Forstrong Global's CIO and president explains why he expects us to be in a robust inflationary period in three to five years
WP presents a weekly series with Forstrong Global president and CIO Tyler Mordy highlighting and analysing seven macro super trends. In part four, Mordy explains his inflationary outlook and the impact of COVID-19. Don’t miss part 5 next Thursday when we’ll focus on splintering world views. If you missed part 1 on the dawn of the fiscal stimulus era, part 2 on globalization in a post-virus world, or part 3 on the rise of emerging Asia, click on the links.
Memory loss can sometimes be instructive. Charlie Kaufman’s 2004 cult classic Eternal Sunshine Of The Spotless Mind is a case in point. The movie follows an estranged couple who both undergo a procedure to erase each other from their memories. It’s an absurd but gripping premise.
The film’s wisdom lies in the way a fragile memory interacts with the mind; how a fragmented recollection can provoke an unforeseen reaction, or how a forgotten experience may change the way we lead our entire lives.
Memory loss is a recurring theme in financial markets too. Tyler Mordy, CIO and president of Forstrong Global Asset Management told WP that people unconsciously repress thoughts of past losses or difficult market periods. For example, many investors recall not losing money in 2008 when, in fact, they did. Memory can distort over time, leaving a spotless history, wiped clean of any disturbing thoughts.
Mordy believes today’s most important loss of memory relates to inflation. Investors have forgotten that higher prices are possible and he pointed to examples of this collective amnesia via “bizarre bonds of the world” that are now priced for “eternal stagnation”. These include the Republic of Austria bringing back its “century bond” at a whopping 1.2%, while Swiss bank UBS now charges wealthy customers for short-term deposits and Denmark’s Jyske Bank will pay you to take out a mortgage.
No-one appears to be expecting inflation any time soon. However, Mordy challenged this consensus view, believing the conditions for a long period of higher inflation have arrived and that the coronavirus crisis has only accelerated this trend.
Crucially, Forstrong are not forecasting rampant 1970s-style hyperinflation but rather inflation stealthily building over time. Mordy expects us to be in a robust inflationary period in three to five years.
So, what’s driving this super trend and how has the global pandemic affected it? The first element relates to a collective amnesia of which Kaufman would have been proud. 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 39 years of disinflation and declining interest rates — will also take years to become convinced that the secular environment has changed.
Then there are several cyclical, policy and structural factors that point to a future of higher inflation. Mordy said deflationary headwinds over the past 10 years were primarily caused by the private sector deleveraging of the U.S. and the Eurozone. It’s difficult to produce a general rise in prices going when people are in austerity mode trying to save.
He said: “Going into 2020 lots of excess capacity has been used. Obviously, coronavirus has interrupted that but, if you take the virus as a transitory shock, which we believe it is, we'll be back to trend soon enough .
“Importantly, on the policy side, in the 1980s, central bankers were hell bent on fighting inflation. In hindsight, however, they overreacted. Now we have the opposite; we have policymakers hell bent on fighting deflation and we would argue that they've also overreacted, sowing the seeds for this inflationary environment.”
Pre-virus, the Fed was so fearful of deflation that they staged a dramatic turnaround in 2019 and dropped rates by 75 basis points. It was historic - the first time in the Fed’s history where rates were lowered without clear evidence of a recession. No economic data justified a cut, Mordy said.
Almost all major central banks were terrified of making a policy mistake and it was no surprise that they all committed to erring on the side of caution. They were already arguing for more collaboration with fiscal authorities and now, as COVID-19 grinds economies to a halt, the latter have obliged and then some, stepping in with wartime measures. This is arguably the most important accelerator of the inflation super trend, Mordy said.
“They’ve blown the top off any sort of policy restraint. Central bankers and fiscal authorities are indulging in unorthodox policy like we’ve never seen.”
The impact of fiscal stimulus will be significant. For while monetary stimulus can lower rates and the cost of credit, it doesn't necessarily mean people are going to borrow, particularly if austerity is the dominant behavioural trend. Fiscal stimulus, instead, funnels money directly into the economy, meaning its dynamics are almost always immediately inflationary.
Mordy said: “The coronavirus has expedited all these unthinkable policy programs - helicopter money, modern monetary theory or whatever you want to call it. It’s created an environment where more radical policy measures can easily be pushed through.”
When we get back to any semblance of normality, which is Forstrong’s base case, these “highly inappropriate” policies will prove to be over-reactive and the ideal foundation for inflation.
Many of the structural deflationary factors that have been cited over the last decade – like the impact of technology, automation, demographics and other disruptive forces on prices – are myths, Mordy insisted. For example, automation does lead to faster productivity growth and falling prices in several industries. But this will also boost real incomes, leading to more consumption elsewhere.
Rising spending lifts prices in other sectors of the economy. This observation holds true for other trends like the rise of the sharing economy and online shopping. Cheaper prices lead to more available discretionary income. Less consumption in one area leads to more in another. See Super Trend 2 about globalization and new patterns of connectedness.
In terms of demographics, slower population growth leads to lower demand. The West has aged, admittedly, generally leading to higher saving for retirement and less spending. But all this mainly applies to the developed world. Most emerging countries have far younger demographic profiles. For example, there are more Chinese millennials than the entire US population.
Mordy said: “All this is bullish. Most emerging markets millennials are experiencing rapid wage growth. The World Data Lab has forecast 2020 as the year when the global spending power of millennials will be greater than any other generation. As the lead consumer cohort, they are set to shape the direction of the global economy in the coming years.”
What do these collective factors mean for investors? Unlike in Kaufman’s movie, a clear read of history is important. Above all, it provides lucidity to the present.
Mordy said: “Investors need to be alert to the past. 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.
“However, benign bond markets should not be expected. The path of least resistance for yields is now up and a secular bond bear market will progressively take hold. Bond rallies will still present themselves. Yet the long-term result will be a yield trend of higher lows and higher highs. This carries profound ramifications for other asset classes in the years ahead. Investors should recognize that many assets were bid up on the ‘lower forever’ inflation thesis.”
This includes a variety of interest rate sensitive investments in the West — REITs, dividend payers and the vast assemblage of ETF product that, through financial alchemy and a masterstroke of marketing genius, produced a higher and more tantalizing yield.
Forstrong clients naturally relished this yield bonanza but no party lasts forever. The asset manager is now shifting its income strategies in these mandates and, ironically, equity markets have become a better source of yield.
This is most egregious in the Eurozone, where the dividend yield on the MSCI Germany stock index was a whopping 316 basis points higher than the nominal yield on a 10-year bund, as of the end of 2019.
“Bear in mind, a gradual rise in yields will play out over many years,” Mordy said. “And while a spike in rates is clearly detrimental to fixed income investors, a slow and steady rise allows for a higher reinvestment rate without incurring large capital losses.
“This is wonderful news for retirees who have had considerable difficulty generating reasonable income in an abnormally low interest rate environment.”