Is the Inflation Genie Out of the Bottle for Good?
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This week, I decided to take a break from shorter-term macro research and instead I discuss my long-term outlook for the global economy. This is a good thought exercise and allows me to take a step back from all the noise going on today.
So in this article, I will analyse how inflation affects (or is affected by) the:
Energy market
Labour market
Debt market
and how this ties back to asset allocation
As It Was
Central banks around the world have an inflation target of 2%. They believe 2% is the most optimal inflation rate for the economy to expand without devaluing the currency. Western nations have been successful in keeping the inflation rate below this level since the 1990s. However, I believe we are going through major structural changes that will result in sustained higher inflation.
Commodity underinvestment is one of the key reasons why I believe this to be the case. Total oil exploration and production have fallen significantly over recent years…
Source: IEA
as has total fossil fuel production.
Source: IEA
Oil is the input for everything in the globe. This underinvestment comes at a time when we aim to undergo a huge energy transition, which needs fossil fuels. In conjunction with this, the ESG (and climate change) movement has disincentivised energy producers to invest in new mines. Governments are further disincentivising new investments through, for example, windfall taxes. On top of this, a decade of poor investment returns for shareholders in the energy and commodity space means these companies are being pressured from all angles to cut back on new investments. If this wasn’t enough to create a structural shortage of commodities, add shut down mines due to COVID lockdowns, Interest rate rises that disincentivise new investment due to higher borrowing rates, and a group of radical activists who wear ‘stop oil’ t-shirts and throw tomato soup at paintings! All of this points to a structural undersupply of commodities, which feeds through to higher prices in the long term.
Goodbye cheap labour
Secondly, Globalisation has been a huge deflationary force over the last 20 years. Production has been moved to countries with cheap labour, leading to increased competitiveness and lower prices for consumers. The pandemic and recent geopolitical turmoil have made companies and countries rethink their supply chain dynamics, and many are moving operations out of China. This provides investment opportunities in the Asian countries that will benefit from this restructuring but will ultimately lead to increased costs for companies as they restructure their supply chains. This will be pushed onto consumers through higher prices.
Furthermore, we have labour participation rates (LPR) – the percentage of the population currently working or seeking work. As you can see from the chart below, LPR in the US has risen from 1955 to 2000 but declined substantially since then. Why has this happened and what does it mean?
The baby boomer generation was born between 1945 – 1964. It takes 20 years to make a 20-year-old, so by the 1970s, this generation was actively seeking work. We can see the LPR exploded higher during this period. Now, this generation is retiring, removing workers from the population. Younger generations are also having fewer children, which is exacerbating the problem. Add to this the pandemic, which caused many people to leave jobs or retire (see LBR today is below 2019 levels), and you have the situation we are in today – not enough people willing to work. This only leads to one thing; wage increases as employees become more scarce. Higher wage costs for a company mean costs are pushed onto customers through higher prices. This leads to higher wages again as workers are getting less with their current salary, therefore demanding higher pay, and so on – there you have the dreaded ‘Wage-price spiral’.
Labour Force Participation rate (%) in the US, Source:FRED
Riddled with debt
The final piece of this puzzle is debt. Many western nations began to experience a slowdown in productivity and labour supply during the 1990s, which leads to a slowdown in economic growth. Slow economic growth is politically unacceptable, so governments committed to huge spending plans from the 1990s until today (alongside the many bailouts and QE programmes over the same period). This has led us to the unsustainably high debt levels we see today – the US given as an example below.
US Federal Debt as % of GDP, Source: Trading Economics
As you can see above, one prior period when US debt was also high was during World War II. However, it can be seen that the debt levels fell by over half in the years following the 40s. Inflation was a major factor in this.
Inflation rate from 1914 - 2022 in the US, Source: Trading Economics
Inflation (and inflation volatility) was very high during the period of the 1940s – 1950s following the war, as you see above. This benefitted governments, who let inflation run hot to reduce their debt load (see below). At a higher inflation rate, the value of debt erodes quickly – at 7% inflation, liabilities will half in a decade, or put another way, the money in your pocket is only worth half of what it was 10 years prior.
High inflation erodes debt (and the value of a currency) very quickly
I believe it’s likely we are entering a period of heightened inflation volatility, much like that of the 1950s or 1970s. If central banks are as serious as they say they are about killing inflation, it is likely to fall substantially in the near term. This will be because we enter a recession. However, due to the structural factors mentioned above, once we come out of the next recession, inflation will quickly rise well above the accepted 2% level once again. This loop could continue for some time until these structural factors are resolved, or we find an alternative solution (maybe technology will be the solution!).
So how does this influence asset allocation?
Periods of heightened inflation volatility generally benefit value stocks. Commodities, precious metals (gold, silver etc), and energy stocks performed very well during the 1970s. Real estate is another sector that traditionally provides inflation-protected payments (as rents are continually raised).
Looking at the performance of value stocks against growth over the last 20 years (see below), there has been a clear winner – growth. Low inflation and low-interest rates over this period have led to huge outperformance of growth stocks, especially within the high-flying tech sector. This is unlikely to continue as we enter this new regime. We see from the chart below that although value has outperformed over the last year (line falling means value outperforms growth), it is still a long way from its average. This suggests I should continue to add value stocks to the portfolio, which I am actively looking for at present.
iShares Growth Index (IWO) / iShares Value Index (IWN), Source: TradingView
“The trend is your friend”
Portfolio Return Year-to-date: -1.7% vs S&P500: -16%
Total Return since inception (20/09/2021): 4.1% vs S&P500: -8%
Let me know your thoughts by emailing me at thesparknewsletter@gmail.com
See you next time,
Peter
Disclaimer
This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.