For those of you who can remember your economics education, you will recall that there are two types of inflation – Cost Push or Demand Pull.
The fear among the ‘Reflationists’ out there is that as vaccination rollouts across the world enable movement restrictions to be lifted, the surge of demand from financially stimulated populations chasing too few goods and services, will create inflation. This inflation fear, along with increased government bond supply, has caused government bond yields to rise sharply in 2021.
Ten-year gilt yields have more than tripled from around 0.20% at the start of the year to over 0.70% at the time of writing. Japanese ten year government bonds, for so long anchored close to a zero yield, now offer in excess of 0.50%. The US equivalent ten year is headed towards 1.50% as can be seen below in the chart from The Daily Shot.
Both ten-year gilt yields and their US counterparts are close to their pre-pandemic levels but still remain well below the target inflation rate of 2% aspired to by both the Bank of England and the US Federal Reserve, stewards of monetary policy in the UK and US.
It was the US Federal Reserve that captured attention last week, clearly believing that demand pull inflation will come into play as the US economy reflates this year, pointing to the amount of savings that consumers have acquired over the past year. However, the Federal Reserve’s Chair, Jerome Powell, would appear to be of the opinion that any demand pull surge will be short-lived and the damage to the economy from the pandemic and consequently on unemployment, will be longer lasting.
As a result, the Federal Reserve are prepared to allow inflation to run above target for some time, compensating for the extended period when inflation has been substantially below target. The dangerous prospect of cost push inflation is perceived by central banks to be less of a threat given the unemployment picture.
The Final Furlough?
The unemployment picture in western developed economies will become clearer when furlough schemes are unwound. Governments on both sides of the Atlantic remain concerned about the underlying levels of unemployment and how long it will take to meaningfully reduce them.
Many strategists have sought to find similar periods in recent history when inflation reared its ugly head. I’ve heard a comparison to the 1970s, which is misplaced as that decade was blighted by two oil price shocks. A decade earlier has also been referenced. What both periods had was significant wage bargaining power via trade unions. In the UK that power was diluted by the Thatcher government of the 1980s and subsequently by technology advances.
With relatively high unemployment rates and little collective wage bargaining, it is difficult to see where wage inflation will come from aside from specific skill shortages.
Letting the air out of the balloon slowly
There is an old adage, ‘Don’t fight the Fed’ so it may well pay to heed their words that any spike in inflation is likely to be temporary, reflecting year-on-year increases from last year’s depressed levels and a short-lived demand surge as economies open up again.
Bond yields have taken fright over inflation, but also the supply of new issues needed to finance economic support packages. However, bond yields are still well below inflation rates meaning negative real rates remain in play.
The Federal Reserve will want an orderly rise in yields to occur rather than a further rush higher that could spook risk assets in general. They, like other central banks, have the tools to do that through their quantitative easing programmes.
Like many investors we are keeping an eye on equity valuations and sentiment indicators, but unlike the gamification of the stock market that brought notoriety to GameStop and other ‘penny’ stocks, we are not market timers.
We continue to find long-term investment themes that should reward our investors over the long term. Most valuations are based on earnings projections which are often distant to reality – in both directions. It is not unreasonable to see growth equities pull back and pause for breath given their recent rise and extended sentiment indicators.
We have little to no exposure to the big ‘tech’ names. Our themes remain valid, potential buying opportunities may arise in them, and we will always exercise appropriate caution when investing our and your clients’ wealth to achieve meaningful objective outcomes above inflation.