June 2021 Insights

Inflation or Deflation: Which Is Lurking Round the Corner?

For the first time in over a decade, investors are beginning to fret about the threat posed by global inflation. But is inflation here to stay? Or will it be gone tomorrow? That very much depends on who you ask.

Annual consumer price inflation rising

Annual consumer price inflation in the UK more than doubled in April to 1.5%, mainly on the back of higher energy prices and clothing costs. In May it surged above the Bank of England’s target rate of 2% for the first time in over two years. Prices are also soaring in the property market: the average house price in the UK was up 8.9% year over year in April – a staggering rise considering the country has barely emerged from its deepest recession in 300 years.

In other parts of the world prices are rising even faster. In the US, house prices in March were up 13.2% from a year ago – the biggest increase since December 2005, just before the country’s housing market last came unstuck, with devastating consequences for the global economy.

The Consumer Price Index jumped 0.6% in May, after having jumped 0.8% in April, and 0.6% in March – all three the steepest month-to-month jumps since 2009. For the three months combined, CPI has jumped by 2.0%, or by an “annualized” pace of 8.1%. Core inflation, which strips out volatile food and energy costs, is forecast to hit a year-on-year reading of 3.4%, its highest level since 1993.

Prices are also surging across Europe. In Germany, a country still traumatised by its brush with hyperinflation a century ago, Deutsche Bank’s chief economist has warned that consumer price inflation could soon reach 5% “on a permanent basis”. Germany is one of the world’s three biggest exporting economies, together with China and the US. All three have seen factory input costs surge as a result of rising commodity prices. In China factories are charging their highest prices in almost 13 years, prompting the Chinese Communist Party to launch controls on the prices of wheat, corn and pork.

Many of these rising costs are getting passed on to wholesalers, retailers and in some cases consumers. Sharp rises in global food prices are particularly worrisome given how destabilizing food inflation can be in emerging economies. A United Nations index of world food costs climbed for a 12th straight month in May, its longest stretch in a decade, heightening concerns over bulging grocery bills. The last time global food price inflation was running this hot was in 2011, on the eve of the Arab spring.

Is Inflation Here to Stay?

Unless prompt action is taken to dampen some of the forces fueling the price spikes, including central bank stimulus, we could end up with runaway inflation, warned former Bank of England chief economist Andrew Haldane. And that, he says, is something we want to avoid “like the plague.”

Most central bankers beg to differ. They have shown little, if any, interest in taking the foot off the gas, having adopted a wait-and-see strategy on the assumption that the current price increases are transitory – the result of the so-called “base effect”. The logic is simple: since prices were falling sharply this time last year as the virus crisis brought the global economy to a standstill and the latest year-over-year results are measured from those low points, it is only natural that prices are rising sharply now.

But what if they are wrong and Haldane is right?

Is the recent spike in commodity, factory and consumer prices a harbinger of sustained higher inflation? Or will rising prices peter out as inflation gives way once again to disinflation or even deflation? It is impossible to know with any great certainty. After all, there are compelling arguments for both.

The Case for Deflation

Here are five reasons why disinflation – a decrease in inflation rates – and perhaps even deflation – a reduction of the general level of prices in an economy – and all the problems that could bring (falling company revenues, increased layoffs, rising unemployment, debt defaults, bank collapses, bank bailouts/bail-ins…) should be a bigger cause for concern than inflation:

 

1) Central banks have been trying to create and sustain high inflation for over a decade, with negligible success.

In the wake of the Global Financial Crisis central banks flooded the financial system with heretofore unimaginable sums of newly created money, through myriad asset buying programs and interest rate cuts. At the time, many analysts warned that such unprecedented monetary stimulus would fuel high inflation. But they were wrong. Why should this time be any different?

 

2) China is not in a position to reflate the global economy, as it did in the wake of the Global Financial Crisis.

