Themes.

Updated quarterly, our evolving views on the thematics shaping the markets around us

Inflation

WHY IT MATTERS | Inflation is for the economy what Samuel L. Jackson is for Tarantino – he may or may not be the lead character of the narrative, but he’s always in the picture and never goes unnoticed. Inflation is vitally important because it’s directly tied to the value of money and economic growth, two things that are quite important in financial markets.

THE TAKEAWAY | Most of the developed world has been in a decreasing inflationary environment (read disinflationary) for the better part of the last four decades, ever since Apocalypse Now hit the theatres in ’79. Institutions have, thus, tried to stimulate inflation since the 1990s in order to avoid negative levels of inflation (read deflation) as it’s widely considered one of the biggest threats to economic stability. In 2020, given the unprecedented level and type of stimulus on the back of the ‘spectacular’ economic collapse we witnessed, we’ve entered a new paradigm in which the advent of inflation (and the subsequent growth of it to undesired levels) is a real possibility.

 

OUTLOOK

  • We’ve been in a long-term disinflationary trend on the back of structural changes that took place over the last five decades. Population growth peaked in 1962 at 2.2% (now at 1.1% and will likely continue to trend lower), technological innovation has helped the price of goods come down and globalization has slowed in the last decade on the back of repeated escalations of geopolitical risks. None of this will likely revert anytime soon.

  • Velocity of money, a key driver of inflation (more on this below), has also been steadily decreasing since the mid-1990s and collapsed in 2020. It will likely rebound into 2021, but it’s unlikely to be large enough to cause an inflation spike.

  • Market’s expectations of future inflation have picked up in the last quarter of 2020, but the overall level continues to be subdued. We expect that any excessive pick-up in inflation expectations is likely to lead central banks to implement Yield Curve Control to avoid bond yields (i.e. the cost of borrowing money to finance fiscal deficits) to substantially increase.

  • Inflation risks will primarily be driven by the need to replenish inventories and the potential increase in spending on the back of higher savings, and in monetary terms, from the sizeable increase in the monetary base.

KEY IDEAS TO FOLLOW

Monetary and Fiscal Stimulus | The more governments get comfortable sending citizens “free” money, the more you’ll hear about the increased likelihood of meaningful inflation. When new money is being thrown around indiscriminately, the value of it should tend to decrease (i.e. inflation should rise).

Velocity of Money | This is an economic indicator that, in simple terms, highlights how quickly money moves around the economy. The faster money moves around, the more the economy is expected to grow. Velocity of Money was already low in 2020 and has collapsed as a result of the pandemic, and, to some extent, should rebound in 2021. The extent of that rebound is likely to determine the level of inflation one should expect.

Inflation Expectations | There’s an interesting ‘reflexive’ side to inflation, as the higher the level of its future expectations, the more consumers are likely to adjust for it, driving inflation higher today. In practical terms (and oversimplifying this to the extent that it will hurt economic PhDs to their core), if you expect your Patagonia vest to cost more in six months (as a consequence of inflation), you’re more likely to buy it today. The increase in today’s consumption as a consequence of higher future inflation expectations drives current inflation higher. Said differently, your view of the future has a material impact on your actions today.

Improvements in Economic Indicators | Any material pickup in income growth, industrial production, consumer spending, or unemployment rate should be included in any future assessment of inflation.

Lower US Dollar | Given its role as the global reserve currency, its relevance in global trade (more than 50% of global trade is in US Dollars) and the number of countries who are exposed to USD-denominated debt, a lower Dollar tends to ease financial conditions globally, which helps drive inflation higher.