In what has become a question of not if, but when, market participants are largely focused on, “WHEN WILL INFLATION FINALLY RETURN AGAIN!?”. It is indeed a very important question that is central to the way investment portfolios must be structured and managed. Is the 40-year bond bull market going to come to an end? Is there a cyclical reversal to a commodity bull market in the works? Are interest rates on the precipice of a long hiking cycle? As it turns out, a lot of people are convinced inflation is in fact due to make a striking return, predominantly based on the massive amounts of monetary stimulus dumped into markets since the onset of COVID-19. Modern monetary theorists abound, there are clear indications that the aspects of MMT favourable to politicians (namely, the unfettered creation of debt and printing of money) are going to be put into increasing practice in coming years. However, thinking back on the arguments posed for QE-related inflation in the wake of the GFC, this outlook sounds all too familiar. I’m not sure there is an economist anywhere who said in 2009 that “we will see no material inflation in developed markets over the next decade”, but here we are!
In light of this, it is important to consider, as a contrarian: what are the possible disinflationary pressures?
1. Massive Debt Servicing
2020 government deficits are sure to be a blow-out at the very least. US Treasury total public debt outstanding has ballooned since March at the fastest pace on record – a rate five times higher than the average over past decade. That figure, higher by over $4tn YTD, is now a whopping total $27.25tn. It is true that rates are low, but consider that even at current levels, 10% of the FY 2020 US Federal budget will be spent on debt servicing – which does not include servicing the principal! This overhang of debt creates a drag on economic performance, a disinflationary pressure. In order to pay down some of this debt, the US government would need to raise taxes, which would lead to US disinflation. Similar issues face most developed market economies.
Chart 1: US Debt-to-GDP ratio explodes upwards in 2020
The boomer generation, typically defined as those born in the years 1946-64, is not getting any younger. As can be seen in the pyramid chart below, there is a significant clump in the age range 50-70, making for an increasing expected burden on healthcare and pension systems. Those late in their career or exiting the workforce create a disinflationary effect, as they are savers first and foremost. This top-heavy age distribution – especially more pronounced in European countries such as Italy, Finland and the Balkans, spells trouble for those central banks around the world trying to spur on consumption, growth and ultimately core inflation. Population growth is key in this respect, versus the exhibited trends in Western nations of higher life expectancy (now typically above 80yrs) and lower fertility rates (sub 2 births per woman and decreasing).
Chart 2: US demographics by age, gender in 2017
3. Populism vs Globalism
An alternative to an increasing fertility rate is an increase in immigration. But it is no secret that with a rise in nationalistic movements and governments in the past few years, there is little appetite for such an influx of foreigners. Broadly, populism is fuel for inflationary forces such as localizing manufacturing, monopolies, trade frictions, lower productivity, and slower technological advance. Indeed, it was with the beginning of the Trump presidency that the Fed embarked on its latest hiking cycle, bringing the Fed Funds Upper Bound from 0.5% at the end of 2016 to a brief, 6mo high of 2.5% in the first half of 2019. The likes of Geert Wilders (NLD), Nigel Farage (UK), Viktor Orban (HUN), Marine Le Pen (FRA), Jair Bolsonaro (BZL) and Shinzo Abe (JPN) have had their time in the spotlight over the past 5 years – and some continue to, but is hyperglobalism really gone? A side effect of the past 3 decades of integration is an astounding interdependence of global economies. With the incoming Biden administration, it could be very possible to see a more cordial global political atmosphere redevelop, particularly among ‘allied’ nations (eg. less aggressive trade disputes, Paris Accord, NATO exercises, UN progress, COVID vaccine coordination etc.). Any resumption of globalism or, at least, a halt of its current demise, would be decidedly disinflationary.
In short, what we have is a slow but steady Japanification of the entire developed world. That is, anaemic growth, deflation, ultra-expansionary policy and a zombified economy. As a possible indicator, with the extent of the COVID crisis and its response having been digested, gold prices have come down 14% since the beginning of August. Some may say that whilst CPI has remained depressed in recent years, we have seen an unprecedented inflation in asset prices, with which I would agree. In some sense, this has actually worked against CPI-type inflation as well, with the velocity of money having been decreased through post-crisis saving / investing. The growth in financial assets has exacerbated inequality, which is no help for consumption. The retort that the stimulus is being directed to main street this time around (ie. brace for inflation!), is about as long lived as Mnuchin’s stimulus cheques.
Ultimately, inflation could or could not be around the corner. Broad expectation that it is around the corner, by precedent of 2009, is no case to assume that inflation is coming in the short term. There are many complex factors that influence how, when and if core inflation is generated in a developed economy, as any central banker will tell you. As shown, there are factors against inflation in the short term, which means low rates for much longer than currently forecast is a possibility. That is reason enough to expect intense bouts of FX volatility over the coming months and years, especially in a possible QE-plus-YCC (yield curve control) environment, where exchange rates provide a pressure release valve of last resort and true price discovery. It will be more important than ever to understand FX related risks and how to mitigate them in a portfolio, especially because higher FX vol / lower rates will also mean a continued hunt for and protection of yields where they do exist.
Author: Caleb Thibodeau