Do We Need to Fear Stagflation?

Leo Wealth

Most of the concerns that gripped the market in September disappeared again in October as several of the risks turned into positive surprises. China’s Evergrande did not implode and avoided official default. The U.S. and the EU agreed to roll back some of the Trump-era tariffs on steel and aluminum. Most importantly third-quarter corporate earnings turned out to be strong again. This all led to markets rebounding nicely in October, reaching new highs. What we must keep in mind is that this is what equity markets do – they tend to trend upwards.

It is important to note that this year company earnings have risen more than the stock market, which means valuations have come down. Therefore, we believe investors should continue to stay invested in equity markets for the long-term as the fundamental economic trend is still positive.

This was confirmed by the Fed, which sees very solid economic growth in the U.S. As expected, the Fed announced that beginning later this month, it will start reducing the monthly pace of its asset purchases by $10 billion for Treasury securities and by $5 billion for agency mortgage-backed securities in November and December. The press release also noted that the pace of tapering is likely to continue thereafter, but that it may change with the economic outlook. The Fed anticipates the tapering process to be complete by mid-2022.

In the press conference, Chairman Powell highlighted that although risks are skewed towards higher inflation; he noted that the Fed expects supply chain bottlenecks will wane, job growth will firm, and inflation will ease by the second or third quarter. However, Powell also admitted that the pandemic is injecting greater uncertainty into economic forecasts. He stated that the central bank is prepared to act if the inflation risk materializes. Powell also explicitly separated the decision to begin tapering asset purchases from raising rates.

Given the strength of the labor market, the large increase in household net worth over the past 18 months, and the pent-up demand for services, we think economic growth will be well-supported, while we still expect inflationary pressures to subside in the coming months. In other words, we think that fears for stagflation are overdone.

If we compare true stagflation in the 1970s to the current environment there is an important difference. In the 1970s inflation and unemployment were both rising, leading to major economic disruption. Now we have relatively high inflation, mostly caused by supply chain disruption, combined with falling unemployment. In other words, a much healthier economic environment.

Stocks Can Keep Rising

Stocks are likely to generate moderate positive returns next year, which will beat the returns offered by bonds and cash. But stocks will likely generate lower returns compared with those enjoyed by investors over the past year as earnings growth is moderating while expectations have risen, leaving less room for upside surprises.

A rise in long-maturity bond yields argues for the outperformance of value versus growth stocks over the coming year, which could be mostly driven by the financial sector.

Should We Be Concerned About Inflation?

The conventional wisdom is that deflation is a much tougher problem to overcome than inflation. But how is that possible? Increasing consumption should be a lot easier than decreasing demand. After all, most people like to spend!

Nevertheless, central banks spent the past decade battling deflation, which was caused by the Global Financial Crisis in 2008. The fear of deflation caused policymakers major concerns. In contrast, central bankers seem to be rather relaxed about the prospect of higher inflation.

It is true that the zero-bound constraint on interest rates makes it more difficult for central banks to react to deflationary forces. However, monetary policy is not the only game in town as fiscal policy becomes more effective as interest rates fall because governments can stimulate the economy without incurring high financing costs.

The problem was that most countries lacked the political will to use fiscal spending to stimulate the economy, but the pandemic changed everything. Governments ran massive budget deficits, while bond yields still dropped. Budget deficits will likely decline going forward, but fiscal policy will remain structurally more accommodative in the post-pandemic period. Politicians around the world have discovered that it is easier to spend than to cut budgets, which is politically acceptable when everyone else does the same.

Got Debt? Spend More!

We are currently in an interesting environment, where the global economy is recovering quickly, inflation is higher than it has been in a decade, and both monetary and fiscal policies are stimulative. Despite this, bond yields are at very low levels.

In this situation, an interesting dynamic comes into play with most countries currently paying a borrowing rate that is below the growth rate of the economy.

When interest rates are very low, not only is fiscal stimulus a free lunch, but you actually get paid to eat more. If the borrowing rate is below the growth rate of the economy, the more profligate a government has been in the past, the more profligate it can be in the future, while still maintaining a stable debt-to-GDP ratio.

