New years often begin with a burst of optimism and a few surprises. There have been plenty of the latter already this year. US Democrats won two Georgia elections to take control of Congress, incoming President Joe Biden unveiled a $1.9 trillion spending plan to boost the US economy and governments around the globe set aggressive targets for Covid-19 vaccinations.
Then US Treasury yields rose, and markets wobbled after some ill-judged, to my mind, comments by Federal Reserve (Fed) officials about potential scenarios for tapering bond purchases and raising rates. Fed Chairman Powell quashed these comments but not before the yield curve steepened and inflation expectations rose.
Could rate moves, fiscal spending plans and vaccine optimism mean the global economy is reflating, returning to normal and bringing inflation with it?
Open that wallet
Supporters of the reflation trade would say that we are in a very low-inflation environment, with enormous levels of fiscal and monetary support pumped into the global economy and high levels of consumer savings accrued during lockdown. With the vaccines will come a release of “animal spirits”’ into the economy as consumers unleash pent-up demand and the velocity of money surges.
My view is that the reflation trade proponents may have gotten ahead of themselves and that we will remain in a low-rates-for-longer environment. We have long argued that the powerful structural forces of too much debt, ageing demographics, and disruption from globalisation, technology and low-cost labour will continue to drive deflation over the long term.
Source: National central banks and statistics agencies. Data as at September 2020.
With so much debt in the global economy – around $280 trillion and rising – any jump in yields may well create volatility in risk assets and cause yields to fall back again. The rise in bond yields is not conducive to the Fed meeting its long-term targets around inflation. That is why the taper talk was damaging, as it has been in the past. We expect central banks to keep policy accommodative for a very long time.
Many “zombie’” companies will be using cash flow to service debt rather than to invest in the long-term growth of their businesses. As credit investors, we focus on companies with robust business models that can withstand the uncertainties ahead, while avoiding more cyclically exposed sectors.
In many ways, the markets are pricing in the certainty of economic recovery and a very linear one at that. Some measures forecast forward inflation at 2.4%, matching the forward levels in 2017-18. Yet, it will take a long time for a full economic recovery from the pandemic.
Recessions tend to be short and violent, and recoveries long and gradual. The challenging logistics of the vaccine rollout, unpredictable nature of the virus, the fact that industries such as travel and leisure will require years to recover, this also suggests a slower recovery than some want to believe.
There is considerable slack in the economy and the employment market. It will take a long time to re-employ idled workers once government support schemes end, and there is likely to be high levels of unemployment for an extended period.
In fact, companies may well come out of the pandemic more productive, putting further downward pressure on wages and employment. It is hard to see either sustained price increases for goods and services or higher wages for workers, with so much spare capacity in the system. Artificial intelligence, robotics and automation will boost labour productivity; and that smart phone on your desk, packed with services, is also disinflationary. Labour’s pricing power in this world continues to be somewhat limited.
It is worth noting that China, as the first major economy to recover from the pandemic, has reported stronger-than-expected economic growth and with no sign of inflation in-spite of a somewhat firmer commodity pricing backdrop. In fact, of late, we’ve been buying 10-year Chinese government bonds, which yield considerably more than US Treasuries. China today faces a contracting workforce, stagnant population growth and, in our opinion, a credit bubble – similar to conditions in the developed world – which means it is likely to experience many of the macro-economic and demographic forces that have driven bond yields lower elsewhere in the developed world.
Undoubtedly there will be more surprises this year, and hopefully, more cause for optimism. But some elements of the reflation trade appear to be overly optimistic. Inflation anytime soon? I do not think so.