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With US President Biden’s $1.9 trillion Covid relief package, alongside the recently proposed $2.25 trillion in infrastructure projects (despite a very loose definition of infrastructure), there is growing concern about the impact these programs could have on inflation and interest rates globally.
While in the past some US politicians pushed for fiscal prudence, there is little resistance now to deficit spending on either end of the political spectrum. Modern Monetary Theory, which argues for expanding the money supply so long as it doesn’t push inflation outside of an acceptable range, now appears to be a legitimate mainstream economic policy.
The inflationary impact of this explosive spending depends on how the money propagates through the economy. If it appears as broadly distributed across the lower end of income earners, the money will be more likely spent on current consumption and have a more immediate impact on prices. If income and wealth accumulate at the upper end of the spectrum, as it has been over the more recent past, a greater percentage will wind up as savings, and rather than call it inflation, we would account for it as an increase in wealth as asset prices rise. However, it is actually the other side of the same coin. For most countries, CPI calculation includes rental rates, not home prices, as the housing cost input, so rising home prices tend to be ignored, thus understating actual homeownership cost.
A surge in post-Covid spending, combined with continued supply-side bottlenecks, can lead to temporary price increases. But unless this is coupled with continuous, ongoing aggregate income growth, simple supply-demand dynamics would indicate that a price increase would be followed by a decline in demand, with prices eventually falling back to the old equilibrium. Milton Friedman famously defined inflation as too much money chasing too few goods. If wages are not rising, consumers cannot consume more. But ending inflation tends to be a political decision, as the action of the central bank taking away the proverbial punch bowl initially tends to lead to a decline in economic activity, which is hard for central bankers to stomach. What seems for now to be a one-off stimulus could wind up being more permanent down the road.
Since the early 1980s, the US has been gradually eroding the exorbitant privilege of the US dollar’s status as the global reserve currency through consistent fiscal deficits and an ever-rising debt-to-GDP ratio. With US fiscal policy continuing along this path, eventually the global financial order will need to adjust, though not likely anytime soon. Some argue there is no other currency that can take the place of the US dollar, but while it may be hard to imagine, there is no need for a single currency to hold a monopoly over international trade. It could make trade somewhat more complicated, but it is possible to operate with multiple reserve currencies. The world has done so in the past and could do so again.
US stimulus spending has the potential to further embolden other countries across the world towards less fiscal constraint. For example, Brazil has significantly expanded its fiscal deficit in the guise of fighting the negative economic impact of the Covid outbreak. The conservative government of Jair Bolsonaro, however, is pushing for continued high deficit spending into 2021 and has sidelined an economic minister who was appointed to help reign in government spending.
China’s economy is now big enough to significantly influence the global economy. While capital markets are gradually opening up, constraints on capital flows limit the ability to operate as a meaningful reserve currency for the time being or act as a sizable counterweight to any negative economic influence coming out of the US. In addition, China’s ability to stimulate through infrastructure spending is coming to a head. A country can spend only so much on roads, rails or ports to generate a positive economic benefit—and China is likely getting close to the limit. In the meantime, the attempt to encourage greater domestic consumption has not fared well with households continuing to save a high percentage of their income. Hence, China at least may not be a source of incremental inflation pressure. For now, China’s latest CPI number is negative.
The investment world has been operating amid declining rates and low inflation for so long that few may realize the impact rising rates would have on investment returns. In short, rising rates generally have a negative impact on returns. For fixed income, bond prices and changes to interest rates are inversely correlated. The negative price impact is more pronounced the further out you go on the yield curve.
For equities, certain industries, such as energy, basic materials or consumer staples, may initially benefit. But over time, as inflationary forces spread, input prices and employee wages rise, negating the margin improvements gained for rising selling prices. Valuation also would be affected. As the economic future becomes more cloudy, investors would logically and rightly expect a greater margin of safety. Additionally, if you inverse the P/E ratio, you can think of the number as an earnings yield. Stock and bond returns are loosely correlated. So, as yields go up over time, P/Es would likely see downward pressure as well.
In the short run, the best investment in a rising inflation environment tends to be real assets, such as real estate or gold. Ask anyone who grew up in a hyper-inflation Brazil. As long as real economic growth continues, banks and other financial services companies may stand to benefit if spreads start to widen so long as loan losses stay in check. Select consumer staples, which have a degree of pricing power, may also be able to pass rising input costs direct to the end consumer, thereby maintaining margins.
The global economy is large and complex, and politicians tend to overshoot the mark, which results in unintended consequences. Normally, mainstream economic thinking would assert that infrastructure repair would not lead to greater economic growth, as it does not create new productive assets. But the US suffers from a larger number of unemployed or under-employed. So, there is some potential to have a positive economic impact with minimal inflation or interest rate impact, at least in the short-run, as long as it is primarily stimulating a slack in demand. If history is any guide, it’s more likely than not that this massive potential spending may overshoot the mark, and investors should be prepared for a possible future where declining rates are no longer a tail wind.
The views and opinions herein are those of the individuals mentioned above and do not reflect the opinions of Vontobel Asset Management or Vontobel Group as a whole.
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