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© 2018 by The Discerning Investor.

  • Bennett

Fear of inflation in a deflationary world

Powerful secular forces are driving down long-term inflationary expectations. The resurgence of cyclical inflationary forces is likely to be short-lived and muted.


When we look back 20 years and reminiscence over S$1.00 chicken rice, or head into a bank and be advised to invest our monies as hedge against inflation, it is easy to conclude that something must be done. Whether it is purchasing a second property, investing in stocks or bonds, or stashing gold bullion in our safes, history tells us to do something.


Yet, how big of a threat is inflation really in today’s context? Small and declining. Inflation occurs when demand for goods and services driven by increases in the money base, grow faster than the economy’s output capacity. For demand to increase, households’ incomes and access to credit must increase. Today, powerful secular forces are simultaneously depressing real wage growth, and increasing output capacity of goods and services, creating a strong deflationary force across the world.


Automation and technological advances


The advent of advanced machinery and computer programs has led to unprecedented productivity increases over the past two decades. From the development of the personal computer, to artificial intelligence and machine learning algorithms employed by hedge fund managers. Technological breakthroughs have meant less people are required to perform the same level of output. Indeed, in the last 40 years, workers’ productivity has doubled.


However, workers have not benefited commensurately from the rise in productivity. According to OECD, IMF and the World Bank data, their real wages have in fact remained relatively stagnant, and labor’s share of national income fell from almost 65% in the mid-1970s to below 56% in 2017.


Figure 1: Changes in labor shares in G20 countries (plus Spain) - Advanced economies

Figure 2: Changes in labor shares in G20 countries (plus Spain) - Emerging economies

Figure 3: Evolution of average wages and labor productivity in selected advanced G20 economies, 1999 - 2013

New technological advancements such as driver-less cars and general AI threatens millions of both white and blue-collar jobs. A study, compiled by McKinsey Global Institute, says that advances in AI and robotics will have a drastic effect on everyday working lives, comparable to a shift away from agricultural societies during the Industrial Revolution. By 2030, it predicts that as many as 800 million jobs could be lost worldwide to automation. While new jobs will certainly be created, it is hard to imagine how it could make up for such massive displacement of labor in favor of automation.


Globalization and the increased pool of labor


Internationalization of trade and commerce, and state directed higher education initiatives have led to an ever-increasing supply of educated, skilled workers in the world to the benefit of corporations. China for example, is expected to graduate 8 million students from Chinese universities in 2017, 10 times higher than it was in 1997 and more than double the number of students who will graduate in the U.S. The resulting abundance of labor supply and reduced demand for labor due to increased productivity has a depressing effect on real wages. Profit-seeking corporations will always turn to the lowest cost alternative, as evidenced by the outsourcing of non-core operations to third world operators and shifting manufacturing bases to low income countries.


Monopolization of industries


Contrary to public perception that we live in a more competitive world, when it comes to large corporations, competition is increasingly lacking. Today, Apple owns 40% of the U.S. smartphone market, Google and Facebook collect more than half of all mobile-display advertising revenue, Amazon owns 44% of all e-commerce sales in the US . There are three effects of such monopoly power.


First, the increased size of their operations facilitates investments in capital goods such as state-of-the-art technologies which pushes down the unit costs of production. Allowing them to offer lower prices to consumers.


Second, by offering lower prices they reinforce their monopoly positions as smaller firms are unable to compete and close. There has been notable decline of new companies formed in the U.S. From 1995 to 2008, there had been on average 500,000 new businesses formed per year. Since 2010, that number has fallen to 400,000, a decline of 20%. There is a net loss of jobs, as smaller companies are more labor intensive compared to their larger, more efficient counterparts. This reduces household incomes and hence, demand for goods and services.


Third, large corporations have monopolized political power through campaign contributions and lobbyists. Today, the biggest companies have over a hundred lobbyists representing them, and collectively spend more than US$3 billion a year on reported lobbying expenditures. Such influence creates pro-industry governments that protect their incumbencies and stifle competition in many ways.