China’s role in boosting demand for products and commodities was essential in reflating the economy after the Global Financial Crisis. But that is not happening this time. China’s economy has not nearly recovered from the steep recession it suffered in 2020, yet China’s central bank is already winding down its monetary support to the world’s second largest economy, which could end up taking the wind out of the global recovery.

 

3) Today’s soaring prices will ultimately choke off demand, leading inevitably to lower prices.

When prices of a sought after product soar there comes a point at which many people stop buying it. This already appears to be happening in certain parts of the US economy, which is further down the inflation road than the UK. In the past month Americans’ buying intentions (6 months from today), as measured by the Conference Board, have cratered across the three major spending categories: homes, automobiles and major household appliances.

 

4) Debt and demographics.

Last year saw the biggest rise in global debt as a proportion of GDP on record. Global debt is now equivalent to over 280% of GDP, compared to around 210% in 2009. As the US economist Lacy Hunt notes, when debt rises so quickly, it triggers the law of diminishing returns. This pulls down the marginal revenue product of debt – the marginal revenue created due to an addition of one unit of resource (ie the currency)– which then leads to a decline in the velocity of money circulating in the economy, which is ultimately disinflationary.

The current demographic trends are also likely to stifle inflation.  World population growth is weaker than ever. And it is particularly weak in the biggest markets: the US, Europe, China and Japan. Historical experience suggests that as population growth declines, economic growth also declines. The main reason for this, according to Lacy Hunt, is that falling population negatively impacts household, business and even governmental investment.

 

5) One of the major drivers of inflation – the fiscal and monetary stimulus unleashed in advanced economies – will soon begin to fade.

In the past year central banks and governments have unleashed a barrage of monetary and fiscal stimulus to counter the impact of the coronavirus crisis. The measures include bond buying programs, lower-than-ever interest rates, furlough programs, stimulus payments and rent, debt and mortgage holidays. Some of those measures are beginning to expire.

In the US roughly 4.1 million individuals will lose access to emergency unemployment benefits over the coming months. In the UK small businesses will have to begin repaying the £46 billion borrowed from the government through its Bounce Back Loan program.

As these stimulus programs and debt holidays begin to wane, the deferred impact of the virus crisis is likely to be felt more keenly in the wider economy. This is particularly true if autumn gives way to more lockdowns and restrictions. More people will lose their jobs, more businesses will go bust and huge numbers of tenants and homeowners will get evicted, and that is likely to exert a disinflationary or even deflationary drag on the economy.

The Case for Inflation

After nearly 40 years of disinflation and declining inflation, trying to make the case for significant inflation may seem like a tall order. But here are four arguments why this time may actually be different:

 

1) Stimulus is flooding into the real economy.

After Lehman’s collapse, central banks unleashed a battery of monetary stimulus but virtually none of it ended up in the real economy. Most of it stayed in the financial system, where it fueled myriad asset price bubbles. But it did not produce lasting inflation. This time, the monetary and fiscal stimulus is pouring into the real economy.

Combined with an unprecedented growth in government-guaranteed lending, this stimulus has fueled an explosion in the broad money supply. And that tends to fuel inflation. The M4 broad money supply in the US – which encompasses the notes and coins in circulation as well as bank accounts –was growing at an annual rate of 29% by the end of 2020 – the highest year‐​end rate since 1943, when the world was at war. Today, it is still surging at 24%.

“Given the sharp rise in the money supply and the willingness of both the government and the Fed to keep pumping new money, it is obvious that April’s year-over-year consumer price index inflation rate of 4.2% is simply a harbinger of more to come,” said the US economist Steve Hanke, who has advised many emerging economies on how to manage high or hyperinflation.

 

2) Surging demand, tightening supply.

As the Chinese economy takes the back seat in the reflation of the global economy, the US consumer is taking up much of the slack. In March, consumer spending on durable and nondurable goods performed a stimulus-driven spike of historic proportions, reaching $2.4 trillion for the month and triggering record trade deficits for the US economy as many of these goods or their components and materials are imported. In April, overall spending remained at a similar level.

