The Return of Inflation

John Leiper – Head of Portfolio Management – 5th June 2020

Quantitative easing, or QE, is where a central bank creates money to buy bonds. The goal is to keep interest rates low and to stimulate the economy during periods of economic stress. It is typically referred to as ‘printing money’ but the actual mechanism is more nuanced.

QE primarily increases the ‘monetary base’ which is a broad definition of money which includes digital money held in bank reserves. This is shown by the white line in the chart below which has risen dramatically following five successive rounds of QE following the sub-prime mortgage crisis in 2008. The rise in the monetary base is credited with the dramatic asset price inflation we have seen across global bond and equity markets.

On mobile: review chart in landscape mode

The ‘money supply’, called M1 and M2, is different to the monetary base and reflects liquid money such as cash, travellers checks and money market funds. Narrower still is ‘currency in circulation’ which refers to the coins and bank notes held in the economy. As shown in the chart above, these measures of money have also risen but they have lagged-behind the monetary base. This is because whilst QE directly impacts the monetary base it only indirectly impacts the money supply. For example, when the Fed buys government bonds it injects money into the system; some but not all of which will make its way to the real economy.

The transmission mechanism, from the monetary base to the money supply is also affected by commercial banks and their ability and willingness to lend. Over the last decade banks have been less able to do this as they cut back on lending to rebuild capital buffers following the 2008 crisis.

As shown in the chart below, money velocity also declined markedly over the last decade. This has reduced the capacity, or effectiveness, of increases in the money supply to lift inflation in the real economy, which has remained subdued relative to asset price inflation in financial markets.

On mobile: review chart in landscape mode

Together, these two forces: (i) the money supply and (ii) the velocity of money, affect inflation in the real economy.

The chart below shows the year-on-year percentage change of the US consumer price index, in white, versus a Tavistock Wealth model for inflation, in red, which is based on the quantity theory of money described above. As shown, this model has proven a good fit historically.

The global economy is already in recession and over the next few months the economic data will only get worse. Higher unemployment, increased bankruptcies and general economic uncertainty will weigh on employment, consumption and investment. To that extent, over the near term, the crisis is undoubtedly deflationary.

 

On mobile: review chart in landscape mode

However, beyond that we forecast a subsequent rise in inflation as multiple factors overcome both recent and broader deflationary headwinds.

Over the last few weeks, the money supply has risen dramatically as the Fed and other global central banks have flooded the economy with liquidity. This is shown in the chart below which shows the largest year-on-year increase in the M1 and M2 US money supply over the last 40 years.

On mobile: review chart in landscape mode

The monetary and fiscal policy response to the crisis has been to treat it like a demand shock. But first and foremost, this is a supply shock which morphed into a demand shock due to lock-down. This means that when demand does pick-up there will be more money chasing fewer goods and services.

At the same time, the velocity of money should stabilise, and could even pick-up. Unlike the last decade, commercial banks now hold adequate capital ratios which means an improved transmission mechanism from the monetary base to the money supply in the real economy. In fact, the US government is now by-passing this via something called ‘helicopter money’ by sending cheques directly to households. Whilst the amounts sent thus far are small, relatively speaking, we expect more to come over the course of the year.

Further, as economies emerge out of lock-down households will soon start spending recently replenished savings. Whilst critics counter that savings could stay elevated for some time, as uncertainty lingers, we believe spending will rise as higher inflation, and inflation expectations, reinforces further spending.

On mobile: review chart in landscape mode

Politically, it is in the interest of national governments to reflate the economy as inflation erodes the value of debt, which is already elevated and looks set to go far higher. Whilst debt is inherently deflationary it will be paid for by yet more quantitative easing.

On mobile: review chart in landscape mode

Further, electorates will likely demand a continuation of the generous handouts they have received from the government. This makes Modern Monetary Theory, or MMT, an increasingly attractive policy option for politicians. MMT is not too dissimilar from QE but is one step closer to actual money printing and therefore potentially far more inflationary.

There will also be immense pressure, going forward, for companies to repatriate production due to the recently apparent vulnerabilities of international supply chains. In the healthcare sector for instance, it is no longer politically acceptable to have key drugs manufactured abroad. Reversing, even partially, three decades worth of globalisation will lead to a rise in the cost of production. This would operate via higher input costs, dis-economies of scale and a reduction in the available supply of labour and corresponding increase in labour bargaining power in future wage negotiations.

Finally, energy prices are a core component of inflation. Oil prices have fallen dramatically over the last decade, from $150 per barrel in 2008 to -$40 earlier this year. With energy prices this low and capital spending in this space declining, as ESG considerations come to the fore, the price of energy is likely to rise, bringing with it higher inflation expectations and real economy inflation.

On mobile: review chart in landscape mode

For the last decade, multiple structural deflationary headwinds have kept interest rates low, supporting ever higher levels of debt and the dramatic rally in bond and equity prices. These arguments are well known and fully discounted. However, the scene is now set for a return to inflation.

Financial markets are forward looking by nature. The key question is when, and how, markets transition from the existing deflationary narrative and start to price-in inflation?

The answer to this question is not simple. For guidance we monitor a variety of asset classes and economic indicators for signs of a shift in investor expectations. One such development has been the recent relative outperformance of silver. As such we recently initiated a new position in an exchange traded commodity which tracks the price of physical silver.

To summarise, we like assets that perform well during periods of inflation, specifically ‘hard’ assets, such as commodities. Our current preference is in the precious metals space and we now own positions in both gold and silver. However, we are also exploring other options in the commodity complex including agricultural products and industrial metals.

On mobile: review chart in landscape mode

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.  

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