Everyone knows that inflation is the elephant in the room that is the global economy. But, actually, there are two inflation elephants in that room, and not everyone can see both.
The inflation caused by the government stimulus, money creation and supply shocks of the Covid19 crisis is the elephant visible to all. The older, larger, and more problematic elephant is the decades long decline in global inflation that began in the mid-1980s in the US and even earlier in other developed countries.
Great emphasis is given by commentators to the question of how high current inflation will go and how long it will endure as the Covid inflationary pressures pass through the global economy. The first elephant gets all the attention.
But an equally important question is – what longer term inflationary conditions will prevail in the global economy after the inflationary effects of Covid are fully in the rear vision mirror? Will the powerful deflationary forces of: ageing populations, tech advances, globalization and increasing wealth inequality, which shrank inflationary expectations for decades, return in full force in 2023/24? Or, alternatively, is the global economy so changed by Covid and other factors that the deflationary forces never reappear?
It is not enough to myopically focus on the shorter-term inflationary effects of the Covid crisis. To make good choices, investors need to comprehend both short term inflationary pressures and long term deflationary pressures in the global economy, and the interaction of the two.
Two elephants are certainly more complex than one. If Covid induced inflation was the only source of uncertainty, then we could reduce the inflation problem to two primary scenarios – inflation falls away quickly or inflation persists. But when the uncertainty of whether powerful, long term deflationary forces reassert themselves is added, then the minimum set of scenarios is four.
Scenario 1: Debt trap (Road to Japan) Inflation falls quickly / Deflationary forces return
In the Debt Trap scenario Covid induced inflation falls away quickly and the enduring deflationary pressures of the pre-Covid world return. The name Debt Trap refers to a situation in which more and more debt is accumulated as central governments and central banks struggle to maintain enough aggregate demand for goods and services in the economy to stave off outright deflation.
This is not a theoretical situation. This was the actual state of the global economy immediately before the arrival of Covid19. Total global debt across households/corporations/central banks/governments rose from 115% of global GDP in 1982 to 265% of GDP in 2019 (and is now 305%). Central banks fear that we will return to an unsustainable path that leads to the slow motion trainwreck of ever deeper levels of debt.
In this scenario, where current inflation falls away quickly, central banks would quickly end their tightening of monetary policy by ending interest rate increases and ending the unwinding of QE.
As inflation continues to fall to the very low pre-Covid levels, investors would conclude that even the massive stimulus of the Covid crisis could not suppress global deflationary forces for long. Shares, bonds, property and other asset prices would then rise considerably under the expectation of a return to near zero interest rates and eventually new rounds of QE.
Scenario 2: Reversal Inflation rises, persists and then falls / Deflationary forces return
The Reversal scenario ends in the same way as the Debt Trap scenario with powerful deflationary forces eventually overwhelming the inflationary effects of Covid.
The difference in this scenario is that current inflation continues to rise and then persists before falling. Central banks would need to continue to tighten monetary policy aggressively to bring inflation under control, which will drive asset prices down. But then share, bond, real estate and other asset prices rise as central banks are forced to end tightening of monetary policy and eventually return to low interest rates and even new rounds of QE.
This scenario is named Reversal in reference to the expected fall and then rise in asset prices as monetary policy is aggressively tightened to suppress inflation and then eventually loosened as deflationary forces re-emerge as the dominant feature of the global economic landscape.
Scenario 3: Goldilocks Inflation falls quickly / Deflationary forces do NOT return
This scenario is the best of both worlds in which inflation falls quickly into the middle of central banks’ preferred range of 2-3%. But powerful deflationary forces do not again materialize. So central banks can maintain their target levels of inflation without resorting to the very loose monetary policy of low interest rates and QE.
In this scenario we should expect asset prices to rise a bit from current levels as inflation concerns abate, but then asset prices stabilize.
Scenario 4: Stagflation (the 70’s show) Inflation rises, persists and then falls / Deflationary forces do NOT return
This is a nightmare scenario for asset prices. Inflation goes higher and persists at high levels. Central banks get no help from long term deflationary forces in controlling inflation. Therefore, monetary policy must be tightened aggressively. And, tight monetary policy must persist even as economic growth slows or stalls completely.
This is a world of high short term interest rates, high real interest rates, falling earnings growth and low business and consumer confidence. Asset prices will fall very substantially across all asset classes and stay down if this scenario eventuates.
The bond market is expecting the debt trap
Treasury bond yields are the rate at which the Federal Government can borrow money for different lengths of time — 3 years, 5 years, 10 years, 30 years. There are standard treasury bonds and bonds protected against inflation. The yields of these bonds can be analysed to show how much inflation the bond market expects in future periods.
US treasury yields predict that core US inflation will fall very quickly from its current level above 6% to less than 2.5% and then remain there. But also embedded in those yields on 30-year treasury bonds is a real interest rate of only 0.9%, which is far lower than average historical averages of over 2.0%. The low long term real interest rate implies that the US Federal Reserve will eventually be forced back to long term loose monetary policy to fight deflationary forces.
So, US treasury bond yields tell us that bond market investors are expecting the debt trap scenario. Investors who expect that scenario should hold their position in the market, and if they are in cash then get invested.
We can see that much of the US share market also expects the debt trap scenario, otherwise the S&P500 would have fallen by more already.
Sam’s money is on Reversal
For what it is worth I am expecting the Reversal scenario to play out. I expect that inflation will persist from here and require substantial tightening of monetary policy to bring inflation under control. I also expect that powerful deflationary forces will eventually resurface.
It is the tightness of labour markets and the amount of cash that households have at hand ready to spend that makes me believe that demand growth will exceed supply growth for a period. Investors who subscribe to that scenario, like me, should wind back on risk in the short run (especially wary of debt). If they have a large allocation to cash, then make a plan for re-entering the market as it moves down.
In a reversal scenario you don’t want to get to the other side of the reversal without being fully invested.
Copyright 2022 Sam Wylie
A shortened version of this article first appeared in the AFR on 6 July, 2022