Monthly Market Blueprint: To inflate, or not to inflate

Thu 17 Sep 2020

In a decision for the history books, the US Federal Reserve, the world’s de facto central bank, abandoned a hard 2% inflation target in favour of a more flexible regime, attempting to prevent deflation resulting from secular stagnation exacerbated by the persistent COVID-recession. Inflation has finally been chosen as the weapon of choice against mounting debt levels.

Over the short and medium term this is good news for investors and risk assets as markets, still disconnected from the real economy, were eager to see more monetary stimulus. The Fed is widely expected to follow with more expansive policies in September, most of which, however, might already be priced in.

The question is of course whether the Fed will actually succeed. “Tolerating” inflation is by no means the same as “stoking” it. If it does succeed, it’s good news for owners of real assets, like precious metals and real estate (more residential than commercial). It’s bad news for bonds, however, as we have already seen real IG corporate yields turn negative, where government yields have been for some time. Bonds are an excellent diversifier but in terms of generating any returns they are bound to give headaches to asset allocators for some time. As for stocks? The jury is still out. On the one hand, extended QE and the history of inflation favour stocks. And of course, much like the rest of the economy they will benefit from depreciating their debt. But inflation might bad news for their clients who might be more reticent than authorities think to buy, after  more than a decade of crises and a 20-year stagnation in wages. Also to raise new debt companies will have to offer better terms, i.e. higher yields. Those who issued a moderate amount of debt since 2008 will be ok. Those who binged should be afraid for their longevity.

But the biggest risk isn’t the possibility off success, but the consequences of failure. Long term “slow money” investors are bound to remain skeptical, as high debt, sluggish growth, low capital expenditure, a depreciating currency, yield curve tampering and inflation-feeding measures strongly echo the painful story of Japan. On the road to Japanisation, attempts to stoke inflation are an inescapable stop. Will the result be the same?

While the mechanics between Japan, a surprisingly “closed” economic ecosystem, and the US, the world’s most open consumer economy and owner of the global reserve currency, are as prodigiously different as are their chances of success, investors can’t help but wonder if these moves are band-aids, signs that the global economic order is in grave need of an overhaul. Until such time as this question is answered, we expect investors to be careful, suspicious of recoveries, and overall growth lethargic and uneven. In other words a repetition of the last decade when fiscal initiatives gave way to constant monetary stimulus as means to keep the world chugging along. And the question is not simply whether stocks and bonds can keep growing ignoring real economy pains, but rather can quantitative easing, which worked under an ailing economic system, continue to boost risk assets under a possibly failing one.