I know what I am about to suggest will go against the grain. But I am a value investor and used to expressing a view that runs counter to the consensus.
On June 10, the U.S. Federal Reserve indicated in very clear language there would be no rate increase through 2021 and possibly 2022. Everyone, however, is convinced that inflation and interest rates will remain low for much longer, well beyond 2022. I beg to differ: Higher inflation and higher interest rates are coming.
Let me explain. The nominal interest rate is the reward one expects for investing in bonds. The reward has three parts: the real interest rate (reward for postponing consumption for the future); the premium you get for expected inflation (reward for possible loss of purchasing power); and the risk premium (the reward for possible loss of capital). I will ignore the risk premium here, as normally it does not apply when dealing with government bonds.
In the short run, the real interest rate is driven by the business cycle. When the economy expands, the real interest rate rises and when the economy contracts the real rate falls. But its long-term trend is affected by factors that change only slowly, namely technology and demographics.
In the short run, inflation is driven by the heightened intensity of economic activity and the pressures it entails, among other things, on productive capacity and the labour and commodities markets. In the long run, it is taxes, economic efficiency and productivity that affect inflationary expectations.
Let us now move from theory to practice.
Demographic developments are exerting an upward pressure on real interest rates. Baby boomers have started to retire and have stopped saving; they are in their decumulation years, