Global Inflation: Has The Force Awakened?
May 26, 2021
Ask Forstrong: How sticky will recent inflation be?
Contrary to alarmist headlines about recently rising prices, high inflation was widely expected. Supply responses are rapidly relieving global bottlenecks.
Yet, looking out further, there are clear and present inflationary dangers: the world is witnessing the beginning of the end of a 40-year period of disinflation.
Markets are complacent and nowhere close to pricing in this new environment. Investors need to position for big leadership changes and ongoing rotations.
What happens when the world is cooped up — in some cases against its will — for more than a year? We are now getting answers to this global experiment. To no one’s surprise, it turns out many are increasingly unwilling to delay gratification, accepting their COVID restrictions with the same indignation as teenagers putting down their smart phones at supper time.
With no release valve, it was bound to happen this way. How long can many handle a continual blur of Zoom, Peloton classes and our own cooking? To be clear, these are problems of the first world variety. And the broader issue is deeply complex, full of trial, error and human tragedy. Depending on virus developments, different nations are re-opening on staggered timelines and proceeding at varying speeds. While America’s restrictions are eroding at warp speed velocity, the Trudeau government is only now contemplating the conditions to loosen constraints along the world’s longest international border. In a few regions like India and Brazil, the pandemic has even tightened its grip.
But never before has the world witnessed such a globally connected phenomenon. For the first time in history, all of humanity, informed by the near universal reach of digitization, has come together, fixated on the same existential threat, consumed by the same fears and anxieties, awaiting the same miracles of modern science.
Now, with a broader vaccine rollout gathering momentum and teaching our collective cells new tricks, the possibility of herd immunity is no longer fanciful. The taste of pent-up anticipation is palpable. People are ravenous to rediscover the world they once knew. Buoyed by the potential of relaxed summer restrictions and flush with stimulus checks, long-deprived consumers are ready to unleash their pre-pandemic mix of spending (apparently teeth whiteners and travel bags are now flying off the shelves). If there ever was an approaching time to indulge, this is it.
As the world steps out into life after lockdown (gingerly for some and brazenly for others), it is also no surprise that inflation is now soaring all around the world. The Bureau of Labor Statistics’ latest inflation report, normally an exceptionally boring affair, could not resist the superlatives: consumer prices rose 4.2% in April from a year earlier, the most since 2008; used vehicles soared the most on record, dating all the way back to 1953; and core inflation, which excludes food and fuel, jumped in April from a month earlier by the most since 1982.
A Pandemic Price Shock
Clearly, the inflationary environment has changed. But the burning question is the stickiness of all of this. Over a short-term horizon, we find ourselves in the rare position of agreeing with the Fed. Base effects and bottleneck surges are driving a temporary surge in prices. The reality is that the world has just experienced a systemic price shock. Incoming inflation figures simply reflect the rebound from a highly abnormal and severely depressed period a year ago (let’s agree to finally call it what it is — a V-shaped recovery). Recessions have always caused supply-side withdrawals, setting the stage for price increases in the subsequent recoveries. This is nothing new or surprising.
The above is different from a general rise in price levels which usually stems from excess aggregate demand. And it is certainly different from the galloping inflation of the late 1960s and 1970s (which peaked at 14% in 1980). Back then, there was no slack in the economy, which was running 2% above capacity on average. And a series of inflationary shocks plagued the economy — escalating costs of the Vietnam war, a doubling of the oil price in 1970 alone and, ultimately, the breakdown of the Bretton Woods system in 1971 (where the US unilaterally terminated convertibility of the US dollar to gold).
The Miracle Of Globalization
Another key difference from the 1970s is that national economies were essentially closed. For most countries, imports were a tiny percentage of GDP (just 3.5% for the US). Contrast that with today’s hyper connected world. Imports have become an important safety valve to relieve shortages and their associated price pressures.
