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The Great Reflation Debate – Market Noise or Structural Change?

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On 15 April, GAM Investments hosted an event titled ‘The Great Reflation Debate – Market Noise or Structural Change?’ Two of our investment experts, Adrian Owens and Michael Biggs, shared their thoughts on inflation and the potential impact on developed and emerging market economies.

06 May 2021

Adrian Owens – Investment Director, Developed Market Fixed Income and FX

Although meaningful inflation is not showing up in official core inflation prints just yet, we expect to see it pick up over the next 12 months. Looking further ahead, on a two to three-year horizon, we believe the forces affecting inflation are already largely in play. First, the Covid-19 pandemic has led to unprecedented amounts of stimulus. But this time it is different, both in terms of scale and the variety of tools employed by central banks, along with the fact many countries are acting in unison. Globally the amount of quantitative easing since the onset of the Covid-19 pandemic is equal to the total amount seen over the past decade. 

An atypical recession 

Second, this is not a typical recession. After a brief dip in March 2020, total income has risen substantially above pre-Covid-19 levels, reflecting the extent of fiscal transfers. A divergence of such magnitude between income and output in a recession is truly without precedent.  We have also seen a massive build-up of excess savings, EUR 500 billion in the euro area and USD 1.5 trillion in the US; this is a feature common to most developed countries. In terms of job losses, year-to-date unemployment numbers are concentrated in Covid-19-sensitive sectors, hence we expect to see a quick rebound in labour market activity as economies reopen. In the US, unemployment rates have fallen rapidly in just the last 11 months, down from 14.8% in April 2020 to just 6% at the beginning of April 2021. 

Fractured global supply chains

Specifically on trade, there are several issues on the supply side. Since 1983, global trade volumes have risen by circa 5.5% per annum, roughly double the rate of growth of the world economy. The Covid-19 crisis decisively broke this trend. Global trade volumes collapsed by around 15% at the peak of the crisis with global supply chains fracturing, in part as countries prioritised their domestic needs over international supply. Global trade barriers have tended to rise in recent years and Covid-19 has provided a further impetus towards localisation; it seems unlikely that globalisation will remain as powerful a disinflationary force in the future. It is possible that the trend could even go into reverse. There are also cost pressures worth noting, for example corporate tax rises and growing pressures to more effectively tax the tech sector. In the US, the Biden administration has set a target of doubling the minimum wage. Environmental, social and governance (ESG) policies are also likely to be costly for many sectors. A national carbon tax was recently upheld by Canada's Supreme Court, for example.

Finally, it could be argued that central bank functions are slow and complacent. The Federal Reserve (Fed) has been explicit in stating its intention to get inflation above target, and not even begin tightening when inflation is above 2%. Indeed, although many forecasters expect output gaps to close over the next 12 months, the Fed is not forecasting its first interest rate hike until 2023. Fed chair Powell has stated that while it is easier to reduce inflation, it is more troubling when it is too low. That may have been the case in the recent past, but I do not think Paul Volcker would have agreed with that in the 1970s.

The deflationary forces of the past two decades may not be going away as Powell is keen to state, but they are decreasing and are centred around demographics, particularly when looking at inflation on a five to 10-year timeline. In recent decades, the working age population has exploded from 700 million in 1980 to above a peak of two billion in 2010. This is now reversing. As we see baby boomers begin to leave employment, we will have fewer productive workers and more non-productive retirees, which will likely raise equilibrium interest rates for a given level of inflation. 

Deficits and debt 

Country deficits and debt profiles look to be troublesome; this has been the case in the recent past and is likely to persist over the next few years. Much of this comes back to demographics. Given the amount of debt countries are facing and the fact many disinflationary forces are subsiding, how do countries tackle debt? To our minds, there are only three possible ways: 1) Default, which is clearly not ideal; 2) Growth, which is increasingly difficult with a contracting labour supply; 3) Tax and / or inflation – both are effectively the same, except one is visible and the other is invisible and we believe policymakers will be more attracted to the latter. 

To summarise, we believe inflation will play an important role over the next few years. Of course, many disinflationary forces remain at work, but in our view the direction of travel could not be clearer. 

Michael Biggs – Macro Strategist and Investment Manager, Emerging Market Debt and FX

In our view, the inflation outlook should be considered in three parts. In the first part, which is likely to place over the next few months, inflation is likely to rise sharply on higher commodity prices, unfavourable base effects, and idiosyncratic price increases on services most heavily affected by the pandemic. While this is largely the consensus view, it could still surprise the market - global oil and global food prices are up by more than 25% since the start of the year. 

However, we do not think rising inflation will be sustained. The second stage in the outlook may start in Q3 when these shocks have worked their way through the system. Inflation in the second stage will depend on the level of spare capacity in the global economy. In our view, high unemployment rates, low capacity utilisation rates and spending levels that are still well down relative to the end of 2019 suggest there is still significant slack. If we are correct in this view, the demand rebound will boost growth but only have a modest impact on prices, and inflation will stabilise in the second half of 2021 and in early 2022 at around target levels. 

The third stage in the inflation outlook will be reached when the rebound in demand uses up the remaining spare capacity and the global economy returns to full employment. What happens to inflation then will be largely a policy choice. Those who fear sustained higher inflation appear to assume that policymakers will choose to allow inflation to rise to well above current target levels, but it is not clear why this should be the case. As the 1970s showed, higher inflation does not help countries erode their debt levels. The benefits of higher nominal GDP growth on the debt-to-GDP ratio are quickly eaten away by the impact of higher interest rates. And when policymakers are finally forced to fight inflation by hiking interest rates, GDP growth falls and debt ratios surge. 

As the 1970s also showed, higher inflation is bad for almost all asset classes, including equities. When inflation rises, the term premium on bonds increases, real interest rates go up, and equity valuations deteriorate. Real total returns on the S&P 500 Index averaged 0.6% per year for the decade. It is not clear why policymakers would want to return us to such an environment. 

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers.

Adrian Owens

Investment Director

Michael Biggs

Investment Manager

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