Chancellor: Time to inflation-proof portfolios

LONDON, Oct 21 (Reuters Breakingviews) - Current debates about inflation are mostly concerned with how long it will persist. Will inflation be transitory, as the central bankers insist? Or will consumer prices continue rising for years to come, as the bond bears maintain? Few analysts, however, consider how today’s highly financialised modern economies are likely to respond to a change in the inflation regime.

The more we consider inflation the less we seem to know, or at least to agree, about what causes prices to rise. Central bankers fixate about inflation expectations. They believe that so long as the public’s expectations are anchored around their 2% inflation target, then all will be well. But a recent paper by Federal Reserve staffer Jeremy Rudd points out that there is neither theoretical nor empirical support for the idea that expectations influence inflation.

Instead, Rudd suggests, when inflation crosses a certain threshold it enters into wage negotiations. This helps to explain the wage-price “spirals” of the 1970s. It’s possible, although Rudd doesn’t say so, that the recent spike in the U.S. consumer price index will soon be reflected in pay increases. Another wage-price spiral may be around the corner.

Monetarists also dismiss inflation expectations. Instead, they insist, in the words of their shaman Milton Friedman, that inflation “is always and everywhere a monetary phenomenon.” In a recent note, Invesco Chief Economist John Greenwood points out that the U.S. money supply (M2) has increased by more than a third over the past 18 months. Greenwood believes that U.S. consumer prices will continue to rise until all this excess money is absorbed into the economy. Inflation will be persistent, not transitory, he predicts.

Yet economists at the Bank for International Settlements have suggested that inflation in recent years has been more influenced by global factors than domestic monetary conditions. According to this view, China’s entry into the global economy weakened wage pressures in the West (whose manufacturing jobs could be shipped offshore) and exerted downward pressure on traded goods prices.

But China’s role as an exporter of deflation may be coming to an end. President Xi Jinping wants to prioritise domestic consumption over exports and profits over investment, as part of his “common prosperity” project. As Henry Maxey, the chief investment officer of Ruffer, told a Grant’s conference in New York this week, China may now encourage exporters to raise prices. The ongoing disruption to over-extended supply chains puts further upward pressure on prices. Despite what many analysts argue, this is unlikely to be a temporary problem: supply chains in future will have to become more robust as manufacturers shift from “just-in-time” to “just-in-case” production – and that means the goods they produce will cost more.

The fiscal theory of inflation holds that countries with large debts invariably inflate away their liabilities. That’s the idea behind financial repression, when interest rates are kept below the level of inflation for years on end. Investment strategist Russell Napier argues that high debt levels in the West provide a political imperative for inflation. Governments, he says, are taking over from central banks as the arbiters of the credit system. The pandemic has accelerated this process: The United States had its “Mainstream Lending Program,” while the British government underwrote “Bounce Back Loans” made by commercial banks. The stagflation often associated with financial repression has already arrived, says Napier.

What these different ways of viewing inflation don’t consider is how the financial system will cope with this regime shift. Falling inflation has been accompanied by falling interest rates. Ultra-low rates have got “into all the cracks”, to use a phrase coined by Harvard’s Jeremy Stein. Investors have taken on more risk to compensate for their loss of income. Corporate debt has increased with companies borrowing to buy back their shares and private equity arranging buyouts. Rising asset prices have substituted for genuine savings. The developed economies have become “hyper-financialised,” says Maxey. In the United States, the financial sector share of GDP climbed from around 2% in the 1950s to more than 8% today.

The inflation bullwhip will induce real pain on Wall Street. Rising inflation may force the Fed to reduce its monthly securities purchases more quickly than anticipated. As liquidity is sucked from the market, we could be faced with another “taper tantrum”. The repo market, where debt securities are used as collateral for overnight loans, doesn’t function properly when liquidity evaporates. Volatility in the U.S. bond market, which roughly tracks that of consumer prices, is likely to pick up. As Treasury yields rise, there’s a chance that the yields on riskier securities could blow out.

For the past quarter of a century, the performance of bonds and equities have been inversely related: at times when the stock market has declined, government bonds usually delivered positive returns. Conventional portfolios, allocating 60% to equities and 40% to bonds, have done well. But as inflation returns, bonds and equities are likely to become positively correlated, rising and falling together, as they did in the 1970s. This means investors will have to rethink their asset allocation.

In particular, they must consider how to reduce the sensitivity of portfolios to rising interest rates – what’s technically known as “duration risk”. The duration risk of the U.S. corporate bond market is at an all-time high. American stocks also have more duration than at any time since the dot-com bubble. Investors can reduce this risk by buying cheaper stocks. Rob Arnott of Research Affiliates, also speaking at the Grant’s conference this week, points out that value stocks in emerging markets, Japan, Europe and the United Kingdom are currently trading at very attractive valuations.

Napier takes the view that investors should own no bonds whatsoever. Inflation-protected bonds, however, may continue to perform well despite their negative real yields. (Their negative yield can be considered an insurance premium against unanticipated inflation.) Above all, says Maxey, investors must be nimble. It sounds counter-intuitive, but it’s also useful to hold more cash – the shortest duration asset – as markets become more volatile. The real value of cash may be eroded by inflation, but at least it provides investors with a means to buy assets when they become cheap.

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