I keep babbling on about inflation, and expectations of its imminent return, because I think it is of huge importance. Two thoughts. The first is that we are mid-way through a multiyear liquidity bubble in which central banks have a huge role to play in providing huge injections of liquidity into the system. The Fed and others are buying up bonds or even Bond ETFs because they want to push everyone into riskier asset classes. Thus, if that liquidity conducive environment was to change because central banks started running scared of inflation, we’d see a major foundation of the equity bull market reduced to rubble.
In addition, stockmarkets are in terms of short-term sentiment enormously influenced by central bank expectations for inflation. If central banks start worrying about inflation, they will be tempted to raise interest rates which will in turn have an impact on bonds, and equities.
But when we say inflation we also need to tread with care. Yes, the actual level of inflation matters – and thus whether you are using a measure for core, CPI or RPI – but what is equally important is what everyone expects inflation to be in the future. Put simply, if there are any nasty surprises, with inflation much higher than expected, then I think it would be perfectly reasonable to expect markets to react badly.
So, in any examination of inflation we need to break down what we are looking at:
- The measure used
- The absolute level in relation to a 2% guidance (and deflation as the threat)
- The rate of change in that inflation reading
- The rate of change in expectations for that inflation measure
- Any indicators that feed into inflationary measures which might suggest an inflationary/deflationary surge is on its way.
- The time frame also matters. Measures might head one way in the next few months but switch direction once we move into the medium term of say a year or two.
The crucial insight we are all collectively looking for is the end of central bank, low inflation, low growth paradigm. If investors think we are moving to a whole new paradigm, a new narrative, then all bets are off, and we could see massive market turbulence.
I think the consensus is overwhelmingly that we are stuck in a low inflation if not deflationary scenario for the next six to 12 months. Once we move out to 2021 and 2022, I think that consensus breaks down. Many, like me, reckon we could see inflation make a very unwelcome return – arguably many central banker s might like such an outcome. But there is also still a significant spectrum of views which suggests that we should really all be much more worried about deflation even in the medium term.
So, with this background out of the way, I thought I’d pick up on two interesting sets of observations. The first is by a new source, Michelle Cluver, a CFA at ETF Firm Global X who’s recently put out a very interesting macro summary. You can see it here at – https://www.globalxetfs.com/cio-corner/inflation-consumption-and-the-economic-recovery/
Her first focus is on money supply and the velocity of money – regarded by many economists (especially those with a monetarist framework) as hugely important. Cluver reminds us that the velocity of money is closely related to savings. Historically, there is a negative 51.5% correlation between the quarterly velocity of money and personal savings as a percentage of disposable income in the U.S.
“When the country spends more and saves less, the velocity of money increases. Conversely, when consumers protect their finances or work to restore them, like in the aftermath of the Financial Crisis, savings rates increase. The chart [below] 2 shows savings peaked at 33.5% of disposable income in April before steadily improving to 19% in June. The COVID lockdowns had a negative effect on consumer spending and business investment while encouraging saving. In line with this, U.S. GDP contracted at an annualized 32.9% in Q2 after declining 5% in Q1.” This bump in savings and thus the decline in velocity would tend to indicate a strongly deflationary pulse.
Which brings us to the second chart, also from GlobalX. This shows US inflation trends – the key insight here is that food inflation is starting to stabilize – coming off its pandemic high. Additionally, since the start of the pandemic, price increases for shelter became more subdued. Overall these two charts should re-assure us about any supply side challenges forcing up price levels in a Covid bounce back.
The next set of numbers comes from analysts at DWS and is focused on the Eurozone and the growth of M3 money supply. The key long-term narrative is that there is a correlation between the growth of M3 and inflation. And M3 money supply is certainly on the rise in the Euro zone. Yet much of that boost has come from the “the public sector [which] has expanded credit enormously to compensate for the expected tax shortfall and increased spending, thus holding large amounts of liquidity at the moment. The corporate sector, too, has upped its liquidity position by increasing debt, not least thanks to generous state-guaranteed loans schemes. In addition, corporate-bond issuance has also risen to record levels, which in the context of central-bank purchases led to higher money supply.”
“On the other hand, we are still coping with a highly fragile economic situation. Millions of employees remain on short-time work schemes. In view of the precarious situation in labor markets worldwide, we would not expect much upside potential for wages. Weak demand and a drastic under-utilization of capacities also do not support the case for a rapid rise in inflation rates. Other factors, like a temporary reduction in the value-added tax in Germany, have pushed inflation rates lower, in some cases even into negative territory.”
Overall, the DWS analysts don’t see any sustained inflationary pressures although “in the longer term, though, we believe there are some factors that could well lead to higher inflation rates in a few years’ time. This does, however, go well beyond the usual lead of money-supply growth.”
Quite. My hunch is that traditional measures of inflation won’t be of much use for investors – they’ll take too long to show any new dynamics emerge.