Is global inflation about to surge?

Via Morgan Stanley:

…investors were a bit too complacent on the uncertainty surrounding the election outcome, unlikely passage of a fiscal stimulus before the election and second wave of Covid-19…the short answer is that the worst of the correction is over in our view but we still think the next month is likely to remain volatile and uncertain as we navigate what is shaping up to be a much closer election than expected just a few weeks ago and risk of further lockdowns as the virus runs its course.

…a key part of his bearish call was based on the view that the equity risk premium should have a larger buffer built in given these very visible risks/events. Fast forward to today and that’s exactly what’s happened, with the Equity Risk Premium widening by approximately 30 bps to 405 bps from the 375 bps level when he made his first call. At the same time, with interest rates remaining steady rather than falling as they typically do when equity markets sell off, the P/E has compressed by approximately 10%.

…it could take some time for the S&P 500 to resume its bull trend in earnest. In other words, equity markets will need to sort out the impact from the election outcome, a second wave of the virus and potential for further lockdowns and perhaps most importantly, higher back end interest rates…

…in a year when more voters are doing so by mail, it could mean the results are delayed or even challenged by the losing side…one could argue the buffer on Equity Risk Premium is still too skinny…it makes sense to start adding to your favorite stocks again.

…evidence is starting to mount that our call for much higher rates is going to be right…10 year yields are about to rise significantly and a 100 bps move cannot be ruled out. In fact, we think it should be expected…[this will] have a net negative impact on P/Es initially as the equity risk premium won’t fall fast enough to fully offset such a rise in rates.

…add to stocks this week but keep a bias toward those stocks that are more fairly priced should a big rate rise occur.

So the ERP works on the way up but not down? And Treasuries are going to get crucified directly into a resurgent virus and lockdowns plus big tax hikes that offset spending programs a lot more than any Trump stimulus did?

How can we possibly compare the 2016 Trump election with its imminent massive tax cuts to today’s growth intensifying virus growth shock? That’s bonkers.

I’m not saying the bond back-up won’t happen. Markets are increasingly incoherent. They have been trying to sell the long end ever since the “blue wave” moved to the base case for election. They are also too bullish on the impact of vaccines.

What I am saying is that this pro-equities Wall St guff has become so pumped on spiv that it needs to be treated with financial PPE every bit as airtight as a virus hazmat suit.

There are some more credible voices making similar arguments. Gavyn Davies at the FT:

The surge in public debt in the major advanced economies caused by the pandemic continues apace. Even on the very optimistic assumption that there will be no need for further major economic lockdowns, Fulcrum economists calculate that the ratio of gross government debt to gross domestic product in the major advanced economies will reach about 141 per cent next year, a rise of around 26 percentage points from 2019. More than half of this extra debt has been absorbed by the central banks.

Few economists argue that this remarkable policy response to a global emergency is mistaken, but it could profoundly alter perceptions about the appropriate settings for fiscal policy. As the vast expansion of public debt has not been constrained by concerns about rising inflation or interest rates, at least in the short term, the traditional reasons given by governments for controlling their budgets will have less political force — especially in the US, if Joe Biden sweeps the board in next week’s presidential elections.

Lawrence Summers, whose speech on “secular stagnation” in 2013 was the most perceptive economic pronouncement of the past decade, has argued that macroeconomics is experiencing a “revolution” similar to the seismic shift towards inflation control in the late 1970s. From now on, there will be “a focus on assuring adequate demand and fairness in our economies”, driven mainly by expansionary fiscal policy.

Mr Summers admits that this policy choice will come with risks but, in the immediate future, it will probably bring net benefits. The medicine needed to treat the pandemic may prove appropriate in future years as well.

The structural economic changes that have shaped the policy response to the pandemic have been persistent for several decades. Real and nominal interest rates in advanced economies have trended strongly downwards since the early 1980s, mainly because private savings have been excessive relative to investment — the prime symptom of secular stagnation. Inflation has been held at very low levels for the same reasons, encouraging central banks to expand the monetary base by acquiring government debt.

This form of monetary expansion has defied the pessimists by having essentially no effect on global inflation. Leading central bankers, including the US Federal Reserve’s Jay Powell and Christine Lagarde at the European Central Bank, are therefore demanding more, rather than less, support from fiscal stimulus. This is very different from the attitude after the 2008 financial crisis, when many leaders in global policymaking argued the rise in public debt should be brought back down. Such has been the change of mood, even among the most orthodox of economists, such as Olivier Blanchard, that it is natural to worry lest the temptation to spend more and tax less will get out of hand.

There are plenty of causes — for example, the green economy, a universal income and infrastructure renewal — that would encourage much higher budget deficits under an administration led by Mr Biden.

Fiscal, monetary and combined stimulus is still trying to fill a bottomless global demand hole made endlessly worse by:

  • Chinese over-production (still getting worse);
  • European over-production (still getting worse);
  • de-industrialisation of developed economies and the gutting of unions that came with it;
  • inequality in the asset-based economies that replaced it;
  • huge technological advancement;
  • huge demographic headwinds.

These forces are a structural hole in demand that require ongoing and endless stimulus to fill even temporarily. The moment it stops we’re back to deflation.

Central banks have finally stopped worrying about inflation because there is nothing worry about. It’s time markets did so as well, telling governments to pull spending every five minutes. Then we might actually be able to get our hands on some!

David Llewellyn-Smith

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