The Inflation Conundrum
The Inflation Conundrum
Things just haven’t been the same after the financial crisis. Inflation has been a slippery slope for the FED over the past few years. Even as the unemployment rate dropped below what is typically regarded as the “full employment” rate, which is around 5%, prices and wage growth have been stagnate. See the chart below showing the 5-year forward inflation rate provided by the FED.
But things are finally starting to change. With the much talked about tax reform plan being implemented, inflation expectations are starting to skyrocket. This has lead to some recent panic in the markets since all assets are priced relative to U.S. Treasuries. Risk premiums on stocks, for example, increase as rates move higher. This is because an equity investor needs to be compensated for the additional risk of investing in stocks as opposed to a Treasury bond, which is considered “risk free”. So as rates on U.S. Treasuries rise, the hurdle rate to invest in stocks also rises. This is a phenomenon that most investors haven’t faced in quite some time.
What makes this whole situation interesting is that the FED has focused their policy measures on trying to pump up inflation as our fragile economy was trying to claw its way out of an elongated recession. At the time the FED was worried about deflation, not inflation. Now it seems the risks have shifted as inflation and interest rates may take off at a more aggressive rate than expected. All the years of excessive monetary policy and government interventions will now be put to the test. With rates still relatively low compared to historical levels, the FED’s options are somewhat limited if things end badly this time around.
My personal thesis is somewhat mixed on the inflation and market outlook. First off, I think the risks from years of quantitative easing have a decent shot at denying the FED a story book ending. I believe that government intervention is good, and arguably needed at times, but to the degree at which central banks around the world have manipulated markets is a little concerning to me. Some countries in Europe still have negative interest rates and I just don’t see how that is supposed to end well, for anyone. So that’s my high level market hypothesis. In regards to inflation, I do believe that inflation and interest rates will remain relatively low in the future. There are still a number of countries with interest rates in negative or near zero territory, which will ultimately keep a cap on inflation. My inflation thesis is mainly based off of secular shifts concerning demographics and technological advances.
Where Did The Inflation Go?
Demographic shifts across the world have had major impacts on inflation and overall growth, particularly in developed markets. As a little ECON 101 refresher, GDP is driven by two main components: population growth and labor productivity (technological advances). As the developed world continues to integrate women into the work force, it creates an additional supply of workers. More individuals contributing to the workforce helps GDP growth. However, as women become more engaged with their careers, birth rates across the developed world are starting to decline. In addition to declining birth rates, Baby Boomers continuing to retire has added increased pressure on country demographics, which ultimately affect economic growth.
Take a look at the image below. Notice that in most developed countries, particularly in Europe, where populations are stagnant and in most cases declining.
This chart is particularly important in the Western World where the lack of economic growth has affected country politics (like Populism, which I mentioned here). This demographic decline doesn’t seem to be changing either. As we saw in the Syrian refugee crisis, European nations aren’t too keen on immigrants entering their country, even though they desperately need it.
The second driver of economic growth is technology. Technological advances help to make the economy more efficient. Instead of having to hire 100 people to pick corn for a month, a machine can now do that same job in a fraction of the time. I believe the biggest technological development and its impact on inflation has been the internet. Check out this crazy chart below, which highlights the growth in internet users.
Pretty wild. This chart also shows that with more information flowing through to consumers, it makes it much more difficult to raise prices. Enhanced price discovery is a good thing. It helps consumers like you and me put more money back into our pocket, which we can allocate to other things.
Just imagine how companies like Amazon have contributed to price discovery. Ever since Amazon became the de facto benchmark for online shopping, it becomes harder to charge prices any higher than what Amazon is currently charging. I believe this effect has lead to downward pressure on inflation moving forward. Companies can’t just jack up prices like they used to. It’s much more competitive now with the internet. Lower prices lead to lower inflation.
In addition to Amazon, there are many other companies popping up all over the place from Uber and Lyft to Personal Capital that have led to cheaper prices and made our economic system much more efficient. But all this innovation has also led to lower inflation and I believe this trend will continue into the future.
A Repeat of Japan?
Similar to what the U.S. has been experiencing, Japan has had an inflation issue for decades. In fact they even have a saying for it: The Lost Decade (失われた十年). When they have a saying for it, you know its bad. Similar to what the U.S. experienced in 2008, Japan was living in an asset bubble that finally burst in the early 1990’s. Since then the Japanese economy has stagnated and they consequently have been trying to do whatever it takes to jumpstart their economy. I mention some of the extreme interventions the Japanese government has taken in Rising Risk of ETFs. However, even with the extreme government interventions, Japan still isn’t even at their 2% inflation target. Why is that?
In reference to the demographic shifts noted earlier, take a look at Japan’s demographic decline below. It’s pretty alarming.
Additionally, there are some cultural differences that affect the inflation issue. The Japanese, for example, aren’t hardcore consumers as compared to Americans, which has a major affect on inflation and wage growth. Just look at the two charts below and you can see the difference between the Japanese consumer versus the US consumer.
As you can see, consumer spending is a little bit choppy in Japan. Compare that with a typical American consumer below.
The consumer behavior you see above affects how companies define business strategy and how they should deploy capital. For Japanese companies, its tough to justify funding certain projects if you know the ROI isn’t very strong. You can see that in the capital spending numbers. From 2008 to 2017, private sector investment averaged -1.44% (Yikes!).
I don’t think we’re at the same level as Japan, fortunately, but their economy is something to keep an eye on since they have utilized a more extreme version of QE than here in the U.S. Just something to keep an eye on. I have no idea how the QE experiment will ultimately play out, nobody really does, but just take note that all that central bank intervention in Japan hasn’t really fixed Japan’s economy.
So that’s all I got on the inflation issue. If you have any additional thoughts please feel free to comment below!