Bond yields are surging and making headlines in the financial media.
But these stories are merely catching up to the work done by the strategy team of BCA Research, which has been doing deep dives for months into the possibility of inflation.
These are hi-lights of a research report by Arthur Budaghyan, Chief Emerging Markets Strategist, who concludes that after nearly 25 years of stocks and bonds generally performing in unison, we’re now seeing a paradigm shift and the result will be higher inflation over the next one-to-three years.
Hi-lights
- The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative.
- Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop.
- The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation.
- Global growth stocks will underperform value stocks.
- US equities will lag international markets.
- Investment strategies and frameworks that have worked over the past 24 years might require modifications.
Inflation Redux
Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months.
Cyclical factors driving core inflation higher in the US are as follows:
1. Core inflation lags the business cycle by about 12 months. A continuous economic recovery points to higher core inflation starting this spring.
2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation.
It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing.
BCA’s Emerging Markets team has previously discussed why US money growth is currently substantially stronger than it was in the post-Great Financial Crisis (GFC) period.
With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money.
Lets’ recall:
Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply
Solving the above equation for inflation, we arrive at:
Price Level = (Velocity of Money x Money Supply) / (Output Volume)
Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend.
At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation.
3. Demand-supply distortions and shortages will lead to higher prices.
The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages.
US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising.
Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services.
As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices.
Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so.
This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large.
4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year.
In short, US authorities are over-stimulating.
On top of cyclical forces, there are several structural forces pointing to higher inflation:
- Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation.
- Retirement of baby boomers entails more consumption and less production and is inflationary.
- Government policies targeting faster growth in employee compensation are conducive to higher inflation, and…
De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising above.
If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins.
Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up.
The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages.
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