A long silence

The last time that inflation was this dormant, Neville Chamberlain began the year as the United Kingdom’s prime minister and three cans of Campbell’s Tomato Soup cost 25 cents. The year was 1940, and not only had inflation not reached 4 per cent during any calendar year of the previous two decades, but eight of those 20 occasions also suffered deflation.

Although recent years haven’t featured deflation, save for 2009, today’s low-inflation streak is even longer. Not since 1991 has calendar-year inflation surpassed 4 per cent. Consequently, the market’s inflation expectations, as implied by Treasury yields, are an all-time low. In the early '40s, payouts on 10-year Treasuries bottomed at just below 2 per cent. That note’s yield is now 0.56 per cent.

That investors have become nonchalant about inflation may be witnessed by the distinctly muted reaction to the federal government’s recent stimulus efforts. In 2009, an US$800 billion recovery bill prompted widespread unease about growth in the federal debt. In contrast, this year’s US$2 trillion CARES Act, accompanied by the suggestion of an additional stimulus bill, has elicited few complaints.

Another perspective: The Congressional Budget Office forecasts that the US will run a US$3.7 trillion budget deficit in fiscal 2020, which represents 18 per cent of expected gross domestic product. That will almost double 2009’s shortfall, as measured by that same ratio of deficit/GDP. That 18 per cent percentage has been exceeded in modern US history only by the World War II years of 1943, 1944, and 1945, and barely at that.

Rising national debt no longer seems to trouble bond-fund managers. Those who fussed about such things have been chased out of the business, replaced by pragmatists who cannot explain exactly why what they learned in their macroeconomics classes no longer applies but who know what happens to investment managers who habitually underperform their peers. Let economists sort out the theories; fund managers have a job to do and shareholders to satisfy.

This approach may continue to succeed. If investment professionals struggle to understand why inflation remains so quiet, far be it for me to provide the answer. Nor am I terribly concerned that the marketplace has become so complacent. While the popularity of bonds triggers my contrarian impulses, I have learned the hard way that sometimes the crowd is correct. For example, 10 years ago critics disparaged the development of a “bond bubble” based largely on the premise that all those individual investors couldn’t be right. So far, they have been.

Wartime economies

Perhaps 2020 will later be recognised as the turning point, the year when inflation was finally rekindled. So far, that has been anything but the case. The bond markets have been delighted by the worldwide slowdown created by the appearance of the coronavirus. That reaction certainly makes sense for the near term. With spending depressed and global economies shrinking, inflation is currently but a concept. It will be a while before prices can increase.

However, warns my friend Bill Bernstein, when the coronavirus is finally subdued, danger may await. The analogy is of a war economy. While the battle against covid-19 is metaphorical, as it is waged with social distancing and ventilators rather than tanks, bullets, and drone strikes, it resembles a wartime activity in that resources have been diverted. Consumer spending is depressed, and, for those who have retained their jobs, assets are accumulating. Eventually, per the wartime thesis, this pent-up demand will explode, thereby sparking inflation.

That certainly has occurred in the past. Inflation in the US exploded after World War I, then again after WWII, and then again after Vietnam. (The latter, admittedly, was greatly exacerbated by the Oil Crisis, which was a separate and distinct problem.) The lone exception among the past century’s four major conflicts was the Korean War, although inflation briefly spiked a couple of years after its conclusion, before once again subsiding.

The analogy, to be sure, is imperfect. While wartime economies typically bring increased employment, the covid-19 pandemic has sidelined workers. Global economies are slack, as opposed to stretched by the addition of wartime projects. Nor, for the most part, could the world’s covid-19 response be classified as a figurative version of total war. Only a small portion of the global economy is being employed against the pandemic.

Nonetheless, the resemblance is sufficiently strong to merit concern. Also worth considering is that eventually global developed governments may decide to inflate their way out of their national debts. They did not make that choice after the 2009 financial crisis, but debt levels were lower then. For example, in 2010, the US had a debt/GDP ratio of 54 per cent, as opposed to 101 per cent currently.

Practical implications

As a reminder—this being familiar territory—the best assets for an inflationary environment are cash, inflation-adjusted bonds, and commodities. Equities aren’t as attractive but nor are they terrible, because over time corporate earnings tend to rise with inflation. Then come junk bonds and finally, at the bottom of the list, the high-quality bonds that have performed so well in 2020.

Three modifications can improve a portfolio’s inflation resistance: 1) moving high-quality bonds for cash and/or Treasury Inflation-Protected Securities; 2) shifting some assets from equities to commodities, and 3) swapping high-growth stocks for value stocks. (Inflation hurts growth stocks more than their cheaper rivals because the cash flows that accrue to growth companies tend to occur further in the future. That is, growth stocks have longer durations.)

I do not necessarily advocate these transactions. Doing so would overstate my confidence that inflation will indeed resurface. (To paraphrase Warren Buffett, when a highly credible investment source—such as Bill Bernstein—attempts the perilous task of predicting macroeconomic events, it is usually the reputation for peril that remains intact.) However, they are worth considering, particularly if the trades align with other reasons for adjusting one’s portfolio.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.