“March and April were the first two months back-to-back in three decades where large-scale inflation has cropped up in the data,” noted San Francisco-based analyst Wolf Richter.

As pent-up demand rises, supply chain shocks and bottlenecks continue to proliferate. The world, as the New York Times recently wrote, “has run out of everything,” from microchips to lumber to housing to running shoes to specialised resins used in car paint. All are rising in price, as too are transport and shipping costs.

 

3) Rising Chinese labour costs?

In 2020, the average Chinese worker earned 30% more than he did in 2016. This is a vital trend to watch given that China’s entry into the global trading system just under 30 years ago took away the pricing power of labour just about everywhere else. And that drove a disinflationary trend that lasted for decades but now appears to be reversing.

 

4) Even if central banks wanted to keep inflation in check (which they apparently do not despite the fact that promoting stable prices is one of their primary mandates), they may not have the means to do so anyway.

The Federal Reserve has been talking about reducing its balance sheet since QE3 ended years ago. But the only time it actually tried to do so, in 2018, it led to a market meltdown and a sharp reversal of policy. If the Fed cannot taper its bond purchases, it is safe to assume that the ECB will not be able to either. For the moment neither central bank seems interested in even trying. Nor, for that matter, does the Bank of England despite its chief economist’s dire warnings.

This is why we believe that inflation is probably here to stay, at least for the short to mid-term and quite possibly for longer. Not only are we seeing a constellation of interacting forces that are creating the ideal conditions for inflation to flourish, but one of the biggest facilitators of inflation – the world’s biggest central banks and governments – appear to have no interest in actually trying to bring it under some semblance of control – at least not until it is too late!

That said, while inflation is in our view the more likely outcome in the coming months, there is no way of being completely sure about it. The global economy is in an incredibly volatile moment right now and inflation is an exceedingly complex force. A large part of it is driven by current expectations of what will happen in the future. And right now, most people seem to think the global economy is recovering strongly from the virus crisis. But that perception can change very quickly.

What is more, if inflation accelerates fast enough, it will eventually force a natural response from interest rates. As interest rates begin to climb, inflation should begin to decelerate and eventually fall, but rising interest rates are likely to unleash a whole set of other problems, including potentially a sharp correction in the financial markets, real economy and housing markets. If that happens, what would central banks do?

Our guess is that they will double down even more on stimulus, since that is what they have done every time there has been a wobble over the past 12 years. And that stimulus could be even greater and as such possibly create even higher inflation. In other words, further government and central bank policies to support markets and economies could produce more inflation, particularly if it is true that the future does ‘rhyme’ with the past.

Navigating the Uncertainty

How does one chart a course for such an uncertain future? What can one invest in to protect one’s wealth as well as possible from two completely divergent economic realities?

We recommend holding adequate cash in case of unexpected financial or deflationary shocks and to take advantage of buying opportunities that may arise.  Some commentators suggest holding precious metals as an inflationary hedge, a strategy which tends to be most effective when interest rates are below the inflation rate.  As well as physical holdings of precious and monetary metals, and other commodities, mining stocks are also considered to be useful inflationary hedges.  These tend to have historically low valuations at present and can offer useful dividend yields.

More traditional investment hedges might include large cap global companies, particularly those offering a reasonable yield.  We are told that higher growth equities are more vulnerable to rising interest rates (which are more likely in an inflationary scenario), however we believe that exposure to technology and also environmentally friendly investments (particularly related to decarbonisation) offer scope for significant investment returns in the coming years.  The latter types of investment are also aligned with demographic changes such as the increasing political and economic influence of the millennial and younger generations. More environmentally friendly companies are a sector where the United States seems to have particular strengths, and which may well see considerable investment inflows, particularly as the US attempts to maintain economic dominance and technologically based competitive advantage.

Finally, although we tend to think of crypto currencies as extremely speculative and too volatile for most of our investors, some argue that those in limited supply represent ‘hard assets’, offering inflation protection in a world where currency printing is seemingly unlimited.  We feel that the jury is still out on this, but an open mind is never a bad thing.

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