We are witnessing this phenomenon in real time. Never mind the miracle of modern science, stand in wonder of the miracle of globalization. If, in March 2020, someone had provided a preview of the following year, what would have struck you about global production and supply chains: how poorly they fared or how well?
The virus initiated a serious collapse in the services sector, resulting in an explosive growth in retail goods. Most would have predicted that a global lockdown would have been the end of consumer life. Instead, this author’s Amazon order history over the last 12 months is a brimming mélange of garage organizers, weighted blankets, Swedish roasted coffee, Vitamix blenders, Aztec sea salt, air pods, a sous vide water oven, gardening tools, plenty of lockdown snacks and a John Maynard Keynes memoir (highly recommended beach reading) — all with delivery times that would make Dominos wince.
What about the pinch points in global supply chains? In most areas, supply has caught up with freakish demand (masks, hand sanitizer and toilet paper). Other areas like semiconductor chips are more serious as consumer spending on electronics have surged and shortages have been exacerbated by the US-China tech war. But here, too, the world economy is rebalancing quickly as the recovery process broadens out and various sub-sectors adjust. Markets are still underestimating the speed and flexibility of the global supply and production response. The early takeaway of the pandemic was the vulnerability of globalization. The ultimate lesson will be its underrated resilience.
Regime Change: From Secular Stagnation To Higher Growth
The above commentary focuses on the supply side (so-called “cost push” inflation). But the outlook becomes completely different when examining the other main cause of rising prices — excess aggregate demand (“demand-pull” inflation). The last decade was characterized by slow growth, disinflation and skittish investor sentiment. Secular stagnation, muddle-through and a new normal were the dominant narratives. A series deflationary shocks supported the view, most notably America and the Eurozone’s multi-year household debt deleveraging. The central issue was a deficiency of aggregate demand.
The world economy is now entering new territory. The kindling needed to light a blaze in demand can be seen almost everywhere. This can be viewed through a consumer, corporate and government lens. With consumers, consider that China’s 2001 entry into the World Trade Organization was profoundly deflationary, unleashing 500 million new workers into the global economy. But wages have risen to the point where China is no longer exporting deflation to the rest of the world. In 2001, a US manufacturing sector worker earned over 27 times the amount of a Chinese worker. By 2019, that figure had narrowed drastically to under 5 times as Chinese manufacturing wages grew a cumulative 845% over the period.
Even with significant slack in labor markets, wages across Western economies are now starting to rise. In fact, last year was the first US recession in which wage growth barely fell. This is a big difference compared to prior crises. What’s more, US household net worth soared by more than $20 trillion last year. The dirty secret is that many household balance sheets have done remarkably well through the pandemic.
Yet many still wonder if the post-pandemic world will roar as it did in the 1920s. How could it not? Taken together, the 2008 crash, the pandemic and the populism that reached its ugly climax in Washington last year add up to a period of relentless distress. It would be strange if, coming out the other side, consumers did not roar.
For corporations, the missing ingredient of both the recoveries in the early 2000s and after 2008, has been meaningful capital spending, with most companies preferring the capital light investment of software and smartphones. This is certain to change in the coming years. Whether readers agree with climate change or not, it is clear that fossil fuels will be steadily replaced by renewable electricity as the globe’s dominant energy. This transformation will be enormously capital intensive and could be comparable to the post-war reconstruction boom, as infrastructure, transportation networks and technologies require vast amounts of fixed capital investment. This is not just a domestic phenomenon either. It will be pursued globally. In fact, the China-US geopolitical tensions only reinforce this trend. The experience of the United Kingdom and Germany in the late 19th century and early 20th, along with the US-Soviet Cold War, suggest that big rivalries act as spurs for massive investment in technology, science and other innovations. This time will not be different.
Finally, the global government response to COVID-19 has set in motion dynamics that mark the beginning of the end of the disinflationary era. On the fiscal side, the pandemic has been a moment of revolutionary break. Stimulus arrived fast and furiously. But plans for additional fiscal spending are still widespread, ranging from tax cuts to infrastructure projects.
