Why inflation is not here to stay
Inflation typically results in higher interest rates, which erodes a bond’s face value and can be particularly catastrophic for low-yielding, longer-maturity assets.
I have no doubt that the current history of inflation is transitory.
The first thing to keep in mind about the inflationary case is the argument that by definition quantitative easing leads to inflation.
This is based on the classic equation you learn in A-level economics that inflation is a function of the amount of money you print and the speed at which it flows through the economy. Weimar Germany and more recently (in 2007) Zimbabwe are used as examples to prove this point.
We have to keep in mind that most of the developed countries did not print money as we saw it in Europe in the 1920s or over the last two decades in some African countries.
And the speed of money circulation – always given as a constant – has in fact collapsed, thanks to the Covid. The very clear monetarist equation did not hold up.
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Indeed, the Japanese experience shows that quantitative easing is in many ways deflationary. When I started in this industry in 1994, people were still learning Japanese because it was seen as the dominant and successful corporate culture of the time.
What has happened in Japan since? They are the ones who have faced aging demographics and very high debt levels, which has led to slow economic growth, necessitating a looser monetary policy, which leads to low interest rates.
All of this has happened over the past three decades. They are the ones who really introduced quantitative easing.
You can translate this argument to the West now. We have an aging population with a very high debt burden, which I think will lead to less economic growth than we have enjoyed in the last 50 or 60 years, and which requires a different or more flexible monetary policy. , which will produce lower interest rates and lower bond yields.
All of this funding, with government backing, prevents the automatic cleanup of the corporate company when the weak fail.
As devastating as it can be for the people who work for these businesses, without the creative tension created by the hardships of failure, you end up with a cycle of surviving businesses that would normally fail, forcing people into more productive activity. .
You could say that this is what has been happening in Japan for 25 years and it is what is happening in the Western world today. So, in this regard, quantitative easing has led to a decline in economic growth.
What we also know about Japan and Europe is that savings rates rise when interest rates fall. It sounds odd, but it’s probably because if you’re saving for retirement, you have to put aside more to generate the same return when you last tapped.
Other factors are easing the pressure one would expect to exert towards persistent and high inflation.
If you look at the global growth rate, it’s been steadily declining for 50 or 60 years.
There was a huge post-World War reconstruction boom, a sharp increase in the participation of women in the labor market, and then massive growth in the availability of credit. All of these things were expansionary.
But women’s participation is now arguably declining. We’ve had this huge credit expansion and increased population growth in the western world, both of which are slowing down – even the lockdown failed to reverse the downward trends in the birth rate. We now have an aging demographics, so we are facing weaker structural growth.
And finally, we should take technology into account. The replication of human skills for machine skills is also extremely deflationary. All you need to do is visit McDonalds and see how some counter workers have been replaced by huge iPads to understand just how ubiquitous technology is – an iPad won’t be screwed up and forced into self-isolation. This trend will only continue.
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Of course, we all know there is a lot of pent-up consumption.
But, on a personal level, I can’t drink 18 months of missed pints with friends or eat 18 months of restaurant meals in a few weeks.
My marginal propensity for after-effects – hangovers and indigestion – will quickly drop to zero.
Much of that pent-up consumption has been spent on cars and home improvement (as anyone trying to buy a car or find a manufacturer to do an extension will attest).
Thus, the wages of manufacturers have increased and the price of used cars has increased by 10% in a few months.
But the Covid crisis has had the opposite effect elsewhere in the economy.
I work in Edinburgh and a lot of my clients are in London, but we all want to reduce our carbon footprint and we have established that Zoom works great in most cases.
I estimate that I will do a quarter of the flights and only book a quarter of the hotel rooms I booked before the pandemic. I won’t be alone.
People will continue to work from home, whether it is one or two days a week.
This leads to a reduction in consumption – spending on work clothes, cosmetics, take-out coffee. So I can see a long tail of things that are going to decline.
And even if you look at areas experiencing a consumer boom, for inflation to maintain its current level, used car prices need to rise not only 10% this year, but another 10% next year. .
It is unbearable. People will postpone consumption. The inflationary argument is cracking.
So what are the implications for bonds?
We don’t think the bond market should collapse or suffer a sell-off. Of course, now is not the perfect time to buy corporate bonds.
This is when the world is in crisis and everyone is petrified by defaults; when the stock markets are on their knees and the appetite for risk has been shattered.
Our view is that almost any time you buy in the high yield bond market, you can expect attractive returns over the long term.
In fixed income securities, you get paid for taking risk.
Go back to any time period and compare the yields of high yield bonds against those of government bonds. The longer the period, the more ridiculous the outperformance of high yield bonds.
It is almost always a good time to buy high yield securities if you are a long-term investor. Don’t let short-term inflation concerns put you off.
Stephen Snowden is co-manager of the Artemis Corporate Bond fund