05 Aug 2020
One of the most heated debates among investors is whether we are about to enter an era of inflation. Matthew Beesley, CIO, shares his view on how portfolios can be positioned for the economic environment ahead.
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It’s a question I’ve been asked a lot over recent weeks. A leading paragraph in an article in The Times a month ago read: ‘Central banks are sowing the seeds of double-digit inflation by printing money and relaxing bank regulations, a paper from the Institute of Economic Affairs has warned’.
Fast forward to today and commentators voice concerns that the weakening US dollar could be the biggest driver of global inflation. And that the intensifying trade war between the US and China could drive inflation or even stagflation.
It could be different this time. Banks are not gumming up the works as in 2008-9, which means measures from central banks should flow more directly into economies. But the big change is the fiscal policy deployed in an attempt to offset the effects on economies of Covid-19.
Then there’s the other side of this fiscal policy. How acceptable will higher taxes be in economies where the human impact of the Coronavirus has been so significant? What will be easiest for governments: raising taxes, cutting public expenditure or simply allowing a little inflation into the system to help erode debt?
Add to this the potential effects of ‘de-globalisation’ and the ingredients for inflation appear stronger than during the past decade.
But it still seems far from inevitable. Factors which work against inflation are still in place. Populations continue to age, even within emerging market economies. The role of technology has become more prominent during lockdowns. And the effect on employment and corporate balance sheets of Covid-19 will soften if not debilitate demand.
Taking a step back, we should perhaps be asking Inflation, disinflation, deflation or ‘noflation’? So let’s have a look at the wider argument about money supply. From the traditionalist’s point of view, inflation is inevitable. Milton Friedman and his cohort of monetarists have ingrained in many of us this sense that that rapid expansion of money supply leads to rising inflation.
In recent months, money with zero maturity (MZM) and M2 (readily-available cash, deposits and securities) have risen sharply. But we saw similar spikes in both MZM and M2 in 2002 and again in 2008, albeit to a slightly lesser extent. Neither led to rampant inflation.
Recently-published research by Alpine Macro (Money, Credit and Inflation, June 2020) helps explain why. It points out that the relationship between money supply and inflation in the US has completely decoupled over the past 25 years. ‘Money aggregates’ – in Alpine’s case, the relationship between M2 and US GDP – have continued to rise while inflation remains anchored. Japan and China are two other examples where this decoupling has occurred.
Money supply has continued to rise while inflation has remained anchored
Why is this? Because money velocity has fallen. Low interest rates have reduced the opportunity cost of holding cash, lowering the velocity of money. But will rates stay low? And if they do, will that keep a lid on money velocity – which in turn will ensure that this decoupling of money supply and inflation persists?
We have recently seen huge amount of monetary and fiscal stimulus injected into many economies. So perhaps we are looking at the return of asset inflation as all this cash seeks a home. Inflation is anchored. Money multipliers have been falling. But ‘money aggregates’ have been rising and monetary policy is ultra-accommodative. So is it as simple as this being a period of ‘risk on’?
It is difficult to make this assertion with full conviction as we adjust to the longer-term effects of Covid-19. Corporate balance sheets may reflect more equity capital and carry more cash. Personal savings ratios have already exploded upwards. Unemployment will rise. This means less spending by consumers and corporates, and less investment. In other words, deflationary pressure.
As such, monetary expansion or money supply will likely drive up asset prices. Perhaps we have an asset price bubble in the making.
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