Many point out that fiscal spending will not be significantly stimulative. Household income subsidies over the last year have a far lower multiplier than public investment (and, in America, the average household saved some 75% of the income transfers for investment or debt repayment). Biden’s infrastructure plan will be spread over eight years and will add only about 1% in aggregate demand annually, assuming it is approved as is. This is all true but does not factor in the political implications of stimulus. If spending is seen to be “working” (as it certainly will in the current cyclical uptick), then politicians will get credit for voting for and implementing it. A feedback loop, where politicians feel emboldened to “do more” and even go bigger, will emerge. Underpinning all of this is Modern Monetary Theory, which has moved from the fringe to the mainstream policy conversation (for more on this topic, click here). Most importantly, a consensus amongst policymakers has emerged: the risks of doing too little greatly exceed the risks of doing too much. Deficit shaming and austerity are now dead.
On the monetary side, global central banks are nearly unanimously assuming that recent inflation will be transitory, an aberration rather than the start of a secular shift. But this is a classic case of generals preparing to fight the last war. In the post-2008 period, central banks consistently overestimated growth and inflation. Now, conditioned by years of inflationary false alarms, they are assuming a long, plodding recovery with the same disinflationary dynamics. The Fed has even made major modifications to its monetary policy framework, completely jettisoning the Philips curve and shifting to an “average inflation targeting” approach. Based on past undershoots of inflation (roughly 500 basis points in the last 10 years for those counting), inflation can run substantively high without breaching the average inflation target.
All of this has a crucial behavioral component: inflation expectations. Central banking has always been a confidence game. Monetary policymakers care deeply about market, consumer and professional inflation forecasts. Currently, they are all pointing higher. The US 5-year break-even inflation rate (a market-derived proxy for inflation expectations) has gone from an all-out collapse last March to breaking out of its historical range and hitting the highest level in nearly 13 years. The University of Michigan’s latest consumer survey is showing 5-year expectations hit a decade high of 3.1%. And the Philly Fed’s latest survey of professional forecasters, which fluctuates far less dramatically than consumer expectations and does not consistently overestimate inflation, showed expectations for 10-year PCE inflation breaching the Fed’s 2% target.
The glaring risk here is that forecasts become self-fulfilling prophecies. If inflation is expected to be higher in the future, people will be willing to pay more at current prices. As inflation rises above target, expectations become un-anchored. And then, with compromised central bank credibility, markets may not trust policymakers to guide inflation back down. Global central banks are making a big gamble that currently high inflation can revert serenely back to its previous course.
Human beings have a habit of framing outlooks in a binary way: will there be inflation or will there not? Or, investors focus on point forecasts: just how high will inflation be? Those are the wrong questions. Markets react to changes at the margin. And, importantly, they react to the interplay between expectations and the actual incoming data.
That means the best approach for investors is to plan for asymmetry in positioning. The reality is that much of today’s asset prices still reflect the disinflationary trends of the last 40 years. Western government bonds, in particular, are still pricing in a deflationary ice age. Complacency remains high. And, now, evidence is surfacing that points to a shift in investment regimes. Momentum is shifting everywhere. For example, the iShares US Momentum ETF is set for a huge makeover this week, with 68% of its holdings changing (tech falls from 40% to 17%, while financials move up from less than 2% to 33%).
Over the coming 3 – 5 years, our investment team expects inflation to average modestly higher than the last two decades. Yet even with this moderate shift, investment leadership will radically change. Losing investments will be those that have been bid up on the “lower forever” inflation thesis. This includes the long-duration growth tech stocks that have become today’s darlings. Winners include bank stocks (which have become well-capitalized and are natural beneficiaries of a steepening yield curve) and industrials (and other sectors that can pass through rising costs). Other cyclical industries will come back in vogue. Emerging market bonds will catch a steady bid as there are few yield plays that offer positive real rates. Higher growth and higher inflation holds the key to these secular shifts. Markets are nowhere close to pricing any of this in.