I moderated an excellent event (the speakers were excellent that is!) on fixed income investing the week before last. The panellists included Steve O’Hanlon, CIO of Rubrics Asset Management, Martin Arnold, a strategist for ETF Securities and Kevin Doran, the chief investment officer at AJBell and a former star bond fund manager. I think it is fair to say that the two main themes of the evening were
- QE is NOT working and
- Inflation is coming (a bit like winter in GoT)
Obviously, we shouldn’t be too surprised with either message, bearing in mind that I was in a room packed full of bond vigilantes, but their warnings do echo with the wider adviser sentiment about inflation, which is that we’re all underestimating the potential for a growth induced inflation pickup.
In this blog, I want to focus on the inflation argument only.
Overall, I’d suggest there are three main narratives about the inflation story at the moment, all of them I think explicable using the metaphor of driving and cars.
The first, beloved of all QE critics and bond vigilantes, is that we are one step away from a car crash. Zimbabwe and Venezuela loom because monetary policy will spin out of control.
The second narrative can be called the sensible ‘check the temperature gauge’ concern beloved of all families stuck on a long journey – “darling, its been a long journey but did you check we have enough water in the engine or we’ll overheat in this traffic jam”. By and large, this is probably the collective mainstream view after a year of solid global economic growth.
The last scenario is the one I subscribe to. It’s named after every teenage encounter with a steep hill – the stall scenario – and describes the impossibility of generating meaningful inflation in the face of the steep hill of disinflation, generated by globalisation and technological change.
Personally, I think the car crash scenario is the one most easily dispatched. In essence, it rests on two arguments. The first is that we’re measuring all the wrong prices and that inflation measures such as CPI/RPI doesn’t tell you what’s happening in the real world of asset prices. To which I can only reply – so what, that’s always been the case. Ever since the dawn of time people have complained that official measures don’t include what others think should be included in inflation measures. But we have these measures because they work, are clearly understood and easy to explain. I accept that asset price inflation is a problem but believe that controlling this should not be part of inflation policy but a more general regulatory and fiscal approach (tax the stuff going up in value for no reason).
The next step in the bond vigilantes argument is to say that at some point we’ll see all this money fiat wash into the real world via wage inflation. Again, a great many very clever people have been waiting for the missing wage inflation story to resolve – and no one has found any evidence that it is a looming economic monster of mayhem. Albert Edwards at SG, for instance, has been closely following US wage measures for some time and singularly failed to find overwhelming evidence of major cost-push pressures from wages (yet).
There are certainly isolated pockets of skilled wage inflation but the overall picture is actually very dismal consisting of real wage decreases for the majority of the population. One other concern, oft repeated, is that we’ll see pressure from the commodity space as all this monetary debasement erodes confidence – with oil prices the key measure (not gold bizarrely, which hasn’t gone precisely anywhere for ages in terms of price). The extreme view is that oil will break out of its narrow $40 to $60 trading range and then head north. This is a not unrealistic fear but I would suggest that the current price highs are related to some obvious OPEC gerrymandering and a slowdown in capital allocation to the US unconventional energy sector. Once OPEC’s self-discipline breaks down – which it will, as night follows day – and the US unconventionals let the capital markets tap open, we’ll see prices head back down again. Thus, taking with them any commodity price fears.
The next coherent narrative around inflation comes from mainstream equity market analysts, in awe of the Trumpian threat to massively decrease taxes and worried that the US recovery will overheat and nudge inflation higher. A note out today by Blackrock’s global strategist Richard Turnhill, I think, nicely sums up this mainstream view.
He reckons that it’s probable that the “U.S. economy is shifting from reflation to inflation – and we have greater confidence in inflation returning to its medium-term trend and the Federal Reserve’s target. Better wage growth and potential fiscal stimulus should cement this transition…This year’s surprise was better-than-expected growth coinciding with cooling inflation, partly due to one-off factors. We see that changing in 2018 as the U.S. economic slack created by the deep 2007-09 recession disappears. The market pricing of higher Fed rates has shifted up, yet the chart shows it remains well below the Fed’s and our own outlook. We believe the Fed is on course to increase rates in December and match its projection of three increases next year. We see the potential for four rate rises in 2018 if growth gets a boost from fiscal stimulus.” The chart below sums up the consensus market view about interest rate projections – personally I think the market pricing is about right for interest rates, though I concede we could see a top at 2.25%.
Turnhill suggests that inflation expectations “were dented this year due to the surprise slowdown, tied to major one-off drops and moderation in some categories such as housing. Yet we see inflation expectations firming up as prices climb at a gradual pace.”. To help measure this potential upwards inflexion, Blackrock has launched something called the Inflation GPS earlier this year “to help cut through the noise on price trends. The Inflation GPS is consistent with core prices climbing back towards the Fed’s 2% target. The October Consumer Price Index supports the signal from the Inflation GPS”.
In particular, the Blackrock strategists reminds that for once “China is exporting much less deflation abroad. That has removed a key drag to global inflation – especially as China’s cuts to industrial capacity underpin commodity prices. “
Nevertheless, Turnhill reminds us that various “structural factors – including the role of technology – should keep price pressures in check.”
I’d suggest this is something of an understatement. In my stalled car scenario, global consumers are staring at a monumental wall of disinflation produced by the twin forces of technological disruption and globalization. Coincidentally, just to ram home this observation, today also saw the release of a report by private equity form HarbourVest. HVPE revealed their global investment “megatrends2 for the next 10 years for private markets. They are:
- A technological leap-forward
- Demographic shifts
- The global role of China
This is all obvious stuff, frankly, but no less revolutionary – and all likely to power the enormous global engine of disinflation. The populists of the left and the right better understand this disinflationary wall of fear than the bond vigilantes – who sit around worrying about QE and monetary debasement.
What the populists and the PE firms both realise is that ordinary families haven’t seen strong wage growth for decades – and that’s because the unions have been broken. They also realise that there’s always an army of cheaper wage labourers waiting to do their job at the drop of a PE or outsourcers hat – thus restraining wage inflation.
They see government budgets under threat from capital globalisation and poor wage inflation, and instinctively understand why debt mountains are growing bigger by the day. The populists will also be soon attacking the technology giants and their lackeys in the media, accusing them of shape-shifting internationalism. And of course, every good populist genuinely understands the threat from China.
Just like Marx in the 19th century, the populists have identified many of the main problems, and then promptly suggested all the wrong solutions. But salute their observational skills nevertheless. And then consider why all these forces – technology, China, an ageing population, towering amounts of debt – will keep a lid on inflation for decades to come. And then stop worrying. And buy income producing assets and sit tight.