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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. In my previous commentary, "Inflation: Has the force awakened?", I focused 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 of 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 U.S. 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 U.S. recession in which wage growth barely fell. This is a big difference compared with prior crises. What’s more, U.S. 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-U.S. geopolitical tensions only reinforce this trend. The experience of the United Kingdom and Germany in the late 19th and early 20th century, along with the U.S.-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). U.S. President Joe 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 U.S. five-year breakeven 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 five-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 underwent a huge makeover at the end of May, with 68% of its holdings changing (tech fell from 40% to 17%, while financials moved up from less than 2% to 33%).
Over the coming three to five 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 hold the key to these secular shifts. Markets are nowhere close to pricing any of this in.
Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article first appeared in Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.
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© 2021 by Forstrong Global. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Performance statistics are calculated from documented actual investment strategies as set by Forstrong’s Investment Committee and applied to its portfolios mandates, and are intended to provide an approximation of composite results for separately managed accounts. Actual performance of individual separate accounts may vary with average gross “composite” performance statistics presented here due to client-specific portfolio differences with respect to size, inflow/outflow history, and inception dates, as well as intra-day market volatilities versus daily closing prices. Performance numbers are net of total ETF expense ratios and custody fees, but before withholding taxes, transaction costs and other investment management and advisor fees. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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