This sounds counterintuitive so it is worth thinking through an example. Suppose you currently earn $100,000 per year and expect your income to rise by 4% per year. You have $100,000 in debt, which incurs an interest rate of 1%, and want to keep your debt-to-income ratio constant at 100% over time.

So, next year your income will be $104,000, and you want to target a debt level of $104,000. Thus, next year, you can spend $104,000 on goods and services, pay $1,000 in interest, and take on $4,000 in additional debt. In total, you can spend $107,000.

Now, suppose you have been spendthrift in the past and have accumulated $200,000 in debt. You still want to keep your debt-to-income ratio constant, but this time at 200%. How much can you spend this year? The answer is $110,000. If you spend $110,000 and pay $2,000 in interest, your cash outflows will exceed your income by $8,000, taking your debt to $208,000 — exactly twice next year’s income. Hence, your debt balance stays the same in percentage terms. Notice that by maintaining a higher debt balance, you can spend $3,000 more while keeping your debt-to-income ratio constant.

Despite running a deficit on your annual budget, your debt ratio does not change. Would you do this in your personal life? Probably not, but that is not how governments manage their debts. It makes sense for governments to spend more, especially when the additional cash is used to generate more economic growth in the future.

One might argue that the interest rate you face would be higher if you had more debt. Fair enough. The important point is that, unlike people, governments that issue debt in their own currencies in a way get to choose whatever interest rate they want. Granted, if central banks keep interest rates too low, the economy will overheat, leading to higher inflation. However, most central banks have stated that they do not mind if the economy runs a little hot.

Paradoxically, the pandemic could turn out to be structurally positive for risk assets. By combining monetary easing with fiscal stimulus, policymakers could steer equity markets towards an outcome where the economy is again operating at full capacity, yet interest rates are lower than they were before.

So, when the economic growth rate is rising due to fiscal stimulus but at the same time major central banks keep interest rates low, this in effect means that monetary policy is getting more stimulative as it allows governments to borrow even more. This is good news for equities and other risk assets in the near term, even if it could produce a major hangover down the road.

Higher Inflation Won’t Force the Fed’s Hand Anytime Soon

When will the Fed be forced to adopt a more aggressive stance? Our guess is not for a while. The Fed announced this week it will taper its asset purchases, but this is just a small step towards normalization of monetary policy.

Inflation in the U.S. and many other countries is likely to follow a “two steps up, one step down” trajectory of higher highs and higher lows over the remainder of the decade. We are currently near the top of those two steps – most of the recent increase in inflation has been driven by surging durable goods prices. Considering that durable goods prices usually fall over time, this is not a sustainable source of inflation

The implication for investors is that monetary policy is currently more stimulative than widely believed. This is the good news. The bad news is that in the absence of fiscal tightening, the Fed will eventually be forced to raise rates by more than investors are discounting when the economy really starts to overheat. But this is far enough into the future to not worry about it now.

Reasons to be Positive About Economic Growth

There are several reasons to think that the long-term economic growth rate could remain strong for the foreseeable future. The first reason is that the drag on growth from the household deleveraging cycle is ending. As a share of disposable income, U.S. household debt has declined by nearly 40 percentage points since 2008. And debt-servicing costs are now at record low levels

Second, fiscal policy is likely to remain accommodative in the post-pandemic period. The combination of lower real rates and higher debt levels has increased the budget deficit consistent with a stable debt-to-GDP ratio in the US and most developed markets, as the example above shows.

This point has not been lost on governments. The IMF estimates that the U.S. primary budget deficit will be 3% of GDP larger in 2022-26 than it was in 2014-19. The IMF also expects most other advanced economies to run larger budget deficits

Lastly, higher asset prices typically bolster spending. According to the Federal Reserve, U.S. household net worth rose by over 113% of GDP between Q4 2019 and Q2 2021. Empirical estimates of the wealth effect suggest that households spend about 5-to-8 cents on goods and services for every additional dollar of housing wealth and 2-to-4 cents for every additional dollar of equity wealth.

