In this three part series, we step back and look at the arguments for and against the awakening of inflation
Introduction
Market valuations in nearly every asset class are well beyond their long term averages. That could mean something has changed to justify a new valuation regime. Equally, it could mean there is a nasty end on the horizon. Many of the arguments either way hinge on one’s outlook for interest rates. Given that central banks are very unlikely to voluntarily kill off the economic recovery, the scenario in which rates suddenly rise largely comes down to the outlook for inflation.
It would be too easy to sit here today and assume that inflation is dead, or doing a great impersonation of Rip Van Winkle and not waking up for a very, very long time. But as they say, assumption is the mother of all stuff ups so the smart investor challenges that assumption before putting all their bets on it.
In this three part series, we step back and look at the arguments for and against the awakening of inflation, presenting the evidence and a range of interpretations so that you can make an informed decision or have some challenging questions for those that advise you. To be clear upfront, my own views of the outlook for inflation have not changed at all. But, I am a big believer in presenting both sides of any case to let people form their own views, hence this series covering the global inflationary outlook and its impact on rates.
“The worst of both worlds – not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of Stagflation situation.” – Lord Iain MacLeod, House of Commons, 1965
It’s November 1965. Robert Menzies is the Prime Minister of Australia; the Beatles’ hit ’Yesterday” had just been released; and the Vietnam War had its tenth anniversary. Less well known, but more on topic for our readers, the term “stagflation” was used for the first time. The UK House of Commons used it to describe “The worst of both worlds – not just inflation on the one side or stagnation on the other, but both of them together”.
This marked the start of the period of high inflation that eventually dragged the global economy into recession in the 1970s. Contrary to popular myth, it was not the oil crisis of 1973 that caused inflation to spike. It was actually complacency about inflation.
Prior to 1965, global inflation had been asleep for eight years, averaging just 1.5%pa in the US. Fiscal stimulus was being applied on several fronts and unemployment was just 4.2% - the same as it is today. Yet the Federal Reserve kept rates very low because inflation appeared under control.
Indeed, any economist who tried to warn about the potential for rampant inflation was shut down quickly, including the Chairman of the Fed at the time who was summoned to the White House when he put up rates that month. Inflation was low enough, so the administration wanted rates left low.
However the problem was that the controls had been switched off and so the US economy, and much of the rest of the world, became vulnerable to unexpected supply side shocks. This included the oil crisis of 1973, which ultimately was the pin which burst a dangerous level of inflationary pressure that had been building throughout the 1960s. Inflation leapt to over 10%pa and stayed above 6% until it was killed by very sharp increases in interest rates in 1981. In that time, global stock markets fell by 60% in real terms over the next decade and rising interest rates meant bonds were no safe haven, decimating the savings of a generation of retirees.
Figure 1: Inflation was bubbling up long before the Oil Crisis of 1973
US Inflation, 1953 to 1982
Is it different this time?
In the next article on inflation, I’ll examine the argument that says it is different this time, including globalisation and the awakening of the massive Chinese labour force, not to mention the Amazon effect. First though, to counter these points we should also consider the argument that nothing has changed and there is real cause for concern about inflation.
Regardless of my personal well documented view that inflation will be very muted in coming years, there are rational arguments why investors should consider hedging against the ever present risk of inflation:
1. Wage growth is far higher than official figures suggest
Baby boomer retirement actually masks a certain amount of wage growth. When a 65 year old retires, a lower paid 20 year old enters the market. Ordinarily, that is the natural order of things, but when the baby boomers distort the ratio of older people exiting to younger entrants, it pushes down the real rate of wage growth. In the US, this impact is around 1.0%pa, meaning that wage growth is actually around 4.6%pa rather than the official 3.6%pa.
That’s a strong argument for US inflation. However, in Australia where official wage growth is 1.9%pa, adjusting for the baby boomers it is still just 2.2%pa, far below the long term average of 4.0%pa. Regardless, US inflation eventually finds its way to Australia, even if it is only due to the falling AUD/USD exchange rate.
2. China's low wages regime is coming to an end
China’s remarkable success increasing household incomes means that the advantage of low cost labour, which they exported through lower price goods, is coming to an end. At least that is the argument and it appears to have some merit. China’s GDP per capita is now at the top end of what is considered a key indicator of a developing economy and the country’s low cost goods have been a major contributor to lower inflation for the past ten to fifteen years.
3. Populist political movement
The global shift to nationalistic, populist politics poses inflation risk. Brexit, Trump and the anti EU movement in Europe all favour less global trade and stronger domestic economies via lower taxes and more stimulus. Right or wrong, these policies are inflationary. There is a strong argument to say this has become a global trend which could lead to a rise in global trade, and a tax rate war breaking out as countries attempt to outdo each other to attract business migration and job creation.
4. Arguably the controls are switched off again
There are many that argue that the Fed and other central banks have left it too long to increase rates. Ultra-loose monetary policy has again created the risk that the brakes are off and economy has built up too much speed to control if a shock occurs.
These are all reasonable arguments for inflation. Each of these characteristics are echoes of the 1960s conditions that led to the dangerous inflationary bubble.
By themselves, they suggest rushing out and buying inflation linked bonds and selling your equities and property holdings. But this isn’t the time to be rash. One must calmly consider the opposite arguments, some of which are equally compelling.
However, if you are concerned about inflation, which as history tells us will show up when complacency is at its peak (as it is now), one of the best and lowest cost hedges for the times is infrastructure backed inflation linked bonds. I specifically highlight infrastructure bonds rather than government inflation linked bonds because they can still generate a decent yield even if inflation doesn’t reappear.
If we are about to experience stagflation again like we did in 1965, infrastructure assets tend to be a great safe harbour in an economic downturn. To paraphrase the first use of “stagflation” in 1965, these assets offer the best of both worlds delivering protection from inflation and minimal downside risk.