Because we're also doing a live market update this month, this note is (hopefully) going to be on the shorter side...but no guarantees.
We've written about inflation before. It was a couple years ago now, and the thesis was basically that wage inflation would pick up, signaling minimal slack in the economy and the need for tighter monetary conditions going forward that had the potential to prick the stock bubble. Spoiler alert: that didn't so happen so much. Real wage inflation did pick up and actually spent most of 2018 and 2019 above 3% before sliding back to the mid-2%'s as the calendar turned into 2020.
What ended up popping the equity bubble was not wage inflation but rather a little spike protein on the surface of the SARS-CoV-2 virus. Of course, that equity bubble was subsequently reinflated faster than you could say "Thank you sir, may I have another", but there's still an interesting question of inflation on the table.
Namely: are we headed into disinflation/deflation, or are we headed in the other direction into (perhaps significantly) higher inflation? It's an important question, because the kind of investments that tend to do well during inflationary regimes are categorically not the kind of investments that tend to do well during deflationary regimes.
Supporting the idea of disinflation/deflation is...essentially the idea that what we have currently is a monetary policy that is a continuation of the response to the last crisis 12 years ago, just on steroids. Everyone said the initial QE programs would cause runaway inflation, and yet here we are a decade on and the Fed couldn't find 2% inflation if it thought that was one of its two reasons for being. Oh wait…
Using debt as a crisis response tool has been shown to be subject to the law of diminishing returns. That is, adding $2T to the economy (through budget deficits financed via debt issuance that is subsequently monetized by the Federal Reserve) has more impact on stimulating growth when total debt is low. It is not unreasonable therefore to assume that any further marginal increases in liquidity via debt will have marginally lower impacts on actual economic production, which mitigates some of the inflationary risks from getting the economy running "hot".
At a certain point, too much debt can actually act as a hindrance to further growth. How much of a hindrance and what point is "too much" are still up for debate, but Japan is the classic case study. After about a 100% gain or so in the last decade, the index is now back at the same level it was in 2007...and 2001...and 1997. As a percentage of GDP, Japan still has roughly twice as much debt as the US, but it's not particularly promising that we're headed in that direction.
Also supporting the anti-inflation thesis is the argument that there's not really a clear source of demand recovery to this crisis. During the GFC, about 61% of global economies were in depression. That leaves more than a third that were presumably doing alright and able to generate at least some export demand to help the struggling ones. During the Great Depression a century ago, that number was 84%. Currently, about 93% of economies are in a recession simultaneously.
We're in the midst of the largest global economic contraction since WWII. Back then, however, there was pent-up demand as a result of wartime conditions (heightened savings, rationing for the war effort) that helped jumpstart the economy. Today, we're starting from a point of already highly leveraged individuals and corporations with a modest (at best) savings track record.
Well that all sounds rather deflationary, doesn't it? Is there anything to support inflationary pressures? As a matter of fact, kind of yes.
Copper is used in all kinds of manufacturing applications and therefore serves as a broad economic activity barometer. It's also one of the early places one might expect to see inflation show up. Last week, copper touched its highest price in 2 years.
What else would be considered an inflation hedge, outside of manufacturing/industry, that is? We'd bet most of you would say precious metals - gold and silver. Correct! Well, gold just touched $1,900/oz for the second time ever. And while not at all-time highs, silver is back at prices we haven't seen in almost a decade as well.
We've argued before fairly extensively that all the various QE activities coming out of the GFC did produce inflation - in the stock market and luxury collectibles market, which is where most of the QE-printed money ended up.
In contrast, the current COVID response has a much more direct-to-consumer fiscal component: namely, $1,200 checks and $600/month additional federal unemployment. Now, it seems like a lot of that has itself also ended up in the stock market, but those kind of direct, UBI-style disbursements are exactly what could lead to a more generalized inflation.
You've also started to see inflation in certain areas of the grocery store in the last couple of months (the meat counter, anyone?) as a result of COVID-related supply shocks. In general, they have also been accompanied by demand shocks, which has kept a lid on any real inflation. Well, that plus the collapse in oil prices plus the start of a housing slump. But if demand is somewhat maintained thanks to direct government stimulus payments, there's the potential for a more widespread inflation to start picking up.
Anecdotally, real wage inflation as reported by the BLS jumped 7.5% year over year in both April and May and was up 5.5% y/y in June. The underlying reason is apparently the loss of low-paying jobs thanks to COVID (note the roughly 50 million initial unemployment filers over those same months). Which begs the question - if most of those job losses were from low-paying jobs (let's accept that as true), and an additional $600/week unemployment assistance results in more income than those low-paying jobs were paying (also true)...then doesn't that mean you're effectively creating an "artificial" demand gap that might reasonably be expected to be inflationary? In the words of Morpheus…"Hm".
Okay, enough fence-sitting, let's pick a side. In our view, there doesn't seem to be a large appetite in the current government to extend/maintain the current level of direct fiscal stimulus for very much longer. Most of the programs are going to expire within a month, and while there has been some talk about extensions, it seems like any extension would be at a reduced amount. Without a continued, direct to consumer stimulus program, we don't see inflationary pressures building up significantly. Perhaps that changes come November, and it is something that we have our eye on, but we'd say the chances aren't good for an inflationary surprise given a continuation of current conditions.
Not good as in one in a hundred?
We'd say more like one in a million.
So You're Telling Me There's a Chance!
About the Blog:
Here lives our collection of newsletters, articles, and some occasional guest posts by outside authors (where indicated) who have quoted us. If you're interested, feel free to browse through the archives here.