1. The end of disinflation?
Prior to the onset of the coronavirus pandemic, we had been living in a world of declining inflation.
The causes of the disinflationary trend, dating back to the early 1980s, are widely recognised as multiple. Some of the explanations have to do with technology, others with globalisation, and still others with public policies. The most frequently proposed explanations include:
The coronavirus pandemic has the potential to upend many of the factors listed above, if not all. However, impacts will not be straightforward. Some consequences of the virus will undoubtedly prove inflationary, but others will not. Some will play out in the short term, and others need to be considered in a more long-term perspective. The issue is how to sort these factors out.
In the short run, the many economic disruptions caused by the virus crisis generate a combination of supply and demand shocks that can only cause inflation volatility.
In the long run, however, the current crisis and its aftermath could catalyse a new inflationary regime that would end the four decades-old worldwide disinflationary trend. As we wrote in the paper Covid-19: the invisible hand pointing investors down the road to the 70s , “the seeds of higher inflation and higher inflation expectations are already all around us”.
The path forward is certainly not clear-cut, as a number of long-lasting disinflationary factors seem too entrenched to disappear while others could even be reinforced by the long-lasting damage from the current deep recession. Nonetheless, today’s events may also result in other factors arising that could lead to a new long-term inflationary cocktail through the interaction of policy stimulus, new social and political equilibria, and the reorganisation of international supply chains.
2. Short-term outlook: significant inflation volatility incoming
In the short term, some mechanical factors and supply side shocks will lead to strong volatility. Indeed, we expect oil and other sector-related disruptions to generate strong headline inflation volatility while more cyclical factors will weigh on core inflation. To be clear, we expect inflation to be down sharply in 2020, but up in 2021, primarily due to oil prices basis effects.
First of all, the drop in oil prices will mechanically weigh on inflation over the next few months. Indeed, lockdown measures and travel restrictions have led to an unprecedented drop in global demand for oil, causing prices to plummet. The price of a barrel of Brent fell to its lowest level since the end of the 1990s, which will mechanically weigh on total inflation in the upcoming months. The contribution of energy prices accounts, by itself, for nearly three quarters of the decline in headline inflation in the United States in the first four months of this year.
Assuming no further oil price declines from current levels, this contribution will continue to negatively affect the situation until the base effects disappear from indices yoy in the spring of 2021, opening the door to a significant positive contribution to yoy inflation prints later next year.
Second, the combination of demand and supply shocks will cause sector volatility.
Supply disruptions inherited from the lockdowns are likely to push up prices temporarily of items for which demand is inelastic—in particular, in the food sector. Several meat-processing plants have remained closed due to lockdown measures, with prices logically increasing, but this is temporary. However, some impacts of the coronavirus crisis could take longer to materialise.
Finally, one cannot exclude the possibility that this health crisis will lead to lasting changes in consumption habits (more use of short food supply chains). While governments will do their best to limit such rises on politically sensitive products and services, they may not be able to prevent them altogether.
Conversely, in many other sectors, the negative demand shock, and therefore disinflationary pressure, will dominate. The causes will be low confidence and the fall in household income that will more than offset the supply shock (this could be the case for durable goods such as cars as well as for leisure activities, among other).
In the short term then, different factors will pull in different directions. For investors, it will be extremely important to dissociate the mechanical effects from more organic ones, and the one-offs from longer-term trends. All in all, we expect Headline CPI, respectively for the US and Euro area, to decline to 1% and 0.6% in 2020 before recovering in 2021.
3. In the long run, ingredients for an inflationary cocktail
The virus crisis has occurred after four decades of inflation trending lower in most of the world.
There are many reasons why the long-lasting economic damage inherited from current events could only bring more of the same. However, opposite forces may also appear, as specific factors of this crisis, and policy responses to it may be sowing the seeds (or reveal pre-existing green shoots) of a new, more inflationary, regime.
On the one hand, the long-lasting economic damage that is likely to be brought about by the current crisis may well reinforce some of disinflationary factors. We take these factors one by one:
It can even be argued that the current crisis may bring risk of outright deflation. Put together, the above-mentioned factors are enough to build a strong additional disinflationary case in many countries. However, the possibility that inflation could become, and stay, negative, cannot be ignored, especially in places where it was already very low before the crisis, notably Japan and Europe. This risk will be all the higher that the crisis itself is long.
Nonetheless, the crisis may generate or accelerate a combination of stimulus policies while new political and social equilibria, and global supply chain developments could prove inflationary.
The brutality of the crisis has triggered an exceptionally large policy response with long-lasting implications. Moreover, the crisis may reveal a political fatigue (with probusiness and pro-globalisation policies) that was already quietly potentially leading to a reversal of the disinflationary trend even before the virus appeared (see Covid-19: the invisible hand pointing investors down the road to the 70s ).
