Entering the inflation debate: transitory or here to stay?

One of the most significant top-down discussions impacting asset prices (bonds and equities) today is inflation: are we heading into a period of inflation or not?  The debate has been rumbling since the policy reaction to the Covid pandemic but is now reaching fever pitch as we’ve seen the first above trend inflation data.

As European equity investors, we believe we must have a view. While it would be nice to simply claim that we’re ‘bottom-up’ and ‘fundamental’, the fact is we can’t ignore the polarisation in markets of the last decade, underpinned by monetary dominance and fiscal repression.

Duration (defensive/Quality) assets have benefitted from the low inflation period and short duration assets (cyclical/Value) have suffered. This part is straightforward to understand: medium-term inflation influences the risk-free rate (RFR) and it’s the RFR that the market uses to discount future cash flows. If expectations are for sustained low inflation, then the discount rate is low and asset prices rise and vice versa.   

The problem is that forecasting medium-term inflation isn’t straightforward. Nothing causes normally amiable economists to become more tribal than asking them to explain the causes of inflation. In this article, we explain why we believe the arguments for transitory inflation are something of a distraction and point to areas of the market that could do well as mid-term inflation emerges.

Monetarists vs Keynesians and the case for transitory inflation

Monetarists can ‘prove’ inflation is a consequence of broad money growth while Keynesians will eloquently explain that as the demand curve shifts (to the right) faster than the supply curve, then prices rise.

Given we can’t even agree on the definitive cause of price moves then it’s not surprising there’s debate at any moment in time as to what the price moves might be.

The Monetarist vs Keynesian arm wrestle has, we believe, become more visceral since the global financial crisis (GFC) because excess money supply hasn’t led to significant inflation¹. This has empowered the Keynesians to look for other rational reasoning of deflationary forces such as demographic trends (declining workforce), technology (increased productivity and labour marginalised) and globalisation (lower cost supply) with post crisis austerity the final straw.

Accordingly, when looking at the post-Covid world, Monetarists have less voice and the Keynesians argue these same three structural trends persist and, hence, any inflation we are seeing today is purely transitory.

This transitory narrative is a function of the severity of the enforced downturn which has impeded but, importantly, not destroyed supply (capital still exists). Therefore, as demand has recovered (surprisingly) fast, supply is temporarily struggling to cope and prices have risen, if only temporarily.

The effects have been exacerbated by the Suez blockage, lack of belly capacity in air transport, low inventories and even the weather in Texas.

If one believes that inflation is ‘only transitory’, logic dictates that it won’t impact the discount rates and therefore duration assets aren’t at risk and short duration cyclicality assets remain value traps….

Time to address the long-term deflationary narrative

The irony is that transitory inflation believers would likely claim to be long term and not worry about the short-term noise. However, we believe they’re perhaps missing the more fundamental structural changes happening post Covid.

We will try to outline why and in doing so will intertwine both economic theories, which we appreciate may anger more purist economists.

Firstly, we need to address some of the structural deflationary points:

• Demographics. These are hard to argue with. European demographic trends are unhelpful albeit, net of migration, the data to 2019 suggest population is broadly stable. An aging population likewise doesn’t help. To us it remains an ongoing pressure but not incrementally so.
• Technology. Often touted as a deflationary force. It increases productivity and hence pushes the supply curve to the right (we can produce more for lower prices). However, importantly, this is nothing new, innovation has been a relative constant over time. We also wonder if, in the post-GFC period, dominated by monetary policy, corporates were rewarded for ramping shareholder returns (dividends and buybacks) at the expense of investment and so exaggerated the deflationary impact.
• Globalisation. We believe this is most contestable as a structural cause of deflation. Transferring production to Asia has undoubtedly been a key deflationary force for at least the past 20 years. China has been both a source of cheap labour and then, through policy, a source of excess production assets. In addition, at times of stress, China has devalued its currency, thereby easing inflationary pressures.

We strongly believe that it’s no longer so obvious. Reaction against the offshoring of US manufacturing jobs to China was a key source of Trump’s appeal. His firmly anti-China policy is one of the few policies the Biden administration has continued to pursue and, with China GDP set to rival the US by 2030, it is unlikely to stop being a vote winner. Within China itself, policy has shifted from emphasising the producer economy towards the consumer with some producing assets being forced to close.

This has been aided by Environmentalism being part of the domestic policy agenda. Lastly, it’s perhaps notable that despite strong domestic wage inflation, and the recent Renminbi appreciation, there’s been no talk of China devaluing – could China actually be exporting inflation?

We should also be aware of emerging market monetary policy setting being more traditional than developed markets currently – it’s developed markets running the largest ever deficits, while China tightens.

The key point is that these structural deflationary forces, while still present, are a less powerful backdrop than we’ve become accustomed to. Meanwhile, there is the incremental risk from emerging inflationary trends.

Inflationary structural trends – are they here to stay?

Covid has changed voter tolerances, which in turn affects policy. This then has an impact on the economic backdrop and, ultimately, inflation risk.

We believe the true impact of the pandemic goes beyond headline fiscal payments, which are only as inflationary as the next cheque/infrastructure project, and more towards a change in what people truly care about and will vote for.

