Inflation has been on the retreat for more than 30 years with the odds seemingly stacked against it returning. From ageing populations to the displacement of workers by new technology, numerous structural trends have stood in the way of a major uptick in prices. In the shorter term, this year's mass economic shutdown should be deeply deflationary.
The market moves of recent months only reinforce this interpretation of events. Government bonds, which tend to flounder at moments of aggressive inflation, remained in high demand throughout the first half of 2020. Value stocks which normally thrive in inflationary periods have continued, in the main, to lag other parts of the market. And yet we could be on the cusp of a big reversal, according to Man Group portfolio managers Ben Funnell and Teun Draaisma. They, alongside analyst Henry Neville, argue that an inflationary period could be on its way.
The severity of the coronavirus crisis has prompted governments to pump billions into their economies, resulting in elevated levels of debt. Recent forecasts for 2020 budget deficits as a percentage of nominal GDP came to 15 per cent in the US, 9.5 per cent in the eurozone, 10.6 per cent in the UK and 8 per cent in Japan, all figures that notably outstrip 2019's readings. Central banks, meanwhile, have supported markets with low interest rates and bond buying programmes.
While governments and central banks do have ways of tempering any inflation triggered by such stimulus, the Man Group (EMG) managers argue in their “Inflation Regime Roadmap” that the deflationary status quo is unsustainable for two main reasons.
Firstly, high debt levels risk financial instability. And encouraging inflation, which would helpfully eat away at the real value of such debt, seems to be one of the most viable ways of dealing with it.
While economic growth would be one solution, this ideally requires four elements: an under-levered consumer with lots of pent-up demand; a rapid growth in the working age population; a productivity boom, and political control of the central bank. While they argue that the fourth element is either already in place or easy to implement, the authors believe the first three boxes have not been ticked in most advanced economies.
In the absence of growth they see three “unpalatable” solutions: a country devalues its currency, defaults on its debt or “purges the system” by allowing the economy to deflate, inflicting substantial pain on businesses and employees. A happier alternative would be to continue fiscal and monetary stimulus and tolerate a level of inflation.
A pro-stimulus, pro-inflation approach could also provide a solution to the growing issue of wealth inequality, something the authors cite as the second reason the deflationary status quo cannot hold.
Google Trends data tells us that the word “inequality” is searched for more than twice as frequently today as it was a decade ago, and a desire to tackle this problem had entered mainstream politics before the coronavirus threw the economy into chaos. From Boris Johnson’s idea of “levelling up” poorer parts of the UK to the “people’s QE” once advocated by then Labour leader Jeremy Corbyn, the notion of addressing inequality through policy has gained traction in recent years. In this context, the authors believe it would be impossible to reinstate the fiscal austerity that came in the wake of the financial crash.
They argue that wealth inequality could be addressed by raising real wage growth for the lower-paid 60 per cent of the population while constraining real income growth for the upper 40 per cent, especially the top 1 per cent. This could be achieved by a combination of higher fiscal spending, higher tax take and higher public borrowing, financed by the central bank.
Such an approach would require a degree of fiscal flexibility, with governments reining in spending when inflation accelerates in a threatening way, only to turn the spending taps back on when the opposite occurs. Governments would also need to be comfortable with the idea of running large fiscal deficits.
Other extreme measures could feed into the mix. This might include governments issuing bonds on below-inflation yields, with the private sector encouraged to buy some of this debt and a central bank picking up the remainder. Central bankers would also need to ignore inflation running above their targets, rather than hiking interest rates in response. Separately we could witness the “re-onshoring” of certain sectors back to local economies, reversing some elements of globalisation.
This brave new world would spell serious consequences for investors. Bonds and quality equities could suffer, while the value investment style might finally shine. Long/short funds may be able to take advantage of the market dispersion brought on by a regime shift.
The authors also suggest a move from “paper” assets to real ones. This could include a preference for the likes of inflation-linked bonds, precious metals, real estate, asset-backed securities and potentially even crypto currencies. But idiosyncratic risks abound: inflation-linked bonds are notably sensitive to interest rate changes, for example, leaving them vulnerable to any monetary tightening that eventually follows.
"Inflation Regime Roadmap", Ben Funnell, Teun Draaisma, Henry Neville, Man Institute