Debt is soaring and unorthodox policy stimulus from central banks is in overdrive, courtesy of coronavirus. For some investors, the cost of such efforts is inevitable: inflation will come roaring back in coming years.
Rising inflation would provide a particular challenge for investors in bond markets, a point that registered in conversations at this week’s FT Global Boardroom conference. The current very low levels of fixed long-term interest rates provide scant protection against an inflationary pulse beating even a little faster inside the next couple of years.
A deep recession, even of a short and sharp variety, means that deflationary forces are strongest at the moment — a prospect underlined by the latest consumer price data from the US and China this week. And time is a slow healer of any pronounced “output gap” — a measure of spare capacity that estimates the difference between the economy’s current level of output and what it could produce without generating inflation. Many economists do not expect that gap to close before 2021. The IMF forecasts a total loss of about $9tn in global output over the next couple of years.
This suggests central banks will struggle to meet their inflation targets, just as they struggled in the aftermath of the last financial crisis. Indeed, expectations of inflation in the bond and derivatives markets for the next decade are still stuck at very low levels in the US and Europe, with only a modest uptick from their recent lows.
Prudent investors, then, should look at building long-term inflation protection into portfolios ahead of price pressures rebounding, once the economy and oil prices recover in coming months. Such strategies should also home in on cheap commodity prices and companies in the industrials and materials sectors, which are trading at inexpensive levels on various measures.
Some argue that pent-up consumer demand will drive prices upward during the recovery, while others say it will be caused by higher costs of production as companies start to unpick their global supply chains.
But the real question, when assessing the likelihood of a more intense inflationary era during the 2020s, is whether central banks can persuade markets that they are not engaged in “monetary financing” — or a permanent expansion of their balance sheets with the aim of funding the government. Andrew Bailey, governor of the Bank of England, recently stressed this point in the FT opinion pages.
But as central banks and governments work increasingly closely to protect economies from the worst effects of the virus, the idea is not so abstract.
Holders of gold — a classic inflation hedge that has risen by about one-third over the past year — certainly sense their moment has come when they look at central banks upping their holdings of government and corporate bonds. With the Federal Reserve’s balance sheet set to rise beyond $10tn this year, some argue this could become a permanent feature of monetary policy, tipping the financial system towards outright debt monetisation.
For now, central bank purchases of bonds are designed to keep long-dated yields low, and as a result, the stimulus provided by quantitative easing remains locked within the financial system. This has been the story for more than a decade of QE, spurring inflation in the prices of financial assets rather than spilling out into the broader economy.
The current record growth in the US money stock for example, has been accompanied by a further decline in its velocity, according to the St Louis Federal Reserve, extending a structural slide since 2010. The velocity of money — or the rate at which it is exchanged within an economy — appears to matter, then, in terms of generating broad-based inflation pressures.
Many note Japan’s post-bubble experience, which suggests that a huge increase in the monetary base does not automatically lead to inflation. Deutsche Bank noted: “As global demographics deteriorate, so disinflation becomes politically attractive; old people prefer low prices to protect their savings.”
Also stemming an inflationary surge is the risk of exacerbating government deficits, which would cause an adverse reaction in bond markets.
Paul Donovan, chief economist at UBS Global Wealth Management, noted that with a pick-up in price rises, government spending linked to inflation such as pensions will rise, meaning that deficits climb. In turn, bond investors are unlikely to stand idly by, and will demand higher yields for new debt that funds future deficits. A likely solution, argued Mr Donovan, is one in which governments compel institutions to hold government debt via regulation — a tactic known as financial repression — while keeping inflation relatively contained.
So for now, investors should be pragmatic. It might be too much to anticipate a 1970s-style resurgence of price rises. But denying outright an eventual rise of inflation seems foolish.
michael.mackenzie@ft.com
Source: Economy - ft.com
