Is inflation poised for a comeback?
Central banks and governments in recent weeks have responded quickly and courageously to the economic threat posed by the coronavirus crisis. Such a synchronous worldwide flurry of monetary and fiscal policy activism is unprecedented in its form and scale. It has sparked a debate among experts about whether or not a huge spike in inflation inevitably lies ahead sooner or later. We do not see a risk of surging inflation, at least not in the near term. On the contrary, we anticipate a deflationary tendency for the next 12 to 18 months. Over the longer term, though, there’s an increasing probability that the protracted period of uninterrupted low inflation rates may come to an end in the decade ahead.
(Overly high) inflation looks a long way off
Inflation in the world’s industrialized nations has been in retreat for years now. The annual inflation rate in Switzerland, for instance, has averaged out to less than 1% over the last decade. Inflation in the Eurozone doesn’t look much different: since 2011, the year that Mario Draghi took over the helm, the European Central Bank (ECB) has invariably fallen short of its 2% inflation target. And even in the USA, where inflation rates are traditionally a bit higher, the price trend in recent years has tended to surprise on the downside. Meanwhile, the Bank of Japan (BoJ), a pioneer in monetary policy innovation, has been futilely trying to lastingly free the land of the rising sun from the grip of deflation for almost two decades. Seven years ago, the assets on the BoJ’s balance sheet equaled 35% of Japan’s annual economic output. At that time, the BoJ owned 12% of all Japanese government bonds outstanding and 0.5% of the Japanese equity market. Today those three figures respectively stand at 115%, 50% and 6%. The BoJ nevertheless had to admit again recently that it would probably continue to come up short of its inflation target in the future.
Target missed
An inflation rate of 2% was already out of reach before the crisis
Core inflation rates
Source: Bloomberg, Kaiser Partner Privatbank
Globalization, automation, digitalization – all of these phenomena have fueled the disinflationary trend over the last two decades. Moreover, it looks as though the Phillips curve – the economic model that describes the relationship between (falling) unemployment and (rising) inflation – no longer works nowadays. We can see this, for example, in Germany, which has registered record-low unemployment figures and significant wage growth in recent years but no notable impact on inflation. Does this mean that a concern about mounting inflation risks in light of the billions spent on buying up securities, the enormous economic stimulus programs and massively swelling government debt is nothing more than alarmism? After all, the coronavirus arguably has already dragged us into a recession at present, and in the past recessions have always had a deflationary impact for quite a long time.
Deflationary tendencies predominate in the near term
Our baseline expectation, in fact, is that we are likelier than not to see deflationary tendencies for the next 12 to 18 months. A look at commodity prices, which are exhibiting a clear downtrend despite a recent mild rally, suffices to draw this conclusion. The coronavirus crisis has dealt a simultaneous shock to both supply and demand. Disrupted supply chains or breakdowns in production efficiency may even cause prices for some goods and services to rise, as we have observed in recent weeks for certain food products. On the whole, however, the weakened demand side is bound to far outweigh other factors in the months ahead. This is being presaged, for example, by surveys of corporations, which predominantly intend to lower their prices in the near future. The soaring unemployment figures in the USA and some European countries will also exert a deflationary impact at first because workers will find themselves in a weak negotiating position in the next round of wage talks.
Low commodity prices…
…have a deflationary effect
Brent crude oil price in USD and Bloomberg Commodity index
Source: Bloomberg, Kaiser Partner Privatbank
Arguments for rising inflation rates
As described at the outset of this article, the current low inflation has very strong inertial forces. However, we see a number of arguments that suggest at the least that (sharply) rising inflation rates in the years ahead are by now more than just an improbable fringe risk. We ascribe a scenario in which inflation lastingly climbs to above 2% by the middle of this decade a probability of 20% to 30% today.
Rapid recovery in economic activity: The coronavirus recession is unique in its nature. The cause of the recession this time isn’t economic imbalances or asset bubbles, but rather an endogenous shock. Therefore, if there are no further infection waves, world economic activity should recover comparatively quickly after a short, steep contraction. Even in our not particularly optimistic U-shaped recovery scenario, economic activity in the industrialized nations should return to the pre-crisis level by the end of 2021 at the latest. In comparison, economic activity in the aftermath of the financial crisis took a much longer 14 quarters to recover. The faster recuperation from the public health crisis could also allow reflationary forces to recover more quickly this time.