More specifically, inflation could emerge from at least three factors:
1. A prolonged period of combined fiscal and monetary stimulus could prove more inflationary than previous crisis-response packages. Indeed:
2. Prolonged monetised fiscal stimulus could be all the more inflationary if decided under the influence of new social and political equilibria more favourable to household income and income expectations in a potential redistribution of the share of added-value between capital and labour in favor of the latter. This could take several paths:
3. Finally, inflation could also be supported by another potential consequence of the virus crisis—that is, the re-shoring of production activities in DM. Indeed:
Given these many opposite forces, the case for a change in the inflation regime seems very open. It remains to be seen, when the fog of the crisis dissipates, whether changes brought about or revealed by current events will be large enough to bring an end to 40 years of disinflation, however deeply embedded they may be in the behaviour and expectations of economic participants. Beyond the cyclical factors, it seems plausible to expect that a crisis of such magnitude will bring about structural economic changes. It will question principles that seemed generally accepted, whether on how to envisage the support of governments for the private sphere, on nationalisation, on the organisation of world trade or even on the necessary control of public finances. The reflection on the revaluation of wages in certain professions was already present before the coronavirus crisis and could now take on a new dimension. All in all, we believe that, on balance, inflation should be slightly higher this decade than during the 2010s.
4. Investment implications of living in a more uncertain inflationary world
Over the past three decades, investors have benefitted from a supportive investment environment of inflation and rates trending lower. As a result, Treasury yields have been moving down, driving positive market performance in the fixed income space.
Negative bond/equity correlation and strong equity markets after the Great Financial Crisis helped to boost performances over the last decade and further suppress volatility. This buoyant market environment led to strong returns in real terms (above inflation) for a Balanced USD portfolio (see graph) with a low level of volatility.
This benign backdrop is coming to an end, as the Covid-19 crisis is bringing volatility back. In addition, looking at the next decade, investors will face lower return expectations on bond markets, as yields are extremely low. Assessing inflation expectations over the short and long term therefore becomes crucial in order to build a resilient asset allocation in a world in which returns will be lower than in the past.
Over the short term, inflation volatility may rise, but the overall level of inflation should stay subdued. In this scenario, some asset classes will continue to be supported by monetary actions. This is the case of investment grade credit and peripheral bonds benefitting from the umbrella of the Quantitative Easing programmes. In addition, traditional equity/bond correlation is likely to persist, as long as interest rate expectations remain anchored. As such, investors should look at safe government bonds as a source of liquid assets that can balance the risk asset allocation.
Source: Amundi. See also Covid-19: the invisible hand pointing investors down the road to the 70s
On a longer-term perspective, however, the era of investor returns propelled by the monetary factor is coming to an end and inflation risk will likely resurface, challenging investment returns. The new regime will lead to profound changes that investors will have to consider in building asset allocation.
In particular, we believe it is crucial, especially for income investors with a long-term horizon such as pension funds, to consider adding a dedicated bucket of their allocation to investments that can potentially help mitigate inflation risk.
In fact, even in periods that didn’t experience a hyperinflationary environment such as in the 1970s, inflation surprises could have significant impacts on the performances of different asset classes. In particular, in periods of inflation surprises, traditional assets, such as government bonds and broad equity indexes, may underperform while investments that are linked to real assets dynamics (liquid and illiquid) have the potential to outperform.
We have analysed the real returns (annualised returns less inflation) of different US-based asset classes in periods of inflation surprises and compared them to all the periods over the last 23 years (from 1997 to 2020) when US inflation (based on US CPI) ranged from -2% to +5.6%. The years of inflation surprise have been identified as years when the realised inflation (measured by the Bureau of Labor Statistics year-over-year change in US consumer prices (CPI) has exceeded the inflation expectations forecast the previous year (measured by the University of Michigan Change In Prices). When this occurs, government bonds, corporate bonds and the overall broad equity index suffered, with real returns that on average turned negative when the inflation surprise had been greater than 1% (see chart). On the contrary, real asset-backed investments, such as gold, commodities and equity sectors linked to the real economy (agricultural, energy and natural resources) as well as inflation-linked bonds (US TIPS), exhibited on average the strongest performances, outperforming their average performance considering all inflation environments.
For this reason, we believe that long-term investors who could face different inflation cycles in the future could potentially hedge the risk related to inflation surprises through an allocation to asset classes backed by real assets. This will be key especially as financial repression that will come with the crisis will keep interest rates low, further challenging the ability of government bonds to deliver positive real returns in case of inflation resurgence.
1. See Juselius M. and Takats E., 2018, “The enduring link between demography and inflation”, BIS working paper.