Inflation: Will the Dog Bark This Time?
In the short run, the shut-in of economic activity has exerted severe disinflationary pressure on the American economy, as slack in output and employment reaches record levels. The Atlanta Fed projects an annualized quarterly decline in U.S. GDP of 45%. But pandemics and recessions eventually come to an end. In the medium run, as the economy absorbs years of potential deficit spending along with unprecedented injections of liquidity, the stage may be set for a rise in inflation.
Over the past two decades, there have been a number of structural factors that have conspired to keep inflation low, typically below the Fed’s 2% target. These include demographics (an aging population inclined to increase savings and rebuild balance sheets), technology (the falling cost of capital goods and the possibility of online shopping), and inequality (wealthier people have a high propensity to save). Financial influences, such as voracious global demand for safe government bonds, new bank regulations that have curtailed lending, and a lack of physical investment, have kept a lid on interest rates and on spending. In the aftermath of the 2008 financial crisis, a collapse of the shadow banking system and in the velocity of money circulation meant that warnings over the inflationary impact of unconventional monetary policies turned out to be false alarms. But the financial system today is healthy, and governments seem to have little appetite for the belt tightening they implemented in the wake of 2009’s budget-busting stimulus. Further, the age of unfettered free trade, globalized supply changes, and labor arbitrage that brought us low consumer prices and weak wage growth, appears to be nearing its end. This time, in short, may be different. *
In this note, we lay out a scenario in which above-average inflation returns to the fore. We evaluate the stages we would expect to go through before inflation becomes a first order worry for investors. We are already some of the way there, though the days of 1970s-style price controls appear quite far off indeed. Finally, we suggest some considerations for investment strategy in a decade with potentially higher inflation rates than the one just elapsed. The standby advice—buy gold, buy property, buy farmland, sell bonds—will not suffice. Investors need a balanced portfolio that will serve them well across a range of economic backdrops and must resist the urge to market-time swings in macroeconomic variables. But, as always, it helps to have a battle plan. Preparation is key.
The Stages of an Inflation Resurgence
Contrary to Milton Friedman’s dictum, inflation is not “always and everywhere a monetary phenomenon”. Yes, in equilibrium, an increase in the money supply without a corresponding increase in production will cause prices to rise. But rarely is the world so simple. Money velocity (the frequency with which a given dollar is spent, which is cratering) matters. Fiscal spending (and the commitment to back it with taxes) matters. Sudden supply shortages or gluts (such as the 1973 oil embargo, or the spike in oil inventories this March) matter. Most of all, expectations matter. Inflation works as a feedback loop. Producers of goods see higher input costs and expect these to continue, so they raise final goods prices. Consumers see prices rising, and bargain for higher wages. Employers see unit labor costs going up, so they raise prices still further. Ultimately this can set off a “wage-price spiral”.
In recent decades, even as unemployment has fallen, expectations of future inflation have remained well anchored below the Federal Reserve’s 2% target. Only rarely since the crisis of 2008 have consumer prices risen by 3% annually. The observed relationship between unemployment and inflation known as the Phillips Curve appears to have broken down. Some have speculated that residual slack in the labor force due to part-time or gig work was holding down the bargaining power of workers. Others suggested that the monopsony power of increasingly concentrated employers was behind low wage inflation. Whatever the explanation, low inflation became a self-reinforcing expectations dynamic in the decade following the Great Financial Crisis. Even with massive government stimulus and an eightfold increase in the Fed’s balance sheet, turning such a process around will take time. Unless policy serves to undermine sticky expectations of low inflation, and all that central bank liquidity actually gets into the real economy—via increased lending by banks and higher money velocity—the dog will likely remain silent.
Below we outline eight steps we would expect to see before a significant, sustained pickup in the inflation trend. There is no guarantee that all of these stages will occur, though each individually is plausible. Based on historical experience, unless the economy goes through all or most of these phases, we would not expect inflation to rise materially over the period of the next several years. For those nervous about inflation’s return, however, these bear watching—we are already some way down the path.
How to Invest for the Return of Inflation
Inflation is one of the greatest risks facing investors. Investors on fixed incomes are particularly vulnerable to a bout of unexpected increases in the price level. Therefore, it pays to keep inflation hedges—precious metals, real estate, or TIPS—at the ready at all times. Simultaneously, when we make long-term investments in fixed income securities, we want to ensure that we are compensated for assuming inflation risk. The “term premium”, or the difference in yield between long-maturity bonds and shorter ones, is an important variable to watch. Currently, it is quite low, suggesting investors are paid very little for taking on the risk of unexpected inflation.
Our counsel now is somewhat subtle. We do not believe inflation is imminent, despite scary stories about massive increases in fiscal spending or monetary aggregates. We do believe, however, that risks now point to the upside, and the policy environment should be considered very carefully as we move forward. As economies exit the pandemic recession, investors will be rewarded for riding a cyclical rebound: industrial, basic materials, financial, and consumer discretionary stocks will perform well. Private investments that take advantage of early cycle opportunities, such as distressed credit, may see a renaissance. But as the period from 2009 to 2013 showed us, investors should be mindful of the long tail of bankruptcies and distress, which, depending on politics, may play out in sovereign as well as corporate credit. The crisis demonstrated that a number of business models and financing strategies are dangerously fragile. Investors should play for recovery but beware stretched valuations and businesses that are binary risks.
In the intermediate term, one can position his or her portfolio for a return of inflation without paying dearly for the privilege. Historic inflation “hedges” such as real estate are relatively affordable now. Investing in infrastructure is one way to anticipate policy shifts discussed above. Metals and energy stocks are cheap as well, although these sectors have been minefields of late. Broadly, we advise to avoid long duration assets without substantial inflation compensation. These could be low yielding 30-year bonds, triple net leases, or royalty streams. Long-term cash flow is terrific, but low coupons in an era of rising inflation are deadly. We also focus relentlessly on pricing power. We prefer to invest in businesses or assets with a durable competitive advantage. That means prime real estate, quality brands, and technological barriers to entry. Pricing power is evident in margins that remain elevated for years. A business which can pass along cost increases is incredibly valuable in a period of rising prices. If they trade at slightly higher multiples than the market in today’s disinflationary environment, we might think of that premium as a form of inflation insurance.
Lastly, our advice is to remain patient and wait. We would neither recommend selling all our bonds nor putting a quarter of our portfolio into gold. The inflation scenario we laid out above is, more than anything, a multi-year process. Each step is contingent. There remain serious disinflationary forces at work in the world economy and they cannot be repealed in a month or even a year. Today, as inflation hedges are fairly cheap, it makes sense to begin to reorient portfolios for a possible future of above-trend price increases. A comeback of inflation would not surprise us as we move past the pandemic and its immediate aftermath. It is best to prepare today.