Tyler Mordy, CIO and CEO of Forstrong Global, argues that the era of higher inflation has arrived but that many are misreading the situation and pandemic ramifications
WP presents a weekly series with Forstrong Global CEO and CIO Tyler Mordy highlighting and analysing seven macro super trends for 2021. In part one, he explained why a fiscal revolution is here, while, for Super Trend 2, he analyses the inflation landscape and its investment implications.
Few bands have matched The Clash for politically charged angst. Their seminal 1979 track, London Calling, captured a feeling in the UK that the world as everyone knew it was ending. They were right.
As Joe Strummer sang, with heightened anxiety, about nuclear errors, impending ice ages, zombies of death and the end of phoney Beatlemania, Britain’s three postwar decades of economic growth and the era of big government spending were over.
Many argue that was The Clash’s creative apex – Rock the Casbah fans would dispute this – but it was certainly the apex of inflation around the world. Soon after, both interest rates and inflation would start a multi-decade decline to the present. Despite Strummer’s dire warnings, the ominous outlooks of that period — whether economic or other — never materialized.
Tyler Mordy, CIO and CEO at Forstrong Global, believes we are now at a similar inflection point in history. This time, however, almost everyone fears persistent disinflation and everlasting low interest rates. Most have forgotten that rising prices are possible, he said, evidenced by the trillions sunk into negative-yielding sovereign debt.
The more bizarre bonds of the world, now priced for eternal stagnation, also clearly point to this view. Peru, for example, recently brought back its century bond — riddled with interest-rate risk — at a whopping 3.2%.
Mordy said: “Allow us to venture out on the shakiest of limbs to toss out a non-consensus idea: the conditions for a long period of higher inflation have arrived. Note that we are not calling for rampant 1970s style inflation. Rather, a gradual uptick in overall inflation will glacially play out over many years.
“It will be nearly imperceptible at first. In the same way that investors took more than a decade after 1981 to believe that inflation would not rise again into double digit figures, today’s investors — conditioned by 40 years of disinflation and declining interest rates — will take years to become convinced that the secular environment has changed.”
Mordy added that, with bonds not the safe haven in 2020 that they have normally been, investors are now witnessing the end of the disinflationary era. For portfolio construction, this presents a tricky proposition, with real interest rates much higher and bonds producing multi-decade low yield.
“There is no easy answer here,” he said. “And it comes at a time when our clients – many of them retirees -- need a reasonable income. Yet constructing an income portfolio has become more challenging than ever using traditional approaches.”
This new inflation era will not burst on to the horizon in one big, curtain-raising event, however. Instead, it will quietly surface. The current conversation is all about secular stagnation, new normals and other dire outlooks, referencing the impact of demographics, automation, digitization and other disruptive forces on prices.
But classic mistakes are often made in the analysis, Mordy told WP. For example, automation does lead to faster productivity growth and falling prices in several industries but will also boost real incomes, leading to more consumption elsewhere. Rising spending lifts prices in other sectors of the economy.
And what about the favourite domain of deflationistas: demography? This actually mainly applies to the developed world. Most emerging countries have far younger demographic profiles and the global millennial generation is now the world’s largest — some 1.8 billion strong and nearly a quarter of the world population.
Mordy said: “When China entered the world economic system, the country had a very cheap currency and labour costs were also cheap. Fast forward 20 years after it joined the World Trade Organization and now China's wages have gone up substantially, their consumer class is much larger and the country is no longer exporting deflation. A robust Chinese economy, as we are witnessing today, is a profoundly inflationary force.”
While several cyclical, policy and structural factors point to higher future inflation, Mordy warned that many are also misreading the long-term implications of coronavirus, failing to differentiate an exogenous shock from a classic recession.
The latter always sparks a longer-running trend change because deep financial imbalances must be worked out over years. However, COVID-19 landed on much different terrain. Heading into 2020, no major global imbalances were evident, with some exceptions: Canada, for example, continues to cling to its status as a country with an epic consumer debt bubble.
Mordy explained: “The private sector deleveraging that needed to happen in the US and Eurozone after 2008 was largely complete, and worldwide banking systems were generally healthy. Global systemic risks were in fact low.
“Now that vaccines are secured, a return to growth is imminent. Yet, global central banks remain clearly focused on the last battle, assuming a long and shallow recovery and a complete lack of inflationary pressures.
“The Federal Reserve has now made major modifications to its monetary policy framework, shifting to an ‘average inflation targeting’ approach. Based on past undershoots of inflation - roughly 500 basis points in the past 10 years for those counting - inflation can run as hot as 7% in a year without breaching the average inflation target.
“The financial implications of this policy shift will be far reaching. In fact, with the Fed’s capitulation to deflationary pressures, they have effectively given a green light to rising prices.”
All major banks appear terrified of making a policy mistake, arguing for more collaboration with fiscal authorities. They are being “indulged” and the arrival of big government spending is the biggest shift towards a more inflationary environment, as discussed in Super Trend 1: You Say You Want A (Fiscal) Revolution.
More money immediately enters circulation and leads to pricing pressures. All of this will quicken the transition towards a more inflationary environment.
So what does this all mean for investors? In short, like the aforementioned fiscal revolution, a new regime is here and the conditions for a sustained rise in price inflation have arrived. The transition will be gradual and bumpy, allowing many investors a period of denial until underlying pressures are more evident. This is typical during regime changes, as it takes time to release old narratives.
Mordy concluded that this scenario carries profound ramifications for several asset classes in the years ahead.
“Investments that have been bid up on the ‘lower forever’ inflation thesis will increasingly be at risk,” he said. “This includes growth stocks, which thrive on low discount rates, and, of course, Western government bonds, which in the grim words of one analyst are ‘where money goes to die’.
“On the positive side, secular headwinds for value stocks are waning. US and European banks have become well capitalized and will thrive on higher net interest margins. Industrials will do well. Commodity prices have largely completed their secular downturn. That means many cyclicals and other sectors that can pass through rising costs will outperform.
“Not many are ready for this change in the investment climate. But make no mistake, inflation is calling.”