(Overly) slow pullback by central banks: Central bankers learned lessons from previous crises, and their reaction to the coronavirus pandemic and its consequences was accordingly swift and comprehensive. Central banks’ balance sheets look set to balloon further in the months ahead. What’s a boon for risk assets could increasingly pose a threat to monetary stability in the longer term. The financial markets in the meantime have become chronically dependent on cheap money from central banks. By now it seems hard to imagine that there will ever be a successful return to “normal” monetary policy conditions. Central bankers are in near-unanimous agreement that deflation and feeble economic growth pose a greater danger than inflation does. At the US Federal Reserve, a symmetric inflation objective that deliberately targets an inflation rate above 2% temporarily is widely accepted by now among policymakers. Monetary policy therefore looks destined to remain ultra-expansive in the years ahead, in part also because the industrialized nations simply can’t afford a turnaround in monetary policy in light of their ever-swelling public debt loads. If inflation actually does pick up significantly in the future, central banks will likely be too late in recognizing it. Moreover, political pressure would probably constrain their ability to take action because governments would view inflating away public debt as a policy option.
Limitless
Further bloating of central-bank balance sheets
Aggregate assets (Fed, ECB, BoJ, BoE, SNB) in relation to global economic output
Source: Bloomberg, Kaiser Partner Privatbank
Fiscal policy activism: Central banks have been very active in the current crisis, and the same goes for governments around the world, which have enacted one economic stimulus package after another. In Europe and the USA, the size of the support measures now amounts in most cases to between 5% and 10% of annual economic output. A globally coordinated economic rescue operation of this magnitude is unprecedented in history. Similar to the monetary policy situation, activist fiscal policy carries a risk that it will be left in place for too long. Even the federal government of Germany has forsaken its frugal virtues (for the moment) – taking on debt without any regard for massive budget deficits has gained widespread acceptance in the face of the coronavirus crisis. The raising of debt is being justified on the grounds of inequalities both between countries (in the case of Europe) and within individual countries, particularly in the USA, where the coronavirus crisis is further accentuating the rift between the poor and the rich. The checks recently sent to US households could usher in a new trend. Widening inequality has since been recognized by both political camps as a key election campaign issue. Further or even permanent transfer payments to support the poorer strata of society, which would primarily be spent on consumption, could foster an overheating of economic activity, with corresponding consequences for inflation.
Fiscal policy activism(?)
Governments are reacting faster and more extensively than before
Fiscal policy measures (excluding loan guarantees, in relation to annual gross domestic product)
Source: Bloomberg, Kaiser Partner Privatbank
Deglobalization: The 2008/2009 financial crisis already dealt a blow to globalization. The coronavirus crisis looks set to further accelerate the reversal of this economic success story, which has accounted, by the way, for a large part of the disinflationary trend seen in recent decades. The public health crisis has poignantly highlighted the risk that economically optimized global supply chains pose. Autonomy and supply security are now back at the top of the agenda for governments and corporate executives in the industrialized countries. Some companies are likely to completely or partially withdraw particularly from China. Besides, the coronavirus crisis has also further escalated the cold war between the USA and China. The trade tensions between the two economic superpowers look destined to remain unresolved for a long time to come. This, coupled with the general trend toward mounting protectionism worldwide, facilitates an upward drift in inflation rates.
The impact of inflation on the financial markets
While debate about the longer-term inflation risks rages, at times acrimoniously, there is a relative consensus about the near-term outlook: there is no prevailing “danger” for the time being. This is the predominant view not just among economic researchers; a look at market-based inflation expectations also reveals a certain degree of tranquility. Five-year breakeven inflation rates for the USA and Europe, for example, are currently pricing in continued low inflation. This also means that investors at the moment can inexpensively hedge against rising inflation rates by holding inflation-protected bonds, because if actual inflation in the years ahead exceeds the currently expected rate, inflation-linked bonds will outperform conventional nominal bonds.
Well-anchored low inflation expectations
The market expects to see no increase in inflation
Market-based inflation expectations (10-year break-even inflation)
Source: Bloomberg, Kaiser Partner Privatbank
What other consequences would rising inflation have? Gold in the past has repeatedly proven its role as a store of value and is likely to glitter in a climate of higher inflation. Also, it will be intriguing to see how much this characteristic also gets ascribed in the future to digital currencies like bitcoin. “Real” assets should generally benefit, so this means that real estate is bound to as well. Among paper currencies, the Swiss franc looks destined to stay strong against other currencies on the back of its fundamental strength and Switzerland’s likely lower inflation rates than elsewhere, even in an inflation scenario.
On the equity markets, a new inflation regime accompanied by an upward drift in interest rates could spark a shift in investment style preferences. The years-long outperformance of growth stocks versus value stocks could thus come to an end. In the inflation scenario described above, we may ultimately also see a reversal in the performance of small-cap stocks relative to large-cap heavyweights. Most large-cap companies have an international focus and would face a headwind in the event of surging protectionism. In contrast, small-cap companies, which are mostly domestically oriented, could arguably expand their profit margins in a climate of rising prices, justifying higher stock valuations.
Catalyst for a value-stock comeback?
Higher inflation (and interest rates) could spark a style rotation
MSCI World Value vs. Growth
Source: Bloomberg, Kaiser Partner Privatbank