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The Inflation Debate Is Returning to Markets Flush With Cash

John Ainger
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The Inflation Debate Is Returning to Markets Flush With Cash

(Bloomberg) -- Perhaps the most challenging riddle for investors in the pandemic is whether another centuries-old scourge is going to return.

Inflation can wreck even the safest portfolio by eroding the value of investments for decades. But you would be hard pressed to find anyone among the younger generation of investors, within developed markets at least, who has faced it in any meaningful way. The last major episode was back in the 1970s and ’80s, and inflation has all but disappeared since the 2008 financial crisis.

But the pandemic has changed the world so dramatically that Wall Street’s heavyweights from Pacific Investment Management Co. to AllianceBernstein Holding LP say it’s a problem that’s bound to return.

Not everyone agrees. Some argue deflation is just as likely, and others like UBS Wealth Management are positioning for softer price increases, a scenario known as lowflation. 

“It is the billion dollar question,” says Christoph Rieger, head of fixed-rate strategy at Commerzbank AG.

The mainstream view is that central banks can rescue their economies now without destabilizing prices in the future. Bonds, the assets most vulnerable to inflation, have surged and the breakeven rate, which gauges market expectations for future price rises, languishes below central bank targets across developed markets. In the euro area, inflation isn’t expected to reach the European Central Bank’s close to 2% target for 30 years.

“The largest investment risk is if investors get it wrong and we are heading for deflation,” Rieger said. “We could be entering a financial crisis like we’ve never seen before.”

With governments paying wages, handing out loans and mailing out checks, there’s now an unprecedented amount of new cash in the financial system. Put simply, there’s more money available to potentially chase fewer goods, a textbook definition for why prices rise.

But there are lots of reasons why that scenario may not play out. Companies and consumers could stash the extra cash in bank accounts, rather than spend it.

“If you look at what you have now compared to what you had in the past, you have larger triggers that would point to higher inflation. But it’s not that simple,” said Lorenzo Pagani, Pimco’s head of European government bond portfolio management. “If you look at almost 100 years of inflation numbers, you have many more days with higher inflation compared to now.”

Japan is a prime example of why stimulus spending doesn’t necessarily drive inflation. The country poured money into its economy for a generation to little or no avail at getting prices to budge. It’s sucked the life out of markets in the process and the country has been forced to battle permanently weak growth as the population ages. 

What Bloomberg Intelligence says:

“There is a long memory of low inflation and markets aren’t pricing in a regime change. The lesson from Japan is to remain highly skeptical. Inflation uncertainty may be hedged through long-dated options.”

-- Tanvir Sandhu, Chief Global Derivatives Strategist

At the opposite end of the spectrum lurks an equally, if not more worrying scenario: deflation. If people emerge from the pandemic less willing to spend, either because they’re unemployed or simply thriftier now that they’ve figured out how to cut their own hair, cook at home and exercise in the backyard, prices for goods and services could fall. That can drag wages lower in a self-reinforcing spiral that leads to depression, as it did in the 1930s.

One of the main conundrums for investors: Is the coronavirus more of a shock to demand because people are spending less, or to supply from factories shutting down? Nouriel Roubini, a professor of economics at New York University, says in the worst-case scenario the current crisis could lead to a particularly toxic mix harking back to the 1970s. Known as “stagflation,” it’s a period of high inflation, but weak economic output.

“We are going to be facing now a significant amount of supply shocks in the global economy,” he said. “Eventually the inflation genie is going to get out of the bottle.”

AllianceBernstein is positioning for a reflationary resurgence through U.S. inflation-linked bonds, known as TIPS. John Taylor, who manages $6.6 billion at the investment firm in London, says the pandemic will be a wake-up call for countries to move manufacturing of essential products back home.

“One of the consequences of Covid will be less of a drive to push for the cheapest venue for production, but to have more of that production within your own borders, which will be a higher cost,” said Taylor. He’s not the only one making that call. Assets in the Schwab US TIPS exchange-traded fund have risen above $10 billion, the highest level in at least a year.

UBS Wealth Management doesn’t see value in U.S. inflation-linked bonds, preferring equities on the belief that there’s stronger growth ahead. Paul Donovan, global chief economist at UBS, says that 85% of people in the U.K. haven’t seen any drop in income, but are spending less anyway. That means when purchases pick up, inflation could happen in pockets of the economy, like consumer staples. 

“Whenever we have a crisis like this, people always underestimate the ability of people to adapt and therefore underestimate the speed of the recovery,” he said on a call with reporters. “The third-quarter growth in the U.K., in Europe and in the U.S. will be the best quarter ever in history, almost certainly.”

Governments also have an incentive to spur price rises, given the huge buildup of debt. In the U.K., borrowing has climbed above gross domestic product for the first time since 1963. In the U.S., it’s approaching records set after World War II.

“Governments will have no option but to turn to the printing presses and directly fund deficits,” wrote Keith Wade, chief economist at Schroder Investment Management Ltd. “Those looking for higher inflation to solve debt problems should be careful what they wish for.”

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