May 18, 2020
Inflation: The Dog That Hasn’t Barked
Please read important disclosures HERE.
May 18, 2020
Please read important disclosures HERE.
The Paycheck Protection Program (PPP), the Money Market Mutual Fund Liquidity Facility (MMLF), the Primary Market Corporate Credit Facility (PMCCF), the Secondary Market Corporate Credit Facility (SMCCF), the Term Asset-Backed Securities Loan Facility (TALF), the Main Street Lending Program, the Municipal Liquidity Facility (MLF), the Commercial Paper Funding Facility (CPFF), and the Primary Dealer Credit Facility (PDCF). Collectively, these acronyms represent about $6 trillion of new money created through joint efforts between the U.S. Treasury and U.S. Federal Reserve (Fed) to help mitigate the economic and market implications of COVID-19.
In a crisis, desperate times often call for desperate measures. As acknowledgment to lessons learned from the Great Depression of the 1930s, federal institutions have embraced economic and monetary stimuli, low interest rates, and free(ish) trade policies to keep the economic wheels turning. But the price tag has been hefty. In a matter of weeks, trillions of dollars were printed — some physically, most electronically — which is on the heels of $4+ trillion created during the 2008–2009 financial crisis just a decade ago. With so many more U.S. dollars in circulation, should investors worry about inflation — a decline in the value of money?
In the short run, probably not. Mass isolation, quarantine, and unemployment severely cripple spending because incomes fall and activities are restricted. Showering the economy with freshly minted money doesn’t incrementally add to pre-crisis levels of spending, it only partially offsets the decline in total spending as a result of the crisis. Checks in the mail from Uncle Sam help pay for groceries and rent, not new furniture in the living room. Clothing, cars, and airline tickets go on sale because demand falls faster than supply. Trillions of dollars are infused into the economic ecosystem and the price of crude oil still falls 60+%. Each U.S. dollar on hand buys as much or more than it did pre-crisis, not less.
Over the long run, though, investors would be wise to keep a close eye on inflation. The world’s governments have printed an incredible amount of fiat currency and created enormous sums of debt in a very short period of time. The following charts illustrate total worldwide debt and that debt within major countries, measured as a percentage of gross domestic product (GDP), since the turn of the century. Notably, the charts only include data through 2019. The impact of COVID-19 on the debt trajectory is yet to come — and it will surely be significant.
Looking to the bond market for clues, we are plainly led to believe that there is little inflation in sight. The 10-year breakeven inflation rate, represented by the yield on a 10-year U.S. Treasury bond with no inflation protection as compared to the yield on a 10-year U.S. Treasury bond that adjusts for the rate of inflation in the U.S. economy (a so-called Treasury inflation-protected security), currently hovers around 1%. In short, bond investors are collectively betting that inflation will average 1% per year over the next decade.
We will only know, of course, after the virus has passed and economic activity returns to some new normal. The proverbial canary in the coal mine may be the debt-to-GDP ratio. If the economy is able to bounce back and expand faster than new debt is created, the global heap of debt may be manageable as total debt as a percentage of GDP declines. However, if debt growth continues to rapidly outpace GDP growth in a lasting fight against economic malaise, at some point, investors may begin to question the credit worthiness of major issuers and demand higher interest rates as compensation for higher perceived risks of repayment. To fight against such a dynamic, the Fed, as it is doing now, may print more and more money to buy more and more debt to keep interest rates down, creating a loop in which fewer bankruptcies and higher employment in the short run (via low interest rates) leads to too much money creation — thus spiking inflation.
The Fed and central banks around the world are attuned to this risk, of course; and on balance, we should have some level of confidence that they will collectively navigate things successfully. Having said that, the stakes are enormous and we are sailing in uncharted waters. Mistakes can happen, which may justify portfolio modifications to help hedge against higher inflation, a risk the broader market doesn’t seem to expect.
Effective hedges may be value stocks, gold, real estate investment trusts, and Treasury inflation-protected bond securities that pay an interest (or “coupon”) rate equal to the Consumer Price Index (CPI). Value stocks tend to fare better than growth company stocks because they are typically defined as companies with low price-to-book ratios. The “book” in the denominator represents book value, or assets on the company’s balance sheet, which tend to move up and down in value in a manner commensurate with local inflation. Real estate investment trusts work the same way as the underlying trust assets are physical properties. Gold is a more obvious inflation hedge, but it can also be a more expensive one, as gold has no yield or profit stream. There are, of course, other potential hedges beyond these examples.
As ever, long-term investors should maintain a balanced, diversified approach with at least some embedded defenses to help navigate all weather in all seasons. When markets mold around a consensus view, surprises can be costly.
Gabe Alpert, “Government Stimulus Efforts to Fight the COVID-19 Crisis,” Investopedia, April 14, 2020, https://www.investopedia.com/government-stimulus-efforts-to-fight-the-covid-19-crisis-4799723