The End of an Era – Inflation is Back!
Q3 | September 2022
September 29, 2022
Image used with permission: iStock/marrio31
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The End of an Era – Inflation is Back!
Q3 | September 2022
Inflation talk is dominating the news. It is on the mind of the man in the street and investors alike – and not just in North America or the lands of the usual suspects, such as Argentina and Turkey. Consumer price indices have shot up in the U.K., Europe, emerging markets and, would you believe, even Japan. This note is not to inform you of inflation, predict its path or ponder the possible recession. Rather, it makes some bigger picture observations and addresses the question of what, as an investor, one should do about it.
Investors can’t predict inflation
Predicting inflation is hard. For the past fifteen years or so, while inflation was consistently low with limited volatility, the market and the U.S. Federal Reserve did a poor job of predicting what was to come. Both consistently overestimated future inflation and, correspondingly, overestimated where future interest rates were headed. Then, one year ago, just before inflation took off, both massively underestimated what was about to happen. At that time, the Fed and the market were expecting just one modest hike in the Fed Funds rate.(1) Since then, actual inflation has reached levels not seen since the early 1980s and the Fed and other central banks are responding aggressively.
The ingredients for renewed inflation have been in place since well before a year ago. The unexpected Ukraine-Russia war is, of course, part of the cause. But this was perhaps more tinder and spark than the pre-stacked firewood.
Fundamental drivers of inflation
As to the firewood, so to speak, the ingredients for inflation were observable. First came the massive monetary(2) and fiscal response to the Global Financial Crisis (“GFC”), then the sluggish post-GFC economic recovery, which meant that the loose monetary and fiscal conditions remained in place well beyond the GFC. When COVID hit, the monetary and fiscal response made the GFC stimulus pale in comparison. JPMorgan Asset Management estimates the COVID stimulus at about 3 times that of the GFC. Government debts ballooned and short-term interest rates fell well below the yield of investment assets – historically, the two have been more-or-less in line. As a result, investors took on leverage and chased all manner of investment assets. Asset prices jumped – most visibly in real estate and speculative assets (such as cryptocurrencies, meme and growth stocks) – but also in plain vanilla bonds and large capitalization equities. If asset prices move so far ahead of consumer prices, the resulting stresses will cause the two to eventually move closer in line. For example, if consumers can’t afford housing and real-estate related costs increase for companies, something eventually has to give. This may well take some time, but either asset prices decline, consumer prices rise, or some combination will occur.
Other inflationary firewood that has been slowly stacked includes the reversal of globalization and the trade wars – manufacturing closer to home and import tariffs both drive up costs. No more threats of offshoring your job means more bargaining power for domestic workers. Also for the labour force, demographic ageing in the developed world means more retirees, that is, fewer workers and more wage pressure. This trend to lower labour force participation started in the GFC – COVID had the effect of accelerating it. In the U.S., estimates are that there are 5 to 7 million fewer workers than if COVID had not occurred (fewer immigrants, more burnt-out early retirees, more stay-at-home people – both parents without available childcare and those too scared of COVID to work – and, of course, excess deaths from COVID).(3)
Even without the COVID-related supply chain disruptions and recent cutoff of Russian energy, in the years before COVID, energy underinvestment inexorably reduced fossil fuel supply. Again, low energy prices in COVID merely exacerbated this (oil and gas wells have high decline rates, so low investment quickly erodes capacity). Some well-intended policies (such as Japan and Germany shutting down nuclear plants and fracking bans in various jurisdictions), political action (Iranian and Venezuelan sanctions), and country-specific issues (civil war in Libya) further reduced energy supply. Gas is available, but it can’t get to where it is needed (cancelled pipelines and LNG terminals). The inflationary implications of all of this went unnoticed as global energy capacity was initially above demand – now, no longer.
The final piece of firewood is the ongoing ESG trend. This trend, while necessary, has a meaningful side effect of increasing costs. This is most easily observed with the intentional added costs of fossil fuel decarbonization, but higher social equality (gender wage equity, better emerging world workplace safety and compensation) and higher governance standards (ask a director what they get paid now relative to a decade ago and how many more people sit on corporate governance, risk, and regulatory committees) are also inflationary.