Lower growth and inflation outlook


These secular forces in unison simultaneously reduce the growth of real household incomes and increase supply capacity of goods and services, leading to lower growth and inflationary expectations.


Figure 4: Treasury nominal yield curve as of 3rd Apr 2018 compared to 3rd Apr 2017

Figure 5: Treasury real yield curve as of 3rd Apr 2018

While the front end of the treasury yield curve has increased due to fed rate hike expectations and the US treasury’s decision to auction more shorter duration bonds, the back end has increased only marginally, with the 30-year bond yield relatively unchanged from a year ago, flattening of the yield curve. Bond investors, clearly do not see long-term inflation as a problem and believe that the fed has institutionalized inflation fighting tools since Paul Volcker and Alan Greenspan’s successful battles against inflation.


With real yields maxing out at 0.90% for the 30-year bond, bond investors seem confident inflation will not materially exceed the current break-even point of 2.07% (difference between 30-year bond yields and the 30-year equivalent inflation-linked bond yield), given the duration risk.


The resurgence of inflationary fears and treasury yields


Treasury yields rose sharply in 2018, driven by higher inflation readings across CPI and core-CPI (excludes food and energy), and the US Treasury’s decision to auction more shorter duration treasury bills in favor of longer duration treasury bonds to contain longer term yields which are often used by businesses to gauge the attractiveness of capital investment projects. Further, Federal Reserve Chairman Jerome Powell’s testimony to congress revealed his expectations of higher inflation amidst accelerated GDP growth, a tax cut stimulus and low unemployment at 4.1%, which could lead the Federal Reserve to adopt a more hawkish policy of accelerated rate increases.


In my opinion, inflation is overestimated by market participants. Theoretically, higher growth, tax cut stimulus and low unemployment should lead to higher wage pressures and rising inflation. However, that’s only looking at the surface.


First, while real GDP increased an estimated 2.3% in 2017, median real wages only increased 0.2%. While new job creation continued, we are not at the point where wage growth will accelerate. This is because although official unemployment (termed U3 unemployment) has fallen to 4.1%, the U6 measure of unemployment which includes discouraged workers, marginally attached workers and part-time workers, stands at 8.2%. Further, the prime age labor force participation rate remain at depressed levels, compared to the 1990s and early 2000s.


Figure 6: Historical unemployment rates 1998 - 2018

Figure 7: U.S. prime age labor force participation rate 1990 - 2018

Second, the investment and employment boosting effects of tax cuts are largely over-stated. Most business contacts surveyed on how their companies would use the additional cash generated by tax cuts, indicated that mergers and acquisitions, debt reduction, stock buybacks and dividends were more likely than an increase in investment and employment. This makes sense, since profit-seeking businesses will only expand operations where there is sufficient excess demand for their goods and services.


Third, while US CPI and core-CPI registered a boost in January, price increases were heavily weighted towards non-discretionary items such as medical services, gasoline, clothes, rent and auto insurance. Europe, China and Japan all saw steady to falling inflation, which indicates the inflation experienced in the US may be in fact imported inflation due to a falling US dollar.


Implications on investing: Don’t feel compelled to increase risk-taking to compensate for inflation


A low interest rate environment since the great recession have led investors to increase their risk exposure by over-weighting growth equities, high yields and real assets, and under-weighting cash and short-term government bills. To be sure, such allocation was deliberated by central banks to spur economic activity, and beneficial when we review equity and high yield returns over the past decade.


However, given the extended bull market for stocks and risky assets, valuations are no longer cheap. And real yields for intermediate-term government securities have turned positive (except for Europe and Japan). Thus, investors can look to government bonds and high-grade corporate bonds as an alternative allocation and be more selective on their stock selections as we are less likely to benefit from the broad-basket stock market gains of the past years.


Finally, there remains the risk that the Federal Reserve may tighten faster than expected, eventually leading to a slowdown in business investment and consumer spending, an inverted yield curve, and subsequent recession. In such a scenario, high-grade government and corporate bonds are likely to provide some insurance against a portfolio of risky assets.