The time is now?

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In the short term, markets have understandably focused on the immediate impact of efforts to contain covid-19 on economic growth. For Insight fund manager David Hooker, a more pressing question is whether recent events may sow the seeds that bring the current era of low inflation to a close.

For now, COVID-19 and the economic crisis that it has triggered, have given investors another reason to think that inflation is dormant. The global economy has experienced a ‘sudden stop’, and it is possible that the resulting recession will be deeper than that experienced during the global financial crisis. Investors have understandably focused on the immediate impact and soaring levels of excess capacity, including unemployment, have led to concerns that, if anything, inflation will be too low.

Reinforcing this view is the persistent lack of inflation around the world – a situation that has existed for over a decade. This appears to have become deeply embedded in market psychology, and the pricing of major government bond markets suggests that these conditions are being extrapolated into the distant future. At longer maturities, the yields of many government bonds only make sense if central banks fail to meet their inflation targets for decades to come.

This conviction – that inflation is now structurally low – has allowed the deployment of easier monetary policy and quantitative easing programmes of gigantic size.

Chart 1: The pace of central bank purchases is unprecedented
Chart 1

Source: Insight and Bloomberg. Data as at 30 April 2020. Rolling 12mth change in major central bank balance sheets)

But covid-19 has changed the world - An era of deglobalisation may have already begun

While the near-term outlook appears benign, it is notable that a number of the trends that have acted to contain inflation over the last few decades are going into reverse.

Even before the current crisis, a reassessment of globalisation was underway, with the US administration using tariffs as a tool to incentivise corporations to prioritise domestic production. Although this has been partially successful, some companies have responded by simply shifting production from China, the main target of the tariffs, to other countries that have low production costs.

In light of recent events, and the rapid breakdown of global supply chains that has occurred, corporations are likely to question their own production models. The lower costs and efficiency of globalised, just-in-time supply chains have been shown to be highly vulnerable to shocks, and the coronavirus may well prove more effective in galvanising a change in corporate strategies than tariffs ever did. Coronavirus may turn out to be the final nail in the coffin of globalisation.

As supply chains shorten, the higher labour costs involved in domestic production, combined with a need to maintain higher inventories and an allocation of resources where lowest production cost is no longer the primary driving factor are all likely to be inflationary.

A technology cold war is brewing and is likely to broaden to other key sectors

Once the threat of COVID-19 has subsided, the political focus is likely to shift to more closely scrutinise the initial weeks of the crisis, and the growing rivalry between the US and China could force countries and companies all over the world to choose sides. It is likely that going forward governments will encourage the use of new ‘national champions’ in areas of importance, with cost no longer the most important factor in allocating contracts. The 5G mobile infrastructure debate is perhaps a precursor of what is to come, with significant discomfort even before the crisis in allowing the use of Chinese technology to build key technology infrastructure. The realisation that basic drugs and healthcare products can become unavailable in a crisis, will likely now broadened this debate beyond just technology, and call into question the dominance of some countries in key products.

Renewed regulatory scrutiny is likely to enforce this change and further interfere with the supply chains of global tech, pharma and consumer-goods firms, in particular. If regional battle lines are drawn it could lead to radical changes for many business models, with many high value products such as mobile phones reliant on low-cost manufacturing and assembly in China and other Asian nations.

Social distancing will impact profitability

As the world eventually returns to work, the longer-term impact of social distancing will become clearer. The shift to remote working and online shopping will almost certainly have become further embedded into normal life. At this stage, it is unclear if companies will need to permanently increase the office space used by each worker and cost saving initiatives such as hot desking could become unacceptable for many workers or whether the reverse will happen with more staff working from home. Factors such as limits on the number of shoppers being within a store at any time and greater distances between tables in restaurants will impact corporate profitability, likely pushing up prices.

For some sectors such as travel, the impact could be even more severe. Pre-flight health screens, health passports and greater use of technology to reduce human contact will all come at a cost. At the same time, the number of people allowed within a coach or airplane may be lower than before – and higher ticket costs are likely the only way that many companies will be able to generate sufficient revenue.

Labour migration

For industries such as agriculture and hospitality, it may become more difficult to persuade migrant workers to leave their home countries for short periods of time if there is a risk that they may become trapped by lockdowns. It is also possible that governments may choose to discourage such travel. For countries such as the UK, Spain and Italy, all of which rely heavily on seasonal workforces for their agricultural sectors, sourcing domestic workers may prove expensive.

It’s clear that all of the above issues are likely to put pressure on profit margins. But, the psychological hangover of lockdown may also make it easier for price increases to be passed on if they are seen as alleviating consumer concerns. A premium for greater space, or locally produced goods may well become normalised in a world emerging from lockdown. This is likely to become more deeply embedded in consumer behaviour with every future wave of the virus.

