increasing more and more, due to advances in the Internet of things, and transport costs are also being driven up by lockdown- related disruption of the container market, and stimulus plans could very well exacerbate these bouts of overheating.
- In the long term, major countries’ recent monetary policies have inspired surprise and, even more so, fears. This massive monetary creation was born of the expansion in the balance sheets of all the world’s major central banks. This raises the basic issue of currencies’ valuation compared to real assets, an issue made even more pressing by the surge in cryptocurrencies, Bitcoin in particular. Meanwhile, latent “trade wars” and onshoring of production facilities are also likely to raise the price of goods in the medium/long term and, hence, boost inflation. We might add that governments, which, as a group are highly indebted, have every interest in seeing an increase in inflation, as that would create conditions more favourable to reducing debt/GDP ratios.
Central banks have created a form of inflation by driving up financial market prices (see chart) and real-estate prices in particular, which have benefited from the spectacular drop in interest rates
International equities and central bank balance sheets
To conclude with this issue of a possible comeback of inflation, as a long-term investor, we do feel that we are arriving “at the end of the road”: traditional 60/40 bond/equity portfolios, regardless of which asset class is overweighted, have performed remarkably over these past 40 years, with especially efficient Sharpe ratios (i.e., risk-adjusted returns). For, whenever economies slow down, with the inevitable negative repercussions on corporate earnings and, hence on equities, interest rates decline and push up bond prices. It happens that the past 40 years have coincided with a long period of disinflation and hence a natural decline in interest rates. But that was then, and this is now!
It now seems that we will have to decide between 1/ low growth and low inflation; 2/ robust growth and a natural increase in interest rates; and 3/ stagflation. In such conditions, the current period of a robust economic recovery and the maintaining of interest rates at low levels looks like a short-term exception.
What is the reality as things now stand?
Many observers feel that current measures of inflation are not relevant, as we are already in an inflationary situation in some sectors, including real estate, construction, financial assets and others. This is true. But in the meantime, let’s look at the available“official” indicators that serve as benchmarks in the conduct of monetary policies.
The latest statistics indeed point to a significant upturn in inflation from its very low, Covid-19-caused levels. This might look like good news for central banks in approaching their 2% target (i.e., the Fed and the ECB). But, for the moment, and as inflation is often measured on a last-12-month basis, it is mainly an inevitable rebound from the unique situation of last year.
We are therefore now seeing a mere rebound in indicators, not yet the start of a spiral
World: total inflation (year-on-year)
The coming basis effects (1) will therefore accentuate this recovery. Inflation is accelerating because the economy is picking up. Oil prices have risen significantly over the past year, and the pandemic’s deflationary impact on the prices of certain services will fade quickly with the gradual restarting of consumer spending against a backdrop of of upward pressure on companies’ costs (e.g., higher freight costs, semiconductor shortages in certain sectors, higher commodity prices due to China’s appetite, prices driven up by trade tensions, for example in lumber prices). Meanwhile, it is quite possible (especially in the United States) that a scenario of rising wages, particularly in light of Joe Biden’s decision to raise the federal minimum wage, will ultimately show up in end prices.
In the euro zone, inflation suddenly rebounded in January to a high not seen since February 2020. The euro zone consumer price index had fallen on a last-12-month basis since last August, but rose by 0.9% in February. Granted, this was only a slight uptick and inflation is still far too weak to erase deflation fears. In particular, it remained far below the 2% defined as the pace of increase in this index corresponding to price stability.
Keep in mind, as well, that on both sides of the Atlantic we are far from full employment, which seriously lessens the risk of a wage/price spiral in the short term, something that the Fed and ECB point our regularly.
The markets have already taken on board a return of inflation, but at moderate levels for the moment, as seen in the charts below on implied inflation trends as priced into inflation-linked bonds.
Realised inflation has already started rising in the euro zone...
Inflation in Europe
...and in the US...
Inflation in the US
...and 5-year US inflation expectations have, within a few months, risen from 1.2% to almost 2.3% currently.
5-year US inflation expectations
Meanwhile, five-year euro zone inflation expectations have risen in a few months from 0.7% to 1.4% currently
5-year euro zone inflation expectations
Similarly, in the euro zone, 10-year German inflation expectations, as priced into inflation-linked bonds, has risen from almost 0.2% to 1.10% currently
10-year German breakeven inflation*
* This instrument measures the difference in yield between a nominal bond and an inflation-linked bond, hence expressing the market’s inflation expectations
These charts show us that the markets have already priced in a rebound in inflation but are not expecting a spiral at this point (the orange boxes show that we are currently in a long-term tipping point).
Accordingly, there is clearly a small risk of a short-term spike in price indices, especially in the United States, where inflation could hover around 3% for a few months, a scenario that has already been envisioned by the Fed, which has flagged that it would not intervene in that case. In the euro zone, we are still far from the 2% target.
In the longer term, it is still too early to grasp the future impact of current monetary policies.
We can only point out that the intrinsic value of currencies is naturally likely to have fallen compared to the prices of real assets, at orders of magnitude that would be proportional to the monetary expansion following the expansion in central bank balance sheets. With this in mind, the main currencies are expected to have lost about 25% to 30% compared to real asset prices. It is nonetheless difficult to draw clear conclusions from these “simple” considerations. There is no “theoretical” limit to the expansion of central bank balance sheets. Moreover, as the world’s main central banks have adopted the same strategies for supporting economies, there have been no major shifts in exchange rates between the main currencies, which is one of the parameters of inflation trends in various countries.
Also in the longer term, deflationary forces do not look “dead”!
Globalisation and the growing interconnection between economies for almost 30 years now and especially since China joined the World Trade Organisation, have led to an across-the-board decline in prices of industrial goods, something that has benefited all consumers. True, some doubt has now been cast on this model for environmental reasons and because of countries’ political and social desire to onshore their production facilities. This has created trade tensions and stirrings of protectionism, in the form of higher customs duties, for example. Even so, based on the Sino-US conflict, it would seem that end impacts were minor in scale and onshoring of production facilities back to the US, marginal. The reason for this is that you need time to reorganise production chains, which are now intensely globalised, and economic logic always ends up ruling the day.
Productivity gains engendered by digitalisation and technological progress. It is very hard to evaluate these factors, but, in our view, the recent acceleration is likely to accentuate this trend further.
An ageing population in the West and in China. Demographic vitality is a key factor in growth and, accordingly, in demanddriven trends in inflationary pressures. From this point of view, the situation is critical in the US and Europe, as well as in China, something that, once again, recalls the situation in Japan.
In the short term, there are many signs that suggest that inflation is on its way back. However, keep in mind that our starting point was highly depressed and that upcoming base effects will be favourable. We could therefore see a foray into the 3% zone in the US (without triggering any reaction from the Fed, which has already taken on board such an eventuality) and the 2% zone in the euro zone.
For the moment, it is hard to imagine a spiral taking hold beyond current levels in the current situation. We are more on the cusp of exiting a deflationary period than on the eve of structural inflation. That, in any case, is our baseline scenario.
The scenario of an inflationary spiral is still with us, however, driven by issues raised by the consequences of unprecedented monetary policies. We have no real conviction on this issue, but if you do fear this scenario, the best hedges are inflation-linked bonds hedged for sensitivity risk, and real assets, including gold. The spike in cryptocurrencies also reflects fears of such a scenario, but we do not yet have a firm conviction on these new assets.
Document completed on 04/03/2021