It is estimated that U.S. homeowner equity has increased by $5 trillion since the start of 2020, while household equity holdings have increased by $15.8 trillion. Together, this would translate into 2.5%-to-4% of GDP in additional annual consumption.

The Global Energy Crisis

One reason for higher headline inflation is the sharp rise in energy prices this year. A perfect storm has engulfed global energy markets. Strong economic growth, adverse weather conditions, and politically-induced supply disruptions have caused energy prices to surge.

Fortunately, the global economy has become less vulnerable to energy shocks. Not only has the energy intensity of the global economy declined over the past few decades, but central banks are now less inclined to respond to higher energy prices by raising interest rates.

Stock returns have been positively correlated with oil prices over the past decade. This suggests that equities can withstand the current level of oil prices. Markets are betting that energy prices will come down. Yet, given the diminished feedback loop between higher energy prices and slower economic growth, energy prices can stay elevated for longer than the market is discounting. Value stocks are one relatively cheap and effective way to hedge against higher-than-expected inflation.

The surge in coal and natural gas prices in China and Europe going into the winter will push inflation expectations higher into the end of 1Q 22.
Over the medium-term, similar spikes in energy prices could become more frequent if capital investment in fossil fuels continues to be discouraged, and scalable backup sources of energy are not developed quickly enough for renewables. Years of subpar investment in the energy sector have made this situation worse. Globally, investment in the oil and gas sector is down 60% since 2014.

The weather has amplified the tightness in energy markets. A cold snap across the Northern Hemisphere in spring 2021 depleted natural gas supplies. Compounding the problem, a lack of wind over the summer reduced energy production by European wind farms, leading to a shift toward natural gas and coal for power generation. A hot summer in Northern Asia raised electricity demand. Flooding in China and Indonesia curbed coal output, while a drought in Brazil reduced hydroelectric generation.

Policy developments have contributed to the dislocations in energy markets. China has been trying to wean itself off coal, which still accounted for 63% of electricity generation in 2020. For a while, Australian coal imports made up for the lack of domestic coal production, but those disappeared last year following a diplomatic row between the two nations. To fill the energy gap, China has stepped up purchases of natural gas from Russia.

Never one to miss an opportunity, Russia has taken advantage of the natural gas shortage by pushing Germany to approve the newly completed Nord Stream 2 pipeline. The US$11 billion pipeline carries gas directly to Germany. Built under the Baltic Sea, it bypasses Ukraine and thus deprives the NATO-allied government in Kyiv of as much as $2 billion a year in transit fees. The pipeline was backed by outgoing chancellor Angela Merkel and has the strong support of the German public. However, opposition from the US has kept the project in limbo.

Longer-term supply chain issues need to be sorted out. Still, higher commodity prices could be needed to incentivize production of the base metals required to decarbonize electricity production globally and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time.

Winter Weather – La Nina

A weather phenomenon that typically delivers harsher winters is on the way and is expected to add to the global energy crisis. The La Nina pattern, which forms when equatorial trade winds strengthen to bring colder, deep water up from the bottom of the sea, has emerged in the Pacific Ocean.

That typically spells below-normal temperatures in the northern hemisphere and has prompted regional weather agencies to issue warnings about a frigid winter. Coal and gas prices are already elevated, and a bitter winter will add heating demand that is likely to spur further increases.

Fixed Income

Bond yields are likely to move higher over the coming year, but this will be driven by real yields, not inflation expectations. In other words, sustained economic growth will drive bond yields and not short-term inflation expectations.

Policy normalization will push up real rates and could offset the impact of receding inflation. Nevertheless, it is possible that we see a short-term pause before bond yields climb higher.

Portfolio Positioning

In the current investment climate having a globally diversified portfolio is important. In our core portfolio allocation, we still have a tilt towards quality and value stocks. We also remain overweight on global financials, real estate, renewable energy, and base commodities.

In fixed income, we continue to favor corporate credit and emerging market government bonds. We also keep a position in Treasury Inflation-Protected Securities (TIPS).

This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market.  They are methods used to help manage investment risk.

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