Simon Cawdery at EFG Bank discusses one of the great debates in the investment industry: inflation, its potential and what investors should do about it.
When I was a university student, I had to write an essay responding to the statement: ‘Inflation is always and everywhere a monetary phenomenon. Discuss’. I will spare you the gory details of my answer, although I would suggest that anyone faced with a similar question in an upcoming exam would do well—irrespective of their opinion, and using a sufficiency of suitable caveats—to steer their answer so that it basically says ‘yes!’. Economics professors tend to have been brought up during a time when inflation caused immense pain to society—wars, famine and poverty occurred because of it, and in curing it. The argument goes: having spent so much energy beating inflation, we should never let it have a glimmer of a chance of recurring.
It is against this backdrop that we have the quixotic example of a European economy mired in recession—extremely severely in parts—and a Central Bank that has refused to loosen policy, fearing that any loosening would unleash inflation. It must seem incredible to non-economists that central banks can worry about inflation when unemployment is in the 20 percent range, GDP is declining and governments are cutting spending and benefits while raising taxes.
So what are economists thinking?
In the economist’s toolbox resides an equation which has almost mystical levels of importance: MV = PT. It is known as Fisher’s quantity theory of money and it says that the level of the money supply (M) multiplied by the velocity of money (V) is equal to the level of prices/inflation (P) multiplied by the quantity of transactions (T).
"When people don't spend money and transact less, economists say that the 'velocity of circulation' has declined. This is what has messed up the quantitative easing programmes undertaken by central banks."
At its core this equation is used by mainstream economists to justify why any increase in money supply will lead to an increase in inflation: if M increases, P must increase. The other two variables are assumed to remain unchanged. In fact, many economists build elaborate theories proving why the velocity of money and the level of transactions will remain unchanged. So, the argument runs, if the Federal Reserve aggressively prints money it must create inflation, which is bad and as a result, interest rates will eventually have to rise and economic growth be curtailed in order to bring inflation back under control. Best therefore not to print money in the first place and to avoid (to misquote Laurel and Hardy) ‘getting us into another fine mess!’.
‘Walk a mile in their shoes’
It is important to understand one last fact about economics professors and their discipline. Economists consider their subject a science (and they have the equations to back up their contention) but they also have a problem. Science works best when the variables in question follow discrete and observable laws. Economics involves humans and, with all due respect, humans are infuriating—we behave in unpredictable and unexpected ways. Thus when economists assume that variables in an equation will remain unchanged, they do so not because they think they will remain unchanged (although sometimes they do), but rather because they have to, in order to bring suitably scientific analysis to the matter at hand.
A simple thought experiment will put this into context.
Consider the following scenarios:
1. ‘Times are tough’. You own a home. The mortgage is bigger than the house’s value. You have a full time job and can just cover the mortgage interest costs as well as make enough for you and the family to get by. What happens if someone unexpectedly gives you a cheque for $5,000?
2. ‘Times are good’. Your mortgage is mostly paid off and you have enough money to dine out a couple of times a week. You’ve been thinking about getting a new 60-inch TV to hang on the wall. Someone unexpectedly gives you a cheque for $5,000. What are you likely to do?
A reasonable person would probably agree that someone in the ‘times are tough’ scenario is more likely to take that cheque to the bank and pay off some debt, or put it in a savings account so that there is a small buffer in case of emergency. The same reasonable person would also probably agree that the person in the ‘times are good’ scenario is much more likely to throw caution to the wind, rush down to the local electronics retailer and splurge on the new TV.
Where did inflation go?
"There are solutions within the fixed income space-- notably floating rate notes, consumer price index-linked notes and such like, that will perform well if interest rates rise."
When people don’t spend money and transact less, economists say that the ‘velocity of circulation’ has declined. This is what has messed up the quantitative easing programmes undertaken by central banks. Money supply has risen, but the velocity of circulation has fallen. In other words, you can print all the money you want but it matters not a jot if it isn’t being used. If money sits idly in a bank and doesn’t flow from one person to another then it can’t contribute to inflation. The evidence shows both a huge decline in circulation over the past four years (the largest since records began) and a level of circulation that is at its lowest ever. No wonder, therefore, that monetary policy has not worked as well as planned and that inflation has not taken off.
The theory says ‘print money, cause inflation’. The evidence shows ‘print money, but no inflation results because of reduced velocity’. What if velocity were to rise back to where it was? What if consumer optimism improves, borrowing rises and spending increases? The potential is worrying since it would take only a small change in velocity (in other words, confidence) to have hugely magnified results. This is a real danger for policy-makers and should be a real worry for investors.
Perhaps velocity will not change (although the evidence suggests it is rarely totally stable), but if it did rise then central banks would need to take aggressive action to stop inflation becoming a major problem. Such action would necessarily include ending quantitative easing (think what that may mean for treasury yields given that the Fed has in the past three-and-a-half years purchased 16 percent of total outstanding US government debt). It would also include raising interest rates— something that is unambiguously bad for most fixed income investors.
Consider, for instance, what most captive investors have experienced over the past few years: declining interest rates. Falling interest rates create strong capital gains for bonds. Consider next a 10-year government bond issued in 2010. It was issued at $100 on February 16, 2010, but today—because interest rates have fallen—is trading at $117. This will mature in 2020 at $100 so the investor is already worried about its total return (which is expected to be just 1.125 percent per year).
But what happens if interest rates rise, say, back to where they were at the beginning of 2010? This same bond would then be trading back at $100 and an investor buying it today would have lost a lot of money in a short period of time. Lest that seem too far-fetched, bond yields rose almost 1.5 percentage points in the first six months of 2009 (a 75 percent rise in yields).
What can fixed income investors do in this climate? One obvious answer is to shorten duration substantially. How much do you really value the extra 1 percent that comes from owning a 10-year bond versus a five-year bond, when the downside risks could be of the order of 12 to 15 percent? Sensible risk management can, and should, play a huge role in the determination of an investment strategy in these unusual times.
A second answer is to evaluate whether your overall asset allocation is right. Bonds have historically been considered a low-risk asset type because they pay a regular coupon and give investors a definite repayment amount in the future (all being well, of course). However, if you had a crystal ball and knew that interest rates were going up then you would also know that bonds would in general lose money— potentially substantial sums. Would fixed income remain a low-risk asset class under these conditions? This is not to presuppose that investors should rush into equities, gold, oil or any other myriad of assets, but they should be evaluating and discussing these subjects.
There are solutions within the fixed income space—notably floating rate notes, consumer price index-linked notes and such like, that will perform well if interest rates rise. Investors should certainly have those on their radars and be paying serious attention to the actual risks inherent in their portfolios, and distinguishing these from the generic labels attached to asset classes.
Times may be tough for economists and their theories may need a substantial reworking, but investors at least have the ability to evaluate scenarios and should do so before they experience regret. Oh, and for the record, if interest rates do go up because inflation occurs, then annoyingly the answer to the question that started this article is ‘yes’ and my professor was right (but they always are, at least when it comes to marking exams!).
Simon Cawdery is senior portfolio manager in charge of investment strategy at EFG Bank in the Cayman Islands. He can be contacted at: Simon.Cawdery@efgbank.com
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