Inflation: collective amnesia reigns

Eternal stagnation of the spotless mind

Memory loss can sometimes be instructive. Charlie Kaufman’s 2004 science fiction film Eternal Sunshine of The Spotless Mind is a case in point. The movie follows an estranged couple who both consciously undergo a procedure to erase each other from their memories. The subject matter makes for stimulating cinema, and this one is admittedly an absurd premise. But it is classic Kaufman: His screenplays typically jump the rails and tumble into a cerebral maze of time and reality.

Yet the film’s wisdom lies in the way memory interacts with the mind. A fragmented recollection may provoke an unforeseen reaction, or a forgotten experience may change the way we lead our entire lives. Kaufman’s mental alchemy suggests even more possible permutations. Perhaps the film’s central idea is that memory – and its impact on our emotions – is always in a fragile state. It can mistranslate information or fail us altogether.

Memory loss is a recurring theme in financial markets too. Investors unconsciously repress thoughts of past losses or difficult market periods. Most damaging is that our brains can manufacture a more flattering version of reality (known as “hindsight bias” for behavioral finance nerds). For example, many investors recall not losing money in 2008. In fact, they did.

Indeed, entire memories can be reconstructed to make us feel good. Kaufmanesque brain-scanning head gear is not needed. Rather, memory distorts over time, often taking a generation to set in. What remains is a spotless history, wiped clean of any disturbing thoughts.

Today’s most important loss of memory relates to inflation. Investors have simply forgotten that higher prices are possible. Need evidence of collective amnesia? Never mind the trillions sunk into negative-yielding sovereign debt. Stand in wonder of the more bizarre bonds of the world, now priced for eternal stagnation. The Republic of Austria recently brought back its “century bond” – riddled with interest rate risk – at a whopping 1.2%. Swiss bank UBS now charges wealthy customers for short-term deposits. And Denmark’s Jyske Bank will pay you to take out a mortgage. Clearly, almost no one expects any inflation in the future.

Let us venture out on the shakiest of limbs to toss out a non-consensus idea: The conditions for a long period of higher inflation have arrived. Note that we are not calling for rampant 1970s style inflation. Rather, a gradual uptick in overall inflation will glacially play out over many years. It will be nearly imperceptible at first. In the same way that investors took more than a decade after 1981 to believe that inflation would not rise again into double digit figures, today’s investors – conditioned by 39 years of disinflation and declining interest rates – will take years to become convinced that the secular environment has changed.

Looking ahead, several cyclical, policy, and structural factors point to higher inflation. Deflationary fears are way overdone. Yes, a credible threat of falling prices did emerge during the global financial crisis and the double-dip recession in the euro area and Japan. But these forces were mainly driven by a deleveraging process in the U.S. and eurozone that needed to run its course. These balance sheet adjustments are now largely complete. Private sector debt levels in the U.S. have returned to 2004 levels when measured against GDP (figures from the Bank for International Settlements at June 30, 2019).

At the same time, most excess capacity in the global economy has been absorbed and many labor markets have returned to near full employment. The unemployment rate in the G7 has fallen from a peak of 8.4% in 2009 to 4.2% (a full percentage point below its pre-recession low of 5.2% set in 2007). Upward wage pressure can build from here.

With this backdrop, policymakers remain hell-bent on fighting deflation. This is the exact opposite situation of the early 1980s. Back then, inflation and bond yields were in double digits. Only hawkish policymakers existed, wrongly fearing further inflation. Today, we have low inflation readings and low bond yields. But there are only deflation-phobic doves left. Some are even threatening outright debt monetization and other helicopter-dropping monetary tactics.

The Fed is so fearful of deflation that it staged a dramatic turnaround in 2019 and dropped rates by 75 basis points. This latest move is historic: It is the first time in the Fed’s history where rates were lowered without clear evidence of a recession. No economic data justified a cut. Then, in March, the Fed cut its policy rate to 0% in reaction to the COVID-19 pandemic and the shutdown of most economic activity.

It’s not just the Fed. Almost all major central banks are terrified of making a policy mistake. No surprise then that they are all committed to erring on the side of caution. And now, central banks are all arguing for more collaboration with fiscal authorities. They are sure to be indulged. With brewing political populism, running larger budget deficits is the path of least resistance. The voting public will ensure that.

