Should we be worried about inflation?
The outbreak of COVID 19 and the subsequent policy response has resulted in an increasing number of clients asking us if this will impact inflation. We do not claim to have all the answers but, as real return investors, the inflation environment is crucial for us to consider.
The outbreak of COVID 19 and the subsequent policy response has resulted in an increasing number of clients asking us if this will impact inflation. We do not claim to have all the answers but, as real return investors, the inflation environment is crucial for us to consider. For the last decade, academics and market participants have argued that technological advancements, globalisation, and deregulation dynamics are some of the structural forces that have aided declining levels of inflation. However, given the unprecedented fiscal and monetary measures taken by governments today, it is sensible to be re-evaluating the environment. We do not believe that rampant levels of inflation should be an investor’s immediate concern; however there is evidence that suggests low levels of inflation might not stay the norm.
The ‘inflationistas’, or those worried about high levels of inflation, claim that the helicopter nature of the stimulus from governments following lockdowns around the world is what makes this time different from 2008. Unlike following the previous crises, fiscal authorities have not reverted to their austere overtures and central bank policy makers are looking to inject credit directly into the real economy. Deficits are larger than at any time outside of war and, in some countries, even go as far as sending cash directly to households. Central banks have committed to even greater amounts of government bond purchases and, this time, are even permitted to buy risky private sector credits in scale. For the first time in history, even emerging economies are considering unorthodox policy measures to provide support. Those worried about rampant
inflation claim that excess money supply will bid up the prices of goods and services.
Admittedly, governments have stepped up the game when it comes to policy response. They have taken a dual pronged approach to tackling this crisis and institutions once thought to be independent are acting in unison. For how long it is yet to be determined. However, these policies have arrived at a time during which the global economy faces the deepest shock to output since the Great Depression. Demand has collapsed globally in every sector, except for those that are digitally accessible, while lockdowns have constrained supply. Early data releases show unemployment and benefit claims have soared. Furlough schemes and others of the like are innovative measures in providing lifelines to companies, but they come with a deadline. Liquidity provided by central banks has helped patch over some of the working capital issues for those able to access funding. However, we see restructurings and bankruptcies continue to make headlines.
Inflation is the increase in general prices of goods and services and usually occurs when demand outpaces the supply of goods, services and money. In a recession, the current prevailing economic environment, demand decreases and takes with it output and income. This is generally not an environment where firms can or want to increase prices. We also do not see an environment where labour can demand higher wages and commodity prices have not surged, so cost driven inflation is practically non-existent. As an example, let us consider the small business owner; they have a coffee shop situated in the City of London. The business will have been practically shut for the last 3 months; cost savings have been made but sales have gone to zero. The entrepreneur, even with openings expected from the middle of July, will not be looking to
set up new stores or hire new employees from day one until they gauge how many people will return to the City instead of continuing to work from home. If the shop does re-open in July, they will not be wanting to raise prices either, concerned that they might scare off the already depleted number of customers. They will also be wary of paying employees more, or even hiring more than the bare minimum. This is not an environment where demand or supply pressures cause major concerns for inflation.
As we faced such an exogenous shock, policy responses from governments act as a mere plug to fill the gap that has been created as economies come to a halt. It is yet to be seen how the path to recovery resumes. However, it is safe to assume that the stimulus provided until now will not cause the economy to overheat. In our example of the small business, that is neither well capitalised or exposed to a digital customer base, the furlough scheme and other small business support schemes only patch the gap and buy time. Question marks remain as to how quickly demand gets back to normal following the easing of lockdown measures.
There is strong evidence that loose monetary policy alone without fiscal support drives asset prices more than the real economy in the West, as witnessed after the Global Financial Crisis. Markets have already reacted very positively to the liquidity injection from central banks and stability in risk appetite amongst financial market participants is evident. I wrote in 2019 regarding the topic de jour: Modern Monetary Theory (MMT) and concluded with how policy choices may slowly be changing. However, no one could predict that COVID19 would be the catalyst to kick-start a new policy regime. Indeed, we might be seeing the early signs of the shift in policy which could have significant implications for the path of inflation. Unlike after the GFC, central banks are directly providing credit to the real economy while fiscal authorities have effectively stepped in as the buyer of last resort.
We are seeing policy makers set precedents for using completely unorthodox measures in a dual pronged fashion. Eventually, these measures should propel the economy out of a deep recession and inflation should reside at healthy but manageable levels. Problems with inflation could arise if this policy mix is used with a heavy hand or with poor judgement in the future. Until now, markets have been enjoying the benefits of this policy mix. It has suppressed interest rates, reducing discount rates on asset valuations, and therefore caused asset prices to increase. How long this continues is impossible to tell, but the persistence in increasing asset valuations should also require improving fundamentals and risk appetite.
Although it may be too early to tell how this will unfold, it is interesting to observe history being created in these times. The taxation consequences of such measures are yet to be considered and, in the future, could also have an impact on inflation. COVID19 took us by surprise, but our approach to multi asset investing remains the same. We continue to prefer investment opportunities that are inflation linked and seek to build portfolios that can provide real returns in a range of environments in a diversified manner. For now, we do not believe hyperinflation should be a short-term concern.
Aqib Hashamali, CFA
Senior Investment Analyst
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