In the last week there has been a reasonable bounce in equities from their March lows and some moderation in market volatility.
Although it is not much to write home about, with this relative calm there has been some shift in market commentary. Price moves themselves are no longer the main story; instead some are now looking beyond the immediate future to the more enduring economic impacts of the virus.
Of note has been a renewed focus on inflation:
- Many have linked policy stimulus with an inflationary threat. Former Monetary Policy Committee member Charles Goodhart and Manoj Pradhan envisage inflation “in the order of 10% in 2021” (Goodhart has previously argued that higher inflation was to be expected anyway, due to demographic forces).
- Others, such as our colleague Randeep Somel have discussed the plausible inflationary threats from a challenge to globalisation and supply chains..
- A study looking at past pandemics found them to be associated with upward pressure on real wages.
As Steven Andrew wrote earlier this week, as investors we should be wary of falling into the trap of forecasting such variables; events this year have shown that only too well. However when considering whether assets are attractive it can be useful to understand what expectations are embedded in pricing and how vulnerable they might be to any surprise.
Inflation: what is the market saying?
When we look at asset prices today, it would seem that few are envisaging inflation threats.
On the surface, the easiest way to judge what’s being priced in for inflation is to look at market implied measures of inflation expectations, and these have declined sharply as market turmoil intensified.
Although there has been a modest rebound from the lows, most market measures of inflation expectations sit meaningfully lower than they had in a phase which has already been characterised as ‘secularly stagnant.’
While these moves have been cited as evidence that no-one believes that sizeable stimulus measures will rekindle inflation, I have written before on how market implied inflation measures can be misleading.
However, even if implied ‘expectations’ aren’t a pure measure of what people actually believe, at current levels, there is little buffer in place against the risk that inflation does emerge.
Inflation: what might the economics tell us?
As Tristan Hanson wrote in 2017, those who have expected the high levels of policy stimulus since the financial crisis to create inflation in the real economy have been disappointed, as have those who have periodically looked for more lasting impacts of oil price increases.
The reasons for this are now becoming more accepted by the mainstream. As Randeep Somel highlights, developed markets have seen low and anchored inflation for a prolonged period of time due to powerful structural forces impacting the supply side. These include globalisation, technological progress and deregulation, and the promotion of competition.
We have seen some challenge to these forces through various political movements and the recent US-China trade wars, but for more pronounced and sustained shifts in the inflation dynamic the pandemic will need to have even more dramatic impacts.
Supply and demand: looking at the scenarios
As frequently highlighted by economist Woody Brock, a useful framework for thinking about the likely consequences of any shift in the economy is to remind ourselves of demand and supply dynamics. As Brock has outlined elsewhere, the long term impacts of the pandemic and the responses of policy makers are no different.
Both GDP growth and inflation are driven by shifts in the aggregate demand for and supply of goods and services. Inflation emerges when demand increases or supply falls.
At the moment, and it has been the case in most periods of stress in recent memory, markets interpret periods of stress as meaning the opposite. The fear is that as companies go out of business, unemployment rises sharply and stays high, and consumers have less to spend and save more of what they do have, the fall in demand creates disinflationary pressure. This leads to lower ‘post pandemic prices’:
This would explain the recent collapse in market implied inflation rates, though we would argue that many investors aren’t thinking about this at all and are just looking for any asset perceived as safe in the short term.
The intention behind the global fiscal and monetary response is to prevent these long term falls in aggregate demand by enabling individuals and companies to get through the temporary shutdown in activity.
The fear of many is that the size of this stimulus does more than this. The quantitative easing of the last ten years has not been sufficient to boost aggregate demand in the real economy but we are now seeing a drastic increase in the extent of this stimulus, with much of it focused on direct transfers to individuals and business rather than bank balance sheets. Some have argued that this could result in a more lasting and inflationary increase aggregate demand in a way that stimulus has not in recent history.
One of the reasons that any boost in aggregate demand over the last ten years hasn’t been able to create inflation is that we have also seen a big increase in effective supply. Technological advance means many things that used to be more costly to produce are effectively free (consider e-mails versus sending letters, streaming versus cinemas, facetiming versus travelling to a meeting), while globalisation has meant price competition on the manufacturing side.
A threat to global supply chains and repatriation of production (including the use of tariffs to encourage domestic production in ‘strategic’ industries) would likely constrain supply and could push prices higher.
Equally the supply-side could be constrained by businesses going bankrupt, with productive assets lost (before higher prices incentivise production later on). Some have even suggested that increased government involvement in the economy (which typically don’t unwind as easily as they happen) could also hinder these incentive effects, and diminish the efficiency of the supply more broadly.
Other supply arguments focus on the role of wage pressures. Goodhart and Pradhan suggest that after their initial predicted inflation spike a longer term inflationary dynamic will materialise as labour bargaining power improves due (among other factors) to a de-globalisation impact along the above lines reducing competition from overseas labour.
Others have cited the link between past pandemics and increased inflation. This, however, is likely the result of significant population falls in highly agricultural or manufacturing-led economies. It is not clear that past pandemics are much comparable with the present given the very different structure of the global economy today and the different mortality profile of the virus at present. Neither is this wage-led argument consistent with the scenario where the pandemic prompts significant levels of persistent unemployment, which is normally associated with lower bargaining power and less wage pressure.
The reality is that all these influences on demand and supply will be happening concurrently (as will a whole host of other, non-virus related forces), it is also the case that even if we knew which of the forces are dominant over the others, forecasting the extent of price shifts involves understanding the slope of the various curves involved.
Nobody can know how the recovery from this shock will play out or what its longer term consequences will turn out to be: the global economy is a highly complex and dynamic system, the above are just possibilities, and it’s unlikely that the powerful structural forces that have delivered the current inflation regime will be undermined easily. What we should put a high probability on is that things will, as ever, continue to be hugely surprising.
The best approach we can follow is to examine the facts as they stand and how confident the market appears to be in its own beliefs. For now, Western bonds continue to be priced on the basis of an ongoing stable inflation environment and for the diversification properties that they’ve generally exhibited in that regime. We should be wary of picking a fight with that view of the world, but we should always take note when asset valuations are offering less protection should we be surprised again.