A Post-Covid World Part 1: Should Investors Worry About Inflation After the Virus?

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The world has undergone a tectonic shift over the last several months due to the coronavirus, many expect the world to be dramatically different in the period post virus versus pre virus. The New York Times, for example, described time as being divided into BC and AC: before Corona and after Corona.

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While we think more will remain the same than change, we've contributed our own investment perspectives into this discussion through a blog series titled COVID as a Catalyst. We'll explore one of the topics discussed in that series today in Part 1 of our two-part series of a post-COVID world. Hi, everyone. Welcome back to The Pulse where we cover trends in the economy, markets, and asset allocation for long-term investors.

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I'm joined today by my colleague Chris Brigham, a senior research associate on our investment strategy team who worked with me recently on the COVID as a Catalyst series of blogs which mapped out the secular investment changes that we expect due to the coronavirus. You may remember Chris, from several months ago when he discussed with us why we expect interest rates to remain low for the foreseeable future. So, Chris, welcome back to the show. Hey, thanks for having me back, Matt.

01:15 - 01:49

So as the coronavirus hit, we began thinking about what the world would look like after. So we put our heads together, Chris and I. And Chris, let's bring you into this conversation. Can you explain to our listeners how we categorize the changes that we expected due to the coronavirus? Yeah, Matt, so we really kind of tried to bucket things into broader categories. And so those four major categories were macroeconomic, technological, microeconomics/corporate behavior and, of course, political, which we're seeing on the nightly news every night.

01:49 - 02:21

And I think one final thing, just to kind of tee up this conversation with that, as much as we expect some things to change, we really do expect a lot of things to stay the same. Chris, let's flesh that point out, because I think if I were to put myself in the shoes of many of our listeners, they're expecting a lot of change, not a little change, but a lot of change due to the coronavirus. Obviously, our lives have changed a lot over the last few months, but maybe go a little bit deeper on that last point that we only expect some things to change, but not dramatically so.

02:21 - 02:39

Yeah. So if you look at the history of, say, the 20th century, when we've had pandemics, wars, this, that, or the other thing, All of those big things happen and then at the end, things somehow go back mostly to the way that they were before. And there are a few things each time that kind of switch.

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So if we look at, say, one hundred years ago, the pandemic of 1918, one thing that we noticed that switched was that before that you had people who had drink from common cups. So if you were in downtown or if you were on a train, you drank from a common cup. As a result of the pandemic, you stopped seeing that. So it was kind of a small thing. And out of that, we got the Dixie Cup.

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So we would expect to see kind of changes like that, more so than over any big overhauls of our lives. OK, fair point. And I appreciate the reference back 100 years ago to that common cup. I've read a number of things about that.

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I think that's fascinating little insight there. So, Chris, we cover numerous amounts of topics in that COVID as a Catalyst blog series. But let's focus on just the three that I think are the most topical ones today.

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And in my mind, that's inflation. So changes to inflation due to the virus, changes to labor specifically in the form of automation, and then finally inequality. So we can get started with inflation. That's probably the question that I get asked the most about. What are some of our perspectives and key takeaways as it relates to the virus's impact on inflation in the not too distant future? So inflation is really hotly debated and it's a highly controversial topic.

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What you tend to see is that a lot of people are very firmly in either the inflationary or disinflationary camps, and a lot of that really comes back to ideology more than necessarily the evidence. So one thing that we've tried to do in our work is really acknowledge the uncertainty. And there's uncertainty there for two really key reasons. The first reason is that we really don't know how inflation works. We don't really know when you get it, when you don't. As much as economists work to try to understand it, it confuses us. So there's just that general uncertainty about what the drivers are.

04:32 - 04:57

And then second, that to the extent that we do have an idea of what drives inflation, whether we actually get inflation or not this go-around depends a lot on both the fiscal policy response that we've seen with the crisis and then ultimately to the Fed's monetary policy response. And I'll come back to that. The Fed is really, I think, what's going to eventually drive the conversation around inflation. OK, so let's discuss those two elements.

04:57 - 05:27

You said essentially fiscal policy and monetary policy. And I think we all have to admit over the last hundred days or so, there's been an enormous policy response from both Congress and the Federal Reserve. So how does that work into your thinking, the firm's thinking as it relates to the significance of the size of that response and then the potential for an inflationary offshoot because of it?

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So when we look at what happened, we basically had the potential to have one of the worst recessions ever seen. And if the policy response wasn't quick enough or wasn't sizable enough to actually go into a legitimate depression. So both from Congress's perspective with fiscal policy and the Fed's perspective with monetary policy, the speed and the enormity of what they did, pulling out all the stops, basically, that was necessary and it continues to be necessary.

