Weighing Both Sides: The Inflation Outlook
March 25, 2019
Image used with permission: iStock/G0d4ather
Weighing Both Sides: The Inflation Outlook
You might be surprised to hear me refer to inflation as polarizing.
Now, I don’t mean polarizing in the climate change or Leafs vs. Habs sense. I’m referring to the contrasting experiences of those who lived through the era of double-digit interest rates and inflation (1974-1985), and members of the greener generations who have barely experienced inflation over 3%. As a reminder, inflation is the year-over-year change in the price of a basket of goods and services. The chart below looks at U.S. Inflation, using the Consumer Price Index (CPI) going back to 1957. It is divided into two 30-year “eras”.
Having minimal first hand exposure to inflation, I lean on research and tales of 12% bond yields to help me form a well rounded view on the most likely outcome for inflation. I was recently reminded by a colleague that 10 years from now there will be almost no financial professionals with first hand experience in a period of significant inflation.
Why am I even talking about inflation? In addition to providing fodder for trips down memory lane, inflation is important as an economic indicator. The influence that inflation has on consumers (cost of goods, income), business owners (cost of labour, market pricing dynamics) and the capital markets (interest rates, currencies) is pervasive. Not to mention, the countless conversations about perceived vs. measured inflation I’ve encountered (more on this another time).
So, could the tales of long ago become tomorrow’s reality, or will we never again see the inflation dragon rear its head? As investors, we must at least try to solve this puzzle, but it’s not easy! There are strong arguments supporting a shift to higher inflation, but we can also make a case for “lowflation” forever. Below is a summary of some of the points:
For higher inflation:
- A “tightening” labour market: While still very moderate, we have recently experienced an uptick in wages in Canada and the U.S. This could create upward pressure on inflation in the form of higher wages and the knock-on effects such as increased costs of services and manufactured goods.
- “De-globalization”: If the recent shift to more protectionist politics takes hold, the review of trade agreements and increased tariffs could have the effect of increasing the costs of raw materials and finished goods.
- Demographics: As the number of working people relative to the overall population declines, the supply/demand scales will have to be re-balanced and could result in a smaller workforce and higher wages. A second possible outcome is an increase in demand for products that cater to the older demographic.
- Global competition: Global trade has changed dramatically over the past several decades. Access to new markets and heightened competition has kept prices low. The U.S. oil revolution, increasing Chinese exports and the offshoring of manufacturing to less expensive jurisdictions are sources of deflationary pressure.
- Lack of wage growth: Despite low unemployment rates in North America, wages have not gone up significantly. In contrast to the labour market point above, there continues to be workers who are sitting on the sidelines and waiting to re-enter the workforce. Additionally, should wages begin to increase meaningfully, global supply chains offer substitutions of cheaper workforces.
- Technological disruption: I could write a blog on just this topic but suffice it to say that increasingly “smart” machines, the exponential increase in affordable computing power, and the access to information that technology has provided allow for lower costs and higher competition across numerous dimensions.
Now that we are armed with arguments for both sides, we must consider the role of central banks. Through monetary policy actions (interest rate and money supply management), central banks do their best to keep inflation stable and moderate. Two percent is frequently cited as a target in developed economies. Historically, this hasn’t always been the case and we know that they don’t always get it right, but by using the tools available to them, central banks will likely limit extreme inflation swings in either direction.
Finally, let’s look at what is reflected in the markets. Bond math (1) tells us that average inflation over the next 30 years is expected to be just 1.5% in Canada. Looking at sentiment indicators, we hear a similar story; February’s University of Michigan Consumer Sentiment Survey showed that U.S. consumers’ 5-year outlook for inflation sits at a historically low level of 2.3%.
So, what’s the verdict? After weighing both sides, we believe that the scale tilts in favour of ongoing low inflation. Surely, it will spend time at rates that are higher than today’s levels, but on balance, the new era of technological developments and global trade, coupled with central banks’ ongoing efforts will most likely keep inflation rates low relative to history.
At Nexus, the average maturity of our bond holdings is significantly shorter than that of our benchmark. Although we don’t think that inflation will be moving higher anytime soon, inflation expectations are so low today that there is little to no compensation for assuming the risk that we are wrong. Should interest rates move meaningfully higher (due to inflation or for any other reason), we would see a significant decline in bond prices with longer maturities. Currently, the yield on a 30-year government of Canada bond is 1.88% which is only a meagre amount more than what investors can earn on a 5- or 10-year bond (1.47% and 1.58% respectively). We simply do not like the risk/reward dynamics that are in place if it is after all, a case of short memories that has caused inflation to exit the current vocabulary.
(1) Bond math refers to the calculated break-even level of inflation that would make a buyer indifferent between buying a long government bond and a long Real Return Bond (bond with coupon payments indexed to inflation).