Every day seems to bring new headlines about the imminent return of inflation, but does the data reflect statistical swings in the pendulum or is this the beginning of a renewed trend?
Our firm view is that we will remain in a low-interest-rates-for-longer environment. While there will undoubtedly be a spike in growth and inflation once economies reopen, we believe this will mostly be due to low base effects and some temporary supply bottlenecks, and that these pressures will fade away after one or two quarters at most. In the short term, inflationary pressures will fluctuate but as investors who seek to balance risk and reward, we look to longer term trends. Structural inflation everywhere is being kept in check by the combined drivers of too much debt, ‘zombification’ of the corporate sector, ageing demographics, and disruption from globalisation, technology, and low-cost labour.
The good news is that the success of the vaccine rollout in developed markets has created a level of justified optimism. What remains harder to determine is whether the incredible valuations of both corporate credit and equity can be sustained if central bank support were to be removed. While it seems that central banks don’t want to rock the boat for now (we don’t expect any rate rises in the US for years, in fact), the underlying structural issues justify caution.
Growth is hard to generate in a highly indebted world
The eye-watering amount of global debt is central to why we believe the uptick in inflation is transitory rather than structural. Global debt levels climbed $40 trillion over the last 12 months alone. In total, the world is sitting on a $280 trillion debt pile, according to the IMF1. This is 3.2 times more than global GDP which stands at $87.5 trillion. Typically, when government debt-to-GDP reaches 50-60% this starts to have a deleterious effect on growth and therefore eventually acts as a drag on inflationary pressures.
Figure 1 shows how this is reflected in the falling neutral rate of interest in the US, where government debt is around 130% of GDP. The Euro area, Japan and China have even higher debt levels than the US, which is why we think the US will continue to outperform other major economic zones in terms of economic growth.
Figure 1: Federal government debt-to-GDP vs rates
Source: Deutsche Bank, US Federal Reserve, Haver Analytics
What about the recent surge in M2 money supply – the total value of money available in an economy? Monetarist economists might say this heralds a surge in inflation too, but we disagree. Much of this is likely due to companies drawing down on bank facilities to stay solvent. A better indicator of future inflation would be looking at this rise in money supply against the context of the velocity of money, which remains somewhat subdued. High money velocity – the rate at which money is exchanged within an economy – is associated with a booming economy, with businesses and consumers spending money and adding to GDP.
Given the overhang in global debt, we don’t see money velocity rising anytime soon. As the famed economist Irving Fisher wrote in 19332, highly indebted economies are likely to see a collapse in the velocity of money and therefore lower inflation.
Demographic changes, such as an ageing population, also tend to restrain the velocity of money. The US is currently on course for one-fifth of their population to enter the 65 years+ bracket by the end of this decade. For every year that goes by, the population in the US gets 1 month older. In China, the population gets 6 months older with every year that goes by. In fact, China recently released a report that its population has shrunk for the first time since 1949. By 2070, it is reckoned China’s population will have halved.
Ageing demographics impact consumer spending, which typically peaks in one’s early 40s; when people hit their mid-70s, their spending almost halves. This is a key reason why we think governments and central banks will need to intervene through fiscal and monetary policy for some time to come, in order to backstop economies as the baby boomer generation continue to retire. Older populations simply save more and spend less of their income.
Weak wage growth is another factor that we think will continue to supress long term inflation. The decline of trade unions along with the increased power and influence of a handful of global monopolies points to continued downward pressure on wage growth. Disruption through AI, robotics and automation will likely further entrench weak wage growth. For structural inflation to become an enduring concern, wage inflation needs to be embedded and accelerating.
In the 2010s we had the longest economic boom in post-war history, with full employment, quantitative easing on tap, and corporate tax cuts – yet inflation averaged only 1.6% in the US. There is currently a lot of slack in the labour market: for example, 1 in 8 Americans are currently on some form of employment benefit payment. If inflation didn’t come through in 2018 when markets were excited about the Trump tax cuts and the labour market was considerably tighter, why should we expect it now? It’s worth remembering that for over thirty years, Japan’s central bank has tried everything that Europe and the US have implemented in the last decade or so in order to generate sustainable inflation, to no avail.
It’s also worth noting that China’s credit impulse is declining, which could be a headwind for the global manufacturing sector. We think this has been one of the best leading indicators for global macro trends over the last 10 years – Figure 2 shows how China’s credit impulse leads global manufacturing PMI’s.
Figure 2: China credit impulse vs global manufacturing PMI
Source: Macrobond and Nordea
Proceed with caution
When everyone sits on the same side, even a small cross-current can capsize the boat. There will undoubtedly be more surprises this year, and our strategy remains nimble enough to change as the facts change.
We don’t believe it’s wise to be all-in on the consensus trade for a return of inflation, particularly when so much of it is already priced into markets. That’s why we continue to run a flexible ‘barbell’ strategy that holds carefully selected corporate bonds alongside medium and long-dated US and Australian government bonds, which aim to defend the portfolio against any adverse events that may occur in the coming months. We have been reducing investment grade exposure recently, where we see limited upside given such tight spreads. Our high yield exposure is short duration with a focus on carry trades and defensively positioned in terms of maturity (expected and measured) and sectors. For example, we expect roughly half the strategy’s high yield exposure to be redeemed over the next twelve months through either a hard maturity date or bonds being called and refinanced.
1Source: International Monetary Fund, February 2021
2‘The Debt-Deflation Theory of Great Depressions’, Irving Fisher, 1933