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But the consequence from that, though, is that at the end of this, we're going to likely end up with debt at post-World War II highs relative to GDP and that, that high deficit right now and then that large debt overhang, that's got a lot of people worried. Understandably so. Right.

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And that's the thing, Chris, is, you know, many of our concerned clients and concerned investors point to the policy response and the size of it as a reason why the dollar would devalue, why inflation would be meaningfully higher. Can you just explain to our listeners some of the reasons to have some concerns about inflation as we look out into the future? Absolutely.

06:43 - 07:16

So to focus on a few of the real reasons that we should actually be concerned, first and foremost is just that to the extent that people do think that the deficit and the debt are going to drive inflation, that might change their behavior and raise their inflation expectations, and then that cycles back on itself and eventually leads to inflation. So that's just, let me just be clear on that. You're talking about inflation expectations, meaning investors or consumers. If they believe that debt levels and deficits cause inflation, that might be just a self-fulfilling prophecy.

07:16 - 07:51

Exactly. And I think that's one of the things that makes inflation so hard to understand, is there's a massive psychological aspect to it. And so as much as you want to put formulas around it, at the end of the day, a lot of it just comes down to what people believe and whether what they believe is right or wrong, it's going to affect their actions, and then it ends up being right in the end anyway. And the interesting thing is, if you were to look into the market today, we can get a sense for what investors believe inflation will be three, five years from now. And last time I checked that that expectation was still very, very modest.

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It was only one and a half, maybe one and three quarters percent inflation levels five years from now. So the significant increase that many are worried about of inflation expectations moving meaningfully higher is not being proven out at the moment in the marketplace. But that's point number one as to what might cause inflation.

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And we got other points. What else do we have? So I think one other reason why we should be worrying about inflation over the coming decades, not necessarily the next couple of years, but over the next, say, 20 to 30 years, is that the US population continues to age and medical care for the aged population is through Medicare.

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And that spending, even though it's not going to take place for another several decades, we can already see that on the horizon as a big, big budget item for the US government. And so that deficit from government spending on healthcare, we know that's looming in the horizon. So that's kind of one reason why we're already a little bit worried about the budget deficit going forward.

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Number two is climate change. So climate change is inflationary for two different reasons. First, it takes out productive capacity, which means that say you have a factory that floods because it's too close to the coast, that capacity is gone. So supply is gone.

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That can be inflationary. And the second reason is a little bit more subtle, it's that we have kind of this normal quality of life and we get economic growth by enhancing that quality of life via investment and development of businesses. But climate change, just to maintain our current standard of living, is going to require a whole lot of spending just to run to stay place. So essentially, it's like running on a treadmill. And that in and of itself is an inflationary pressure as well.

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So, Chris, just for the benefit of our listeners, inflation and the drivers of inflation are all fairly complicated. So let me just summarize what we did summarize in the blog series and what you said so far. Debt levels and deficits are not in and of themselves causes for inflation.

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So I think that link that many investors make, that we've issued a lot of debt to support the economy post the virus, is not really rooted in reality. The last decade or so, for example, where the US issued a lot of debt and expanded the Fed's balance sheet to fight the global financial crisis didn't cause any inflation. So I think that's the most recent and best example for why deficits and debt levels aren't necessarily a cause for inflation.

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That being said, there are reasons to worry about inflation. You covered a number of them. You said, to the extent that people start to worry about inflation, it might be a self-fulfilling prophecy. Additionally, the increase in healthcare costs could, in and of itself, cause inflation. And finally, climate change, and our willingness and ability to counteract climate change might cause inflation.

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I think there's another one as well, which we often talk about, which is globalization, or rather the reversal of globalization. Globalization for several decades has put downward pressure on costs for many corporations. And to the extent that that has peaked, globalization, that is, well, then that would push costs higher and that could feed through ultimately to prices on the shelf for consumers, couldn't it?

11:23 - 11:36

Yeah, absolutely. That's another really good reason why people should have concerns about inflation. But at the same time, there are also several really good reasons not to be so worried. OK, so let's get to those. Let's get to the other side of the coin.

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Chris, what are the reasons that we explored in our COVID as a Catalyst blog series why investors don't necessarily have to be worried about inflation? So overtime, there are a couple other reasons why inflation concerns might be a little bit overblown. So the first reason is that there's a really intuitive link between deficit, debt, and inflation. But you don't really see that in the real world data and you don't see it for the US. You don't see it in other countries. In the US,

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If we think back to the stagflation of the 1970s, which seems to be the case that everybody is worried about today, that actually happened when the US debt was at post-World War II lows. And yet when the debt levels have been higher than that, we haven't really seen that level of inflation. So the correlation between the two just in the US isn't really that high. Of course, the situation then, and apologies for interrupting, the situation then that catalyzed that inflation had nothing to do, as you say, with debt and deficits.

