Many experts have raised the specter of inflation, starting from as early as late 2020 to more likely 2-3 years out. While I am not accomplished enough to make a prediction, I will attempt to lay out what the consensus view is on inflation trajectory. What makes it harder to predict is that there is some element of randomness around inflation and it depends not just on economics but also on consumer psychology. This blog would also be incomplete without discussing the implications for a few asset class which I will discuss in the later part of this blog.
Almost everyone agrees that the current recession is deflationary in the short term. There is no inflation currently and most experts agree that one should not expect inflation in the short term. There is a huge demand shock in the system due to pandemic and it has manifested in reduction in prices for many items including oil, rental apartments, eating outside of home and others. Unemployment rates are extremely elevated and may still continue to remain there in the winter as companies continue to assess the outlook for next year.
However, many experts point towards a number of inflation (or reflation) drivers in the next few years:
- Increased money supply, especially driven by credit guarantees from government over bank lending
- Localization of supply chains which may drive the cost of goods higher
In response to the slowdown the Federal Reserve provided swift liquidity and increase in money supply leading the world in terms of monetary responses. Increased money supply by itself through increased indebtedness may not drive inflation as has been the case in previous increase in indebtedness in 2009. However, Russell Napier has pointed out that this time its different. Government is going to the commercial banks, getting them to lend and guaranteeing the loans making loans a contingent liability on government balance sheet. Changes in Fed’s responsibility (through exigent circumstances) which may use Fed liabilities for spending, absorbing losses or making it as a legal tender will drive inflation higher.
The other reason which is hypothesized driving inflation of goods is the localization of supply chain. The main argument has been that China has been a big deflationary force in the overall US economy due to its cheap exports. However, if the tariffs increase or manufacturing is brought back inside the country it may drive the prices of goods and services higher – a driver of inflation.
Increase in inflation would mean that the nominal bonds may not be able to sustain value in the longer term – although the short term outlook is very unclear. Government is likely to exert yield curve control pressures through its purchase of treasuries as well as forcing institutions such as insurance companies and financial institutions to buy treasuries to maintain yield curve control. Unclear if that can be effective as eventually market forces may be too strong as the bond market starts to decline. Ultimately, there are not many takers of long dated treasury bonds in principle. Even then we haven’t seen a decline in the long duration treasuries.
Stocks are an interesting proposition as well. Tech stocks in particular may be getting inflated as a result of very low discount rates. If the rates start to go up as a result of inflation, their toplines are not impacted but the overall valuations can go down significantly. There are clearly a number of stocks that will respond positively to inflation.
Assets that may be defensive in this situation are clearly Gold, Commodities as well as TIPS. Commodities are clear hedge against inflation as well and may be leading indicators to inflation.
The risks to this forecasts can be if US goes into the Japanese trajectory of no inflation and no growth. A stagflation could be a possible outcome – but one that may have a lower odds. Ultimately, my goal through these blogs is to articulate various view on growth, and inflation scenarios and think about the asset allocation based on the odds of outcomes. This might be the real “all weather portfolio” that us individual investors need.