Definition: reflation is the expansion in the level of output of an economy by government stimulus, using either fiscal or monetary policy
Bond yields are climbing rapidly amid concerns that super-accommodative monetary policy together with Joe Biden’s monster fiscal stimulus package in the US, will drive inflation sharply higher. In this note we contrast what the market is telling us with the real-world as we see it and briefly revisit our long-term thesis about the fundamentals of the global economy in 2021.
It’s probably too early for nominations for 2021’s word of the year but, if anyone is making a list, we have a suggestion: reflation. Over the last week or two the financial press seems to have written about little else. On first inspection, it doesn’t seem to be a hugely contentious issue; lockdowns deflated economies, reopening should see them reflate – especially if given a helping hand by policymakers. It is in the context of this ‘helping hand’ that journalists, asset managers and commentators are loading reflation with a good deal more than the simple idea of air being pumped back into something that was previously looking a bit deflated.
The read across is most simply seen from a recent quote from economist Ed Yardeni, ‘We may finally once again be on the road to reflation. I’m seeing more and more signs of mounting inflationary pressure as a result of unprecedented stimulus…’ The words sound unhelpfully similar, but while few would argue that, after huge declines in output, a reflation is welcome, it is not the case inflation necessarily follows.
What has really turbocharged the reflation discussion in recent days is the movement of government bond yields. Considering the all-important US 10-year government bond, lockdown pessimism sent yields here down to just 50bps last year. News of vaccines to combat the virus allowed yields to recover to 93bps by the year end. Since then, they have powered ahead, moving by more than 60bps higher to c160bps at peak. Rising yields mean falling bond prices, and losses on bond portfolios. And, so the thinking goes, if reflation leads to much higher inflation then, who knows how great bond losses might be? In the modern world of rapid communication, instant dealing and the dominance of short-term considerations, such sentiment has led to what the press is now terming a ‘bond market rout’, further inflaming negative sentiment and triggering follow-on selling from computer-driven strategies and other momentum investors.
So, has the world just woken up to the impending threat of much higher inflation? One key development here is the capture by the Democrats of the two run-off senate seats in Georgia. This cleared the way for the new president to pass a much larger stimulus package than was previously mooted, raising concerns in some quarters as to whether such largesse was either necessary or helpful. Despite such concerns in some quarters, key players such as Jay Powell, the chairman of the US central bank, has reiterated his commitment to keeping interest rates at ultra-low levels for a prolonged period. He is clearly not fearful of higher inflation – and neither are we, for the simple reason that it does not fit with any empirical observation.
There is certainly normalisation apparent is several areas, but this is not inflation. Consider, for example, oil. Here, prices are 35% higher year on year but, at $63, they are almost exactly where they were at the start of 2020. That year-on-year percentage rise is set to increase markedly in the coming months regardless of where oil prices go from here – because they got very, very low in 2020, culminating with the much-discussed negative prices which, caused great consternation last April. Importantly, however, this is not inflation.
For us, any consideration about the likelihood of genuine inflation drives us to look in two places: the jobs markets and the consumer price basket. On jobs, the US has more than 11m fewer people in work than before the pandemic. True, unemployment is declining, but at the most recent reading it stood at 6.3% – still higher than the peak in several recessions in the past. The same dataset showed average earning growing at a snail’s pace – by just 0.2% in January. Without a tight labour market, and the implied wage growth that follows, an inflation problem is hard to envisage.
Turning to consumer prices, these rose at an annualised pace of 1.4% in January, despite the oil price (a sizeable component of CPI) moving up by more than 7%. When we look at the wider basket of goods and services included in CPI inflation measures, we find it difficult to see where the drivers of consistently higher prices will come from. For the major components such as shelter (rent), transport and food and beverages, it is hard to make a case for sustained upward pressure on prices – given what we know about the job market, and the responsiveness of supply in a modern economy.
This brings us to our long-term view of the world economy. To us it is self-evident that this has changed fundamentally over the last 20 years. So much so, that it appears absurd to even discuss the possibility of a return to the levels of inflation seen in the 1970s and 1980s – back then supply was hugely constrained in so many areas of life. By contrast, the years since the financial crisis have seen a global economy in which, far from struggling to control inflation as in prior decades, central banks have resorted to rock-bottom interest rates and a whole collection of unconventional policies to try to force inflation up to even modest targets. Explanations for these fundamental changes are not hard to find in our view. Almost the entire globe has embraced competitive market economics over the past two decades, and a tech-enabled, integrated global economy is a very, very competitive place. And competition is very deflationary. A further point of note here is that there is a tricky side-effect of low interest rates. Cheap money does encourage spending – as the authorities intend. However, cheap money also means entrepreneurs and companies can borrow – and use the funds to build new capacity, start new firms and offer competing services – all good for the consumer, but all driving further competition.
To the extent that the virus impacts this at all, it is likely to exert downward pressure on prices. It has certainly exacerbated the inequality challenges that were increasingly making themselves felt before its onset. It is clear that the less well off, less securely employed, have borne the brunt of the economic impact of the virus. Meanwhile, thanks to rising house prices and stock markets, the wealthy may have become even wealthier. Once the virus all-clear is sounded, it is not obvious that the wealthy will increase their spending hugely – given that wealth tends to be stored, while, of course, those whose economic circumstances have deteriorated over the past year will be less able to increase spending.
What does all this mean for investors? We have recommended the inclusion in portfolios of funds of longer-dated bonds to improve diversification. In risk-off periods, such as when the economic outlook is deteriorating, rising bond prices should compensate to some degree for lower equity prices. In recent days we have seen the opposite; concerns that economies will overheat and generate inflation – have prompted investors to sell bonds, forcing yields higher. In our experience, such moves are self-correcting. Rising bond yields represent a tightening of financial conditions – addressing the very concerns that caused them to rise in the first place. Therefore, we would not be surprised to see bond yields retreat once more in the coming days and weeks
