THE CASE FOR INFLATION TO STAY UNDER CONTROL
Perhaps the most discussed topic today is that of the direction of inflation. It obviously matters to pension funds with inflation linked liabilities. It also matters to other investors, because of the impact of higher inflation on asset valuations.
For nine years, Linchpin has done an annual inflation survey by monitoring 13 indicators. In December 2020 the net score was +3, compared to +1 a year earlier. We were still wary of predicting an immediate surge because of the powerful deflationary forces we still saw, such as technology and the over supply of labour in the world.
Nine months later, high street inflation has risen to over 5% in the U.S., close to the highest level in twenty years. While food prices were the main driver earlier in the year, right now energy is responsible for the surge. In the U.K. there are additional supply side blockages resulting from BREXIT to contend with.
The question for investors is whether this is the beginning of a period of higher sustained inflation. We think unequivocally not, and this article sets out why. We agree that inflation looks almost inevitable in the longer term, because indebted governments have a huge incentive to inflate away the real value of their debt. That said, we do note that over history, bouts of higher inflation have been interspersed with centuries of none at all.
However, we do not think this year’s jump is the start of a sustained inflationary period. The starting point of our case is that the world’s economy is already slowing down again. The headline flash figure for the U.K. in July suggesting no growth at all is just one number. Much more important are indications of business momentum. Our friends at CrossBorder Capital measure daily economic data releases against consensus estimates (i.e. net surprises) and have noticed a steady and significant decline. In fact, in the U.S. it peaked in September 2020, in Asia in January 2021, and in Europe in June 2021.
They would argue that the withdrawal of monetary stimulus is another indicator of a future slow-down in the economy. It may not be coincidental that the global data here also started turning downwards in September 2020 and CrossBorder would make a case for causality. Over the past year the ECB has been the tightest major central bank, despite its pronouncements, and the Federal Reserve the easiest. We note in passing that the Bank of England has been even tighter than the ECB, which increases the risk of a significant policy error.
We then turn to bond markets, where the fall in yields has taken many investors by surprise. We have in previous articles mentioned that it may be a function of the reliance on repo markets to keep the financial system afloat, and their requirement for good quality collateral – aka US Treasuries. Regardless of that, the flattening yield curve is consistent with both a slowing economy and lower inflation. The US ‘break-even’ measure of inflation is currently at 2.3%.
What would make us turn out to be wrong? The key risk to me seems to be supply side shocks. A lot of what is driving high street inflation at the moment is driven by a shortage of supply: natural gas most obviously, but also everything from carbon dioxide through second hand cars. In the U.K. the effects may have been exacerbated by BREXIT, but other countries are seeing similar trends, so it is clearly wider based than that. Disruption to international business caused by COVID is an obvious cause, but there may be additional factors such as the shift towards shorter supply lines. If these supply-side issues prove to be sustained or new ones such as climate change activism kick in, inflation may stay higher for longer. Bond markets are not currently pricing this in, so this has the potential to cause a shock to markets.
Finally, if inflation does subside to a more comfortable 2 to 3% level, what does that mean for markets? We would argue that at least in the short-term 10-year bond yields will remain at around current levels of around 1 to 1.5% in the U.S. That still means a negative real interest rate of around 1 to 1.5%, which would probably be acceptable to the Federal Reserve. We expect yield curves further out on the curve to flatten further as risk appetite wanes with economic growth. In passing, it is interesting to consider the Chinese bond yield curve, which is much steeper at the short end, but flatter between 2 and 10 years’ maturity. We would argue the distortion is in the U.S market, coming from the need to collateralise repo markets, and not in China.
As for equities, they do not look massively overpriced if our view is right and bond yields stay low. However, if inflation does prove sustained and bond yields rise, all bets are off. Equity valuations have historically fallen when inflation levels exceed 2.5%, and the long duration of growth stocks may exacerbate that this time round. The prospect of stagflation would be even more alarming for investors.
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