Inflation’s coming – in time!

   By Guest Blogger Ryan Lewenza

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The economic toll, among other things, of the global pandemic has been devastating. From what I read, the conversations I have, and what I see around me, it’s heart breaking to see so many people hurting during this scary and uncertain time.

Due to the economic damage caused by this pandemic, governments around the world have responded by providing unprecedented benefits and support to those impacted by this virus. And with all this increased government spending and deficits, central banks are ramping up the printing presses again, leading some to fear that much higher inflation (some are even calling for hyperinflation) will come and blow everything up.

For example, we’ve seen the Federal Reserve’s balance sheet increase from US$4 trillion to start the year to US$7 trillion currently. As a result of this monetary and fiscal stimulus, we’ve seen US money supply skyrocket. M2 money, which includes all notes in circulation and bank deposits and money market funds, has surged 23% year/year! My data goes back to the 1960s and the next highest annual change was back in the 1970s when it hit 13.5%. So just looking at this, many assume inflation is set to skyrocket.

US Money Supply is Rising at a Record Clip

Source: Bloomberg, Turner Investments

But money supply only captures one aspect of inflation. When looking at inflation we have to examine all the key areas including wages, commodities, and the things we buy like food, energy, electricity, etc. Focusing on the US, I reviewed all the key components of inflation and while food inflation is on the rise – the main thing people tend to focus on – many other key areas like energy and apparel are experiencing major price declines.

While I see oil prices recovering next year as demand rebounds, oil prices are likely to remain contained (i.e., $60/bl), keeping gasoline prices low. With unemployment still quite high, I see minimal wage growth pressure over the next few years. And I see pressure on residential and commercial rents until Covid passes. Basically, I see a number of shorter term deflationary trends over the next few years, which should help to offset the dramatic rise in money supply.

US CPI 12-Month Percent Change, Select Categories

Source: US BLS, Turner Investments

Looking longer term there are also a number of major deflationary trends to consider. Some include:

• Globalization: The most significant deflationary force in recent decades has been the offshoring of jobs and manufacturing to China and other low-wage countries. Look at the tags on your clothing or the stickers on your new TV and odds are it was manufactured in China, Vietnam or Mexico, where through their low wages they can manufacture consumer products on the cheap and ship it back to us. There’s a reason why Walmart, Costco and Amazon are some of the largest companies in the world.
• Technology: After globalization, technology has and will continue to be a major deflationary force. Technology helps to improve productivity (a good thing) but comes at a cost as technology has helped replace millions of jobs in the US and globally. Technology has led to “disintermediation”, which removes the middlemen or intermediary in areas like finance and technology. Think free trading from Robinhood and online purchases using Shopify’s online platform. And it will only get worse with automation and AI, which will have huge ramifications on the labour market and wages.
• Demographics: The world’s population is aging and this has implications for inflation as older people tend to spend less and be less productive, generally speaking. According to the UN, by 2050, one in six people in the world will be over age 65 (16%), up from one in 11 in 2019 (9%).
• Debt: Lastly, high debt loads can be deflationary as more and more capital goes to servicing the debt rather than being directed to more productive areas like investment.

So, while the large increase in deficits and money supply are inflationary, there are a number of deflationary trends, helping to offset the impact of the rising money supply. Basically, the simple thesis of higher money supply, leading to much higher inflation is not so cut and dry.

Given the deflationary forces that I’ve highlighted above, in the medium term (i.e., 3-5 years) I see inflation remaining fairly low and contained, but longer term I do see the potential for inflation to rise and potentially sharply, which could cause dislocations to the economy and client portfolios. One day we’re going to have to pay for this debt binge, but as a society we’re pretty good at kicking the can down the road and delay taking the hard medicine, hence why I see inflation as a longer term concern.

US Inflation Has Been Low for Years

Source: Bloomberg, Turner Investments

At Turner Investments we always try to take a longer term view and to help combat against the prospect of higher inflation longer term, we have included positions in the portfolio, which could benefit from rising inflation. These include our long held position of preferred shares (if inflation picks up central banks will have to begin hiking interest rates, which given that the Canadian preferred share market is dominated by fixed resets, they would benefit from this) and more recently we’ve started to introduce floating rate bonds and bank loans, which would also benefit from rising inflation and in turn, higher interest rates.

It never hurts to have some hedges in the portfolio!

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.