Some of these inflationary effects are temporary. Supply chain disruptions will clear up, labour force participation should improve, energy supply will respond to higher prices, and productivity should recover (COVID protocols caused a major decline in labour force productivity). Inflation isn’t really a one-time increase in prices. Rather, it is an ongoing price spiral – cost increase begets price increases, begets wage increases, which feeds through to cost increases and so on. Some of this is already occurring. For example, the U.S. railroads just agreed to a 5-year deal with unions whereby wages will increase about 4½% per year from 2020 through 2024.(4) Efforts by the central banks to slow the economy will relieve some of the inflationary pressures. Yes, higher interest rates may be a good thing! Nonetheless, with all the inflationary drivers that have built up, it seems likely that inflation will decline more slowly than one might wish.
What’s an investor to do?
It’s one thing to spot the inflationary drivers discussed above, but that doesn’t help determine inflation’s specific path or the timing and extent of any possible recession. If predicting this and other future events can’t be done with any reliability, then the simple solution for the investor is not to try. Rather, stay in the market and use a quality-oriented investment approach that will grow in good times and prove defensive in bad times. Given that you are not sure what lies ahead, a quality long-term oriented investment approach is designed to withstand what might happen. An investment approach that is frequently adjusted for what you think will happen almost assures you are moving with the herd and, in investing, moving with the herd typically means repeatedly buying high and selling low.
A few broad comments can be said about this new, more inflationary environment.
- For companies, a more uncertain inflationary environment means you’re not in Kansas anymore. In an uncertain world, companies typically make fewer new investment decisions, so real corporate growth and overall economic growth may be lower. Some companies will struggle to manage their costs or pass through cost increases, so margins will get squeezed, especially if consumer demand softens.
- For home owners, real estate will adjust for inflation over long time periods, so your primary home is your friend in an inflationary period. For shorter-time periods, the “long term” may not apply. If Canadian real estate has already gone up in nominal value due to asset price inflation that, until recently was not accompanied by consumer price inflation, the adjustment period will be painful for a new home owner if home prices stagnate or decline in nominal terms, while consumer prices rise. The saving grace for the homeowner, and frankly for the entire consumer segment of the economy is that, with time, consumers will get employment income increases while their mortgages will decline in real value and become easier to pay, even as mortgage rates go up.(5)
- For investors, bonds are a poor asset class. Investors have very little idea what after-inflation return they will receive from bonds – especially longer-term bonds – but there is a high probability that it won’t be good. Even with higher nominal short-term interest rates, short-term real returns are firmly negative. For example, the 3-month Canada T-Bill carries a 3.5% nominal yield – quite juicy compared to recent history – but, assuming inflation in the next 3 months of 5.5%, this T-Bill has a real return of negative 2.0% for a non-taxable investor and negative 3.9% return for a top-tax bracket taxable investor.(6) A 10-year Canada bond, currently yielding 3.1% nominal, will have a negative real return if inflation over the next ten years is anything more than 1.4% for a taxable top-tax bracket investor. In this sort of environment, holding bonds has a cost – only hold them for the narrow purpose of adding some short-term stability to your portfolio, if you have known cash outlays in the next few years that you want near-cash on hand to fund, or perhaps for “dry powder” to buy equities if they take a big hit.
- For investors, equities are the main game in town. Companies may have difficulty adjusting to higher inflation in the short term, but over time management will adapt their businesses to better manage inflation and accordingly, equity returns will adjust higher.
(1) The Federal Reserve’s expectations for the future path of interest rates are shown in the Fed’s so-called “dot plot” and the market’s expectations can be derived from the shape of the yield curve.
(2) Monetary stimulus in the GFC included a reduction of central bank policy rates but, as rates were low even before the GFC, central bank quantitative easing was a large part of the overall monetary stimulus.
(3) JP Morgan Asset Management.
(4) Part of this will be paid retroactively for the elapsed period since 2020.
(5) This assumes that the homeowner has a fixed rate mortgage or, if they have a variable rate mortgage, mortgage rate increases lag inflation increases, which can be the case for a period of time but not indefinitely.
(6) The assumed 5.5% inflation rate equals the most recently published actual inflation rate for the past year. The after-tax return assumes a 53.5% tax rate for an individual Ontario investor. Note that to calculate the accurate real after-tax return, deduct the tax from the full nominal return first, then deduct the full inflation rate. Many people erroneously first deduct inflation from the nominal return and then deduct tax from the real pre-tax return.