Ariel Bezalel and Harry Richards explain why deflationary forces still hold sway in the global economy and where they’re finding opportunities in Jupiter’s global unconstrained bond strategy.
The vast scale of government and central bank support provided to the economy over the last six months has led many investors and market commentators to question whether, after decades of low and declining inflation, we have reached an inflection point where inflationary forces will have the upper hand over the coming years.
Adding fuel to this debate is the Federal Reserve’s new policy of Average Inflation Targeting (AIT), which aims to deliver maximum employment. The Fed has confirmed it will not raise interest rates until inflation has been higher than 2% “for some time” and projects no rate rises until 2023.
So, are we moving from a deflationary environment to a more secular inflationary environment? We think it’s doubtful.
As it stands today, the average inflation level stands at 0% across developed markets. We have long argued that the powerful structural forces of too much debt, ageing demographics and technological disruption (the ’three D’s’) will continue to provide disinflationary pressure. These are deep structural forces that have been decades in the making and will certainly not disappear overnight.
Japan, which has been engaged in a quantitative easing (‘QE’) programme since 2001, highlights that eternally loose monetary policy alone is not enough to fuel inflation given the weight of the three D’s. While the tweaks to the Fed’s framework might have important implications in the long run, especially when near to or having achieved full employment, for now they simply serve to provide firmer forward guidance. In that sense, we have seen it all before – low interest rates accompanied by aggressive bond-buying has been the Fed’s approach for a decade, yet they have consistently undershot their 2% inflation target. Why should now be any different?
People are saving more and spending less
The rapid growth in the Fed’s M2 measure of money supply is a key factor behind reflationary hopes. Theory might suggest this heralds a spike in inflation, but you can’t look at money supply in isolation – it is critical to also consider the velocity of money. This is a rate that measures how often a unit of currency is used to buy goods or services. The coronavirus crisis has induced a precipitous fall in the velocity of money. This suggests that more people are saving or investing their cash, rather than spending, which is inherently deflationary.
The velocity of money has declined
Source: Bloomberg as at 22 September 2020
Night of the living debt!
Much of the increase in money supply has been driven by QE. But we are sceptical of QE’s impact on the real economy, since it is essentially just an asset swap that results in cash being parked at the Fed. These are funds that commercial banks cannot touch. So, we don’t see conventional QE as a meaningful inflation risk. It is banks that create money and therefore inflation, not central banks, and banks remain reluctant to lend – in fact, US banks are tightening lending standards.
US banks are tightening lending standards
Source: Bloomberg as at 22 September 2020
Much of the stimulus-driven explosion of corporate debt in the last six months is being used to service liabilities or replace lost revenue, rather than being put into productive projects. This debt is keeping “zombie” companies alive – businesses that would be unable to survive without the extremely low interest rates which allow them to service their debt load.
Hasn’t Covid-19 driven prices up?
Covid-19 has definitely muddied the inflation picture due to rapid shifts in spending habits. For instance, people have been buying more goods and fewer services (‘stockpiling’ food and essentials led to inflation in those sectors), while used car prices in the US are rocketing as more people decide to drive rather than take public transport at a time when used vehicles are in relatively short supply.
But Covid-19 has also brought with it some powerful new deflationary forces, including the fallout in commercial real estate. Moreover, used car purchases are mainly one-offs. There has also been a collapse in global travel and tourism, which represents as much as 10% of global GDP. Some of that demand may be slow to return; it took airlines around six years to recover capacity following 9/11. There is also lot overcapacity in the airline sector which is unlikely to come back.
Monopolies, China, and the weak power of labour will thwart deglobalisation
There is no doubt that a combination of geopolitics and Covid-19 has highlighted the fragilities of long, complex, global supply chains. Many developed economies are now considering whether to ‘re-shore’ manufacturing facilities as a result. This potential for ‘deglobalisation’ is often cited as another reason for greater inflation to come.
But there are a few roadblocks to this argument. First, relocating supply chains back to developed economies may lead to cost-push inflation, but it would also leave countries like China with excess capacity, which typically results in price deflation. This disinflationary pressure may go some way to negate the cost-push inflation in the developed market that is conducting the reshoring. It’s also worth noting that, in theory, cost-push inflation causes lower economic growth and a fall in living standards.
Second, the power of global monopolies alongside the current high unemployment levels caused by Covid-19 cost-cutting will continue to supress wages and deepen income inequality for some time to come. Ultimately, this lays the foundations for consumer spending to remain challenged which in turn risks causing defaults rates to rise for both consumers and corporates.
The game changer for inflation would be if central banks were to get more serious about more extreme policy, such as Modern Monetary Theory (MMT), ‘helicopter money’ (making payments directly to consumers) or a more permanent shift towards debt monetisation. But we believe that point is still one to two years away.
In the short term, inflationary pressures may fluctuate but as investors who seek to balance risk and reward, we look to longer term trends. There remain plenty of opportunities in today’s bond markets for experienced investors to unearth. Given the deflationary backdrop, we believe a healthy allocation to AAA-rated government bonds remains warranted, while in corporate credit markets, given supportive central bank policy, we are focusing on companies with robust business models that can withstand the uncertainties ahead.