What caught my eye?v.87:Inflationary note in a deflationary tune
In this issue we ask whether investment landscape has transited from disinflationto inflation and how similar current environment is to ‘67 or ‘87 regime changes.
The 1950s-60s was the ‘Golden Age’. It was a time of reconstruction and risingproductivity; low unemployment and subdued inflation. In the DMs, it was also aperiod of mass college enrolments, job security and declining inequalities. It ledto a secular bull equity market that lasted almost two decades. The first signsof trouble appeared in late ‘60s and by ‘70s, investors entered a differentworld. State activism destroyed the Bretton Woods monetary system and gavebirth to modern fiat currencies. The age of inflation was born. Through ‘70s-80sand into ‘90s, the investment landscape was dominated by inflationary concerns,causing negative correlation between rates and equities. Inflation was thebogeyman, with equity investors fearing harsh CB responses. Hence, fromlate ‘60s until well into ‘80s most equities were in secular bear market territory.
In 1990s, environment underwent a radical change. The backlash againststate activism led to free market philosophies. It inaugurated a world of rapidfinancialization; but it was also an age of persistently falling inflation and cost ofcapital. The global de-regulation of product, labour and capital markets hasintegrated massive supply of EM labour. But it also emptied DMs middle class,raised inequalities and unleashed policies that replaced stagnant incomes withassets and leverage. It gave birth to Greenspan ‘put’, focus on avoidance ofvolatilities & provision of ample liquidity. The consensus that ‘inflationary beast’was contained morphed by the mid-2000s into a fear that deflation was thenew bogeyman; hence rates-equities correlation turned positive. Equities reliedon CBs risk suppression and containment of deflation via assets wealth impact.
Are we witnessing a regime change? Proponents argue that disinflationarypressures (due to inclusion of EMs labour and baby boomers) are behind us. Associeties bump against capacity constraints and embark on late-cycle stimulus,inflation will be back, possibly as bad as in 1967/68. While possible, this viewunderplays deflationary pressures from technology & financialization.
Since the early 90s, technological changes and overcapacity have been forcingcorporates to consolidate and improve efficiency (~70% of the US industriestoday are much more dominant & concentrated). Technologies have also beendissolving labour markets and reducing labour’s pricing power. Strengthening ofcorporate and declining labour power are precluding tightening markets fromflowing into higher wages. We also doubt that a commodity shock (a la ‘70s) islikely while today’s much higher debt burden cannot absorb any rise in the costof capital. Thus, disinflation still remains the core secular theme; but one canhave interludes of inflationary break-outs, within a deflationary channel (here).
We have described 2018 as the year of decisions and consequences andalso the year when volatilities could return with vengeance (irrespective ofeconomic strengths, as markets are not economies). Today, G4+Swiss CBs arebloated with ~US$16 trillion of assets, providing limited ammunition to fightrenewed disinflation while making liquidity withdrawals very dangerous. Unlike‘60s/70s or ‘87, economies are also now far more driven by asset prices; henceprice discovery and volatility can easily destroy wealth impact and tip the worldback into disinflation. As in 1987, contagion between FX, bonds & equities wouldsignal a turning point. Trigger? US$ weakness could easily turn from reflatingto deflating global economies via higher US import prices, more robust Fedresponse, disinflation in non-US economies and deflating asset prices. There arehard & conflicting policy choices to be made, with chances of errors multiplying.
