Ravenscroft Group | Kevin Boscher
04 Jun 21
Boscher's Big Picture - The jury is still out on the long-term inflation prospects
Concerns over inflation continue to dominate markets and news headlines with the recent blowout US CPI numbers providing the catalyst for a sell-off in both stocks and bonds. Although markets have since recovered and appear more stable, the outlook for inflation remains the key issue for investors at the current time. As the US and other global economies re-open and start to normalise, it is clear that a range of economic indicators are being significantly distorted by both surging demand across a number of goods and services together with supply side bottlenecks and shortages. In the post- pandemic world, it will take some time for these distortions to work their way through the system and over the next few months, price and wage fluctuations could be violent but one-time relative price adjustments. Alternatively, they could represent the start of a sustained inflation uptrend that will have major consequences for the global economy and financial markets. In my view, it is too early to see through the fog to the underlying reality.
Short term price spikes and government stimuli
The arguments for higher inflation over the next few months are clear-cut and have been widely anticipated, largely due to the low base effect of the collapse in energy and commodity prices last year. Given that the drop in the reported inflation numbers was at its worst point last May, the numbers should continue to look bad for a while due to these effects, plus the aforementioned Covid-related distortions. For example, the huge spike in used car prices in the US accounted for 0.5% of the 0.9% month-over-month rise in core CPI. The semiconductor shortage cut auto production, which has forced people to buy used cars, driving up prices. Similarly, surging demand for new properties and home renovations, at the same time as raw material shortages are pushing up prices. In addition, whilst there are clearly some wage pressures in certain industries, mainly consumer services, this is largely due to a number of Covid-related factors including the very generous furlough programmes, schools not yet back to normal and concerns around the virus itself. These pressures should subside as the economy re-opens, the vaccination programme reaches a wider spectrum and as the income subsidies are terminated. In the meantime, it’s difficult to argue that wage increases are becoming widespread with nearly 17 million available labour resources, which is six million more than a year ago.
In addition, and at the same time, both fiscal and monetary policies are extremely stimulative as Governments, led by the US, fight battles against Covid, income inequality and climate change. Also, commodity prices are rising and the Dollar is falling, which adds to inflationary pressures. We need to remember, however, that monetary policy has been very accommodative for some time without triggering higher inflation, largely thanks to the powerful secular disinflationary forces at play. In addition, it looks unlikely that Biden will be able to pass his more aggressive spending plans, which means that we may be seeing the peak in the US fiscal impulse. Finally, whilst many people are concerned that rising commodity prices will drive up longer-term inflation, this is a risk, but it should not be exaggerated. Commodity prices soared in the 2000s, but core inflation remained subdued as companies were unable to pass on the increased costs to consumers and the impact was absorbed by either rising productivity or lower profit margins. Also, with China modestly tightening policy and with some of the current demand and supply distortions eventually subsiding, there is no guarantee that commodity prices are in a new secular up-trend.
Return to the norm
A key point here is that the large jump in the inflation rate is reflective of both the severity of the pandemic-triggered recession and the speed and strength of the subsequent recovery. During these dramatic swings, relative price shocks abound, causing erratic moves in reported inflation. Over time, the base effect will wane and the demand for and supply of most goods and services will likely return to trend. Central banks, led by the Fed, are certainly of this view and believe that recent price moves are not necessarily reflective of a long and enduring demand or supply shock. They are also acutely aware of the secular forces at play putting downward pressure on inflation, including high debt levels, an ageing demographic, excess savings, and technological disruption across many industries. Indeed, the accelerating pace of technological change has picked up momentum during this pandemic as businesses and individuals adjust to the new way of working and living. For all these reasons, central banks, correctly in my view, see the rise in inflation as transitory and will stay accommodative. Markets tend to agree with this assessment at present.
Current trends not a repeat of the past
There is a growing view that the current “regime change”, whereby fiscal policy is becoming more dominant and backed up by a very accommodating monetary stance, is similar to the period from 1965 to 1980, when US inflation rose in three major waves from 2% to a peak of over 14% in 1980. It is important to understand the background macro environment to this period, as it is very different to today’s back drop. Inflation initially surged during the second half of the 1960s mainly due to President Johnson pursuing a “guns and butter” policy as he fought an escalating war in Vietnam and another domestic one on poverty, racism, and inequality. This was labelled the “Great Society” programme and it occurred at a time when the US economy was already hot and running above capacity.
The next key event was the breakdown of the Bretton Woods System in March 1971, whereby the Dollar was de-pegged from Gold, resulting in an initial 10% depreciation in the trade weighted Dollar. Oil was another important factor as the oil price firstly more than doubled (from c$4 per barrel to $10 pb) in the early ‘70s on the back of the Yom Kippur war and a subsequent OPEC embargo and then more than doubled again in the late ‘70s, after turmoil in Iran seriously cut supplies. During this period the Fed was very reluctant to let this relative price shock get absorbed by the real economy, largely because the US economy was much more dependent on manufacturing and was already experiencing stagflation, a stagnant economy with high inflation. Consequently, the Fed adopted a very aggressive easing policy whereby it monetised the rising cost of oil, causing the Dollar to decline much further and inflation to surge. This ended in 1981 with Paul Volcker’s “cold bath” policy which included 20% interest rates at the peak. Price inflation has been on an irregular path downwards since this time and perhaps troughed near zero in April last year.