The post-Covid regime shift is happening to address the issues of Inequality and Climate Change. The vulnerability exacerbated by the health crisis is creating tolerance of big government. Unlike after the GFC, when the response to a financial crisis was fiscal austerity, today the electorate want fiscal dominance.  The newly created EU recovery fund, worth €750 billion, is such an example. 

These, we believe, are inflationary forces. Big government is historically a poor allocator of resources compared to the private sector – it curtails supply (the British auto industry in the 1970s is a good example of this).Addressing inequality at a micro level means a greater share of stakeholder profits going to wages rather than to shareholders and management. This would direct resources to lower income earners who have a greater propensity to spend and therefore drive demand.

Inequality at a macro level means infrastructure projects and providing incentives to invest, thereby driving full employment and reducing social scarcity. Full employment as a policy is inflationary.   

The climate agenda is a wrapper to digest the fiscal shift but it is also inflationary in its own right.    Net neutrality requires capital investment: we need to build turbines, solar parks and transmission networks, which creates demand for physical assets.

However, we also need to build the infrastructure with renewable commodities meaning cement needs to be ‘green’ and steel needs to be low carbon. Some commodity producers will invest and take advantage, but others, previously running for cash, will be forced to close and hence we will finally see capacity come out of the market.

Consumers will be affected too with tolerance for higher prices (especially if wages are increasing) for greener products and replacement demand driven by policy – think replacing vehicles for hybrid or electric alternatives as internal combustion engine (ICE) cars are being banned from urban areas. This is inflationary.

Environmental policy is affecting capital availability already. Financial regulation means asset allocators need to disclose environmental data with the fastest growing asset class being ESG compliant funds.

These fund flows impact corporate capital allocation with environmental projects getting cheaper funding than brown projects. There simply isn’t cheap money available for coal, new oil or other environmentally challenging industries and, hence, over time, there will be a squeeze of supply. We know we are approaching peak oil at some point, however, what happens if peak supply comes first: prices rise – inflationary.

We believe there are some incremental inflationary forces at play, absorbing output gaps. These, combined with the perhaps abating ‘structurally’ deflationary forces will lead to net inflation, but on the condition of monetary complicity.

Monetarists believe money growth is key and MV=PT (or Money Supply times Velocity of money (rate of exchange)) is equal to Prices times Transactions. What does seem to be true is that without money growth, there’s no inflation. Simply because without new money, increased demand growth from, say, Government crowds out private sector demand and so net there’s no growth.

Importantly then, post-Covid, we have both fiscal dominance and monetary accommodation. Post-pandemic, broad money growth has been far greater than following the GFC and we also have a banking system that’s fully functional, i.e. neither deleveraging nor working out bad loans.

Monetary policy makers are shifting their mandate to remain accommodative for longer with targets of full employment and average “synchronised” inflation. This allows developed market central banks to stay ‘behind the curve’, meaning they do not feel the need to address the current inflation scenario.

There’s also consensus that central banks want fiscal cooperation in support of their tired monetary bazookas and will manage the interest costs through yield curve controls if required.

As per the Fischer equation, MV=PT, with ‘V’, the velocity of money, as the balancing item. The ‘V’ is probably best understood as how much the money in the economy changes hands. It has fallen over many years and fell more drastically post Covid as the saving rate has increased. However, we believe ‘V’ will increase as economies unlock, the savings rate falls and inequality falls (lower incomes have a lower propensity to save). 

With abundant liquidity meaning banks will be able to lend (even as savings are reduced), central banks printing money and velocity increasing, then prices will rise: inflation.

Transitory inflation is just a distraction - cyclical stocks and Europe set to benefit

We believe that arguing about the short-term transitory inflation numbers misses the key point.  Yes, short-term inflation is spiking because of bottle necks. However, asset prices are based on mid-term inflation forecasts, not crisis-related data. Therefore, it’s mid-term inflation we need to think about.

It’s our strong belief that mid-term inflation will be sustained at above central bank targets, albeit not rampant. Indeed, inflation-linked bonds are signalling as much. Yet, the ongoing polarisation of the equity market with preference for long duration and growth equities would suggest something different.

In our view, from a top-down perspective, the types of companies that could benefit from nominal growth are the short duration equities and these are the cheapest parts of the market. We believe they are cheap hedges to the mid-term inflation risk that we have argued for above.

In addition, from a bottom-up perspective, it’s the same sectors and companies that will be a direct beneficiary of the political shifts we’ve mentioned. The environmental agenda is pro-investment; it’s pro-cyclicality.  

Companies in industries exposed to construction materials, utilities, automotive OEMs and even banks through volume growth, all might benefit. These are also where currently the most compelling valuations are.

Likewise, the impact from more re-balancing of stakeholder profit shares and fairer taxes with bigger government are less onerous on European companies. This is simply because they have been operating under a more egalitarian environment for longer than other global regions. 

Generally, equities are owned with the aim of protecting you from inflation. However, many portfolios that have outperformed over the last decade, and more, have been ones that have benefited primarily from a lack of inflation – so one composed of bonds and long-duration/growth equities.

As we move into a new regime of inflation for the reasons argued, in our view, this type of portfolio is unlikely to do so well. On the contrary, our valuation discipline has resulted in our fund ranges being exposed to short duration or cyclical stocks, which we believe are well positioned in the more inflationary backdrop we have outlined.