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It had to do with an economic shock, it had to do it with oil embargoes and skyrocketing oil prices, which then fed through to the rest of the cost structure for consumers.

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Absolutely. That was a different source, kind of. If you think about what people talk about as the causes of inflationary spikes, that doesn't really factor into people's models as much in terms of the causes of the 1970s inflation. And then, I guess reason number two why inflationary concerns might be a little bit overcooked is just that people worry about the money supply.

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Kind of on one hand is fiscal policy. On the other hand is monetary policy.

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People worry about the money supply and essentially think that if the money supply increases, then each dollar has to be worth less. But that hasn't really been true in the US or around the world for decades. So the velocity of money, just kind of how fast a dollar turns around the economy, that's been falling in the US for several decades. It's been falling outside the US for even longer. And that's kind of the plug in the equation, that you need to actually see an increase in the money supply lead to an increase in inflation. And we just haven't seen it outside the US.

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We haven't seen it in Japan. We haven't seen it here. We haven't seen it in Europe.

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We don't know really when we'll actually see that velocity of money kind of hold steady or even grow, which is something that you kind of need to see to see that feed back into inflation. Chris, I think that's a nuance that's often missed by investors, which is that it's not simply that there's money out there in the system, more money than there was the period before. It's that that money has to turn over many times.

14:16 - 14:29

The multiplier effect, as you describe it, the velocity effect has to increase so that you then and only then do you get higher levels of inflation. We just haven't seen that.

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We certainly didn't see that in the period post the global financial crisis, the economy was just too weak. And even though interest rates were low and there was expanding balance, certainly at the Fed and Congress allowed for significant fiscal spending, the velocity stayed fairly low.

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And so then we didn't get the inflation that many were worried about and that potentially could continue to be the situation today. I was going to actually add one more thing to that, Matt, is that if you look at why the velocity of money has been falling, especially in the US post the great financial crisis, a lot of the money that was created is actually just sitting on banks' balance sheets as excess reserves. And so that money is just kind of sitting there, not doing anything, not going around the economy.

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And this time around as well, a lot of the money that people saw created in the last few months, that has them worried,

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That is also sitting on banks balance sheets as excess reserves. So that's also still not flowing through the system or even too, I think it's fair to take it not just to banks, but to consumers.

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A lot of the money that was sent out either in unemployment, mostly in unemployment benefits, is sitting in savings accounts, cash, so that money isn't out there necessarily being spent at stores, and so that's an important thing and that's a nuance which isn't fully appreciated by the market from time to time. And I think that's the case today for many of those who are worried about expanding balance sheets and debt levels are missing this philosophy aspect.

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So, Chris, obviously there's good reasons to worry and good reasons not to worry about inflation. How did we categorize the tipping point between either significantly higher inflation from where we stand today or the opposite?

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So ultimately, this is going to come down to the Fed and it's going to come down to, when things get better, when we're in recovery, do they raise rates at the right time or not? And what makes this hard is that in advance of that moment, it's very difficult to know what they're going to actually do when that time comes.

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And the economists and our fixed income division are worried that they in Congress and likewise central banks and legislatures and governments around the world are becoming increasingly joined at the hip because monetary policy doesn't have the same impact it used to. So they need to use fiscal policy more aggressively.

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If that happens, if they do become joined at the hip, that's when you start to worry about inflation expectations breaking away, because history has really shown that at those moments when a central bank becomes kind of beholden to the government and doesn't raise rates when they should be raising rates, that's when bad things happen in terms of inflation.

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So that's what people are really worried about. But it's really going to come down to that decision by the Fed probably a couple, two, three, five years from now. And so it's hard to say right now what that's going to be. Until that day comes, we can't really know. I think that's a great insight, by the way, Chris, from our fixed income departments and our economics team, that monetary policy is now so joined at the hip with fiscal policy.

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I think that is a key tipping point that we need to watch closely as it relates to those inflation expectations. Inflation expectations may very well move higher if the market, if consumers, if investors believe that central banks, the Fed or otherwise, would be unlikely to raise rates if we do have a bout of inflation because they are joined at the hip.

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So, again, there's a particular and a useful insight then I think is often missed by the market. So, Chris, we're going to have to leave it there. And thanks to all of you for listening.

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