There are some other salient differences between that period and now. The US was essentially a closed economy in the 1970s with imports only 3.5% of GDP. They are now almost four times larger, hence when the economy is running tight, the US can import more, which acts as a safety valve. As the Dollar weakens and import prices rise, this usually results in reduced demand, which again acts as a dampener on inflation and activity. At the same time, there is an abundance of savings in the rest of the world, which means that the US can easily import cheaper foreign savings to make up any shortfall in domestic savings should the economy run too hot. Secondly, manufacturing was almost 25% of the economy in the ‘70s, it is closer to 10% now. The world is currently going through a huge revolution of technological innovation for both producers and users and this is likely to accelerate in the years ahead, as previously mentioned. The rapid digitisation of the global economy, including robotics, AI and 5G are inherently deflationary since they boost productivity and substitute capital for labour.
Finally, unionized workers represented about 25% of the labour force back then compared to approximately 10% today. Hence, wage rigidity is much less likely, especially as many workers must not only compete with each other for jobs but are also competing with workers in low-wage countries. As far as oil is concerned, prices have risen materially over the past year or so as the economy has rebounded strongly. Prices could certainly strengthen further as activity accelerates and given the unstable geo-political background. However, prices are very unlikely to double from here and the US is largely self-sufficient at the same time as China is importing less. If anything, the oil price is likely to reinforce deflationary pressures as the decarbonisation of the economy proceeds and technology continues to reduce the cost of green alternatives.
Economic recovery and inflation
The main argument for inflation becoming a more persistent and longer-term issue revolves around the fact that the powerful economic recovery - which is based on unprecedented pent-up demand, rapid money supply growth and enormous government spending on Covid relief through to infrastructure spending – will bump up against supply-side constraints and put upward pressure on inflation. At the same time, the return to the Keynesian fiscal dominance and monetary accommodation policies of the ‘70s will spur persistent Dollar trade and financial flows overseas, weaken the Dollar, lead to a resources intensive boom in emerging markets and a Mainstreet focused boom in the US. In turn, this will put substantial upward pressure on resource prices and on wages. This has a similarity to the 1970s, but the main difference is that now the economy is recovering from a deep shock and recession, whereas back then, it was already booming, and the inflation “genie” was out of the bottle. Psychology could also play an important role here as inflation expectations start to rise, encouraging consumers to bring forward purchases, hold less cash and demand wage rises at the same time as companies, expecting higher input costs and selling prices, hold more inventory and working capital.
It's true that US household savings (and global savings generally) are at record levels thanks to higher asset prices, reduced consumption and Covid emergency payments. However, there is no certainty that consumers will embark on the expected spending boom since the outlook is still hugely uncertain and for many, repaying and reducing debt levels remains the priority. Consequently, companies are unlikely to significantly increase investment (other than in technology) until the Covid-related confusion clears and before they have more clarity regarding the longer-term prospects for supply and demand. For similar reasons, banks are likely to stay cautious about significantly expanding credit - even if demand picks up - given the uncertainty, tough capital requirements and the risks around rising interest rates.
From a monetarist perspective, US money supply is firing on all cylinders and theory dictates that “inflation is always and everywhere a monetary phenomenon”. Hence, they would argue that the excess money will eventually lead to a pick-up in the velocity (circulation) of money which is a key component of rising inflation. This could happen over time but again it’s not a given. Surging money supply does not automatically lead to higher prices if the excess funding is saved rather than spent, which has been the case for most of the past two decades. For example, for most of the 1980s, the money supply rose strongly but the velocity of money declined, and inflation fell. Also, like everything in economics, you have to look at both demand and supply. Even if the supply is increasing, the demand for money can fall resulting in higher savings and falling velocity. Indeed, it is becoming increasingly evident that the velocity of money is largely a function of interest rates and, has therefore collapsed along with falling price inflation.
Three things to watch
As you can see, it’s incredibly difficult to look through the Covid-related haze and determine the future path of inflation with any degree of certainty. Not even central banks, with all the data and expertise available to them, have much conviction, although they clearly lean towards the current uptick being transitory. We need to remember, however, that both governments and central banks want higher inflation to grow their way out of the debt problem. Having been in the disinflation camp for the past 20 years or so, I am struggling to change my views. I am watching three things in particular; firstly, will consumers actually go on that massive spending spree and draw down of their savings? Secondly, will the huge US fiscal spending plans actually materialise and persist beyond the next year or so? Thirdly, will we see the second round effects coming through over time, i.e. savings are spent, wages start to rise more widely, aggregate demand starts to exceed aggregate supply across many goods and services, companies start to increase their inventory, velocity of money accelerates and psychology begins to shift. I am also conscious that the inflation picture in the US is likely to be quite different to that in Europe and Asia, since monetary and fiscal policies are nowhere near as expansionary and deflationary forces are more powerful ex-US. With China modestly tightening, it’s possible that any excess US spending will be accommodated by a widening trade deficit and/or a weakening Dollar rather than through higher inflation.
In the meantime, global reflationary momentum continues apace, and I remain positive on both the economic and market outlook beyond the next few weeks thanks to plentiful liquidity, strong economic and earnings growth, powerful policy support and reasonable valuations across many sectors. I still expect equities to “climb the wall of worry” and grind higher over the next 12-18 months with the rotation into value and cyclicals continuing. Markets always find lots of reasons to worry. Our long-term themes based around the ageing demographic, increased healthcare spend, technological revolution, environmental challenges and growing wealth of the emerging consumer remain very attractive investments. In the near-term, we could see some weakness due to a number of factors, including inflation concerns and any disappointment around the economic re-openings. However, any weakness would likely prove to be another opportunity to add to equity weightings, as has been the case for some time. Longer-term, caution is required as rising inflation on a persistent and structural basis is probably the key risk that threatens the optimistic macro picture and markets. Hence, we need to monitor this risk closely and ensure that we have the appropriate balance in our portfolios as we navigate our way through the fog.