Populism increases policy risk

This retreat in globalisation and rise in nationalism coincides with stagnant productivity growth and widening inequalities, which in turn is increasing social tensions. Although these changes reflect long-term trends, the rise of populist parties has accelerated rapidly during the last decade. This coincides with two important events: the diffusion of social media, and the global financial crisis. It is very likely that both phenomena have allowed new parties and leaders to rapidly gain political traction, redefining the political landscape in many countries.

Although crisis leading to a rise in new, more extreme, parties is not a new phenomenon, the speed at which this change is now occurring is unprecedented. A lack of trust in mainstream political parties and global institutions increases the risks, as more radical and unconventional policies can be brought forward without challenge. Indeed, the intrinsic riskiness of populist leaders can actually make them more attractive to disappointed voters, who welcome risk because it gives them a chance to make up what they have lost. Policies that effectively monetise debt or rapidly expand demand have historically been inflationary.

Central banks can’t be relied on to anchor inflation

Post the global financial crisis, the resolve of central banks to purely target inflation has gradually worn away. Inflation targets have been expanded to include unemployment and broader economic factors. The line between central banks and government policy has also blurred with the introduction of quantitative easing. Adjustments in monetary policy are now arguably more to accommodate and support expansionary fiscal policies than with an eye on long-term inflation. Central bank independence, once critical for market confidence in a country’s bond market, has been replaced with debates about lack of supply in markets now faced with a dominant buyer for whom long-term fundamentals have no relevance. It is now questionable whether central banks globally would have the ability to take the hard decisions necessary to combat a resurgence in inflation, especially one that was accompanied by weak growth and high unemployment.

Chart 2: The line between central bank and government policy is blurring as central bank balance sheets expand
Chart 2

Source: Insight and Bloomberg. Data as at 30 April 2020. Federal Reserve balance sheet as % of US GDP.

Faced with higher debt burdens, governments may welcome higher inflation

In an era where central bank independence is becoming ever more questionable, a period of higher inflation may not actually be unwelcome for some politicians. The debt profile of many governments is likely to radically change in the months ahead. Lower economic activity will see revenues decline at a time when major fiscal stimulus packages are being implemented. In the US, the fiscal deficit was at elevated levels even before the crisis hit. Even in a scenario where the virus is contained and activity rapidly rebounds, debt to GDP will likely be markedly higher in coming years for many countries. Another period of austerity is likely to be difficult for many politicians to palate, and a period of debt-eroding inflation may be more tolerable.

Debt monetisation by another name

At this stage, major central banks appear to be prepared to expand their balance sheets sufficiently to purchase all of the debt that will need to be issued by governments to fund their fiscal deficits in coming years. All have resumed or expanded large-scale asset purchase programmes.

Quantitative easing was introduced as a temporary measure post the global financial crisis but has effectively now evolved into debt monetisation. Limited, gradual bond purchase programmes have evolved into unlimited shock-and-awe policies, extending into corporate bonds and even equities in Japan. When governments have monetised debt in the past, inflation has always followed. In the future, we may look back at today’s central bank purchases and wonder why it wasn’t considered to be debt monetisation.

Keep a close eye on money supply

The effects of quantitative easing are poorly understood, in part because standard models of monetary policy predict that it doesn’t work. Post the global financial crisis, quantitative easing was introduced against a backdrop of governments aggressively tightening fiscal policy and bank deleveraging. The inflationary impulse from central banks expanding their balance sheets was simply a counterbalance to powerful disinflationary forces elsewhere and, as a result, money supply was largely unchanged. This new expansion is against a very different backdrop. Governments are now pursing an aggressive fiscal expansion, and the banking system is better capitalised and being actively encouraged to lend, with government guarantees being offered on loans. This could potentially translate into an acceleration in broad money supply growth, historically a precursor to higher inflation.

Conclusion

The whole structure of current asset prices appears to be underpinned by the expectation that inflation – and by implication interest rates – will remain low for an extended period. The yields available in many long-dated government bond markets, only make sense if central banks fail to meet their inflation targets, on average, for a generation to come. Low yields in turn feed into elevated prices in other asset markets such as equities and property.

An unexpected rise in inflation is thus something that investors should be most determined to guard against. If perceptions change, and central bank policy becomes constrained as a result, it could have far reaching implications for asset prices.

An important question will be how anchored inflation expectations prove to be. In Japan, the central bank has been at the forefront of unconventional policy and, after various rounds of fiscal expansion, government debt/GDP is high. It is understandable that some people view the current status quo in Japan, and the lack of any inflationary pressures, and believe that other major central banks are simply following the same path. Japan, however, also faces a severe disinflationary headwind stemming from its demographics, that acts as a natural anchor to inflation expectations. If the public in other major economies loses faith in the ability of central banks to take the necessary steps to control inflation, then inflation expectations could rise more rapidly than currently believed.

Sometimes, warning signs that should have been clear at the time only move into focus with the benefits of hindsight. With this in mind, we would note that the Bank of England’s quarterly Inflation report was last year renamed the Monetary Policy Report…

Important information:

https://www.bnymellonim.com/outlook/global-disclosure/

MAR001185, GE0143

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