Crucially, the impact of monetary stimulus is far different than fiscal thrusts. Most misread the transmission dynamics of quantitative easing (QE). What is now clearly known (and forecast as early as 2009 by your favorite Canadian macro managers) is that QE does not work during deleveraging periods. More available liquidity does not automatically lead to more credit creation and higher inflation. This is the classic “pushing on a string” metaphor Keynes originally used during the 1930s depression.

Fiscal stimulus is a different beast altogether. Importantly, the transmission effects of fiscal thrusts are much more direct, boosting consumption and investment. More money immediately enters circulation and leads to inflationary pressures.

What about all the structural deflationary factors that have been cited in support of secular stagnation, new normal, and other similar outlooks? Here we refer to the impact of technology, automation, demographics, and other disruptive forces on prices. Many of these are a myth. Classic mistakes are often made in the analysis. For example, automation does lead to faster productivity growth and falling prices in several industries. But this will also boost real incomes, leading to more consumption elsewhere. Rising spending lifts prices in other sectors of the economy. This observation holds true for other trends like the rise of the sharing economy and online shopping (reducing the need for retail outlets). Cheaper prices lead to more available discretionary income. Less consumption in one area leads to more in another.

What about the favorite domain of deflationistas: demography? To be sure, demographics have been a deflationary force for most of the last 40 years. Slower population growth leads to lower demand. And the West has aged. In general, this tends to lead to higher saving for retirement and less spending.

But all this mainly applies to the developed world. Most emerging countries have far younger demographic profiles. Consider that the global millennial generation is larger than the boomer one. In fact, they are now the world’s largest generation – some 1.8 billion strong and nearly a quarter of the world population. And contrary to the image of lazy and entitled Western youth (luckily this author is squarely in generation X), millennials are mainly an emerging markets story. Nearly nine in every ten millennials live outside developed markets. There are more Chinese millennials than the entire U.S. population (hat tip to the FT for supplying these statistics).

All this is bullish. Most emerging markets millennials are experiencing rapid wage growth. The World Data Lab has forecast 2020 as the year when the global spending power of millennials will be greater than any other generation. As the lead consumer cohort, they are set to shape the direction of the global economy in the coming years. Indeed, demography is destiny.

Investment implications

A scene in Eternal Sunshine of The Spotless Mind shows a television ad for the company that performs the memory-erasing procedure. “Why remember a destructive love affair?” it teases. The clear answer for investors is that unlike in romance, a clear read of history is important. It instructs. It opens the mind to new scenarios. And, above all, it provides lucidity to the present.

Looking ahead, investors need to be alert to the past. The conditions for a sustained rise in price inflation have arrived. The transition will be gradual and bumpy, allowing many investors a period of denial until underlying pressures are more evident. This is typical during regime changes, as it takes time to release old narratives.

But benign bond markets should not be expected. As the COVID-19 crisis begins to fade, the path of least resistance for yields is now up and a secular bond bear market will progressively take hold. Bond rallies will still present themselves. Yet the long-term result will be a yield trend of higher lows and higher highs.

This carries profound ramifications for other asset classes in the years ahead. Investors should recognize that many assets were bid up on the “lower forever” inflation thesis. This includes a variety of interest-rate-sensitive investments in the West – REITs, dividend payers, and the vast assemblage of ETF product that, through financial alchemy and a masterstroke of marketing genius, produced a higher and more tantalizing yield. To be sure, our clients relished in this yield bonanza (with our Global Income mandate producing stellar returns since its June 2008 inception). But no party lasts forever, and we are now shifting our income strategies in these mandates. Ironically, equity markets have become a better source of yield than bonds. This is most egregious in the eurozone, where the dividend yield on the MSCI Germany stock index was a whopping 316 basis points higher than the nominal yield on a 10-year bund (as of end 2019).

Finally, bear in mind that a gradual rise in yields will play out over many years. And while a spike in rates is clearly detrimental to fixed-income investors, a slow and steady rise allows for a higher reinvestment rate without incurring large capital losses. This is wonderful news for retirees who have had considerable difficulty generating reasonable income in an abnormally low interest rate environment.

Tyler Mordy, CFA, is President and CIO for 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 March 26 issue of “Ask Forstrong,” available on 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.

Notes and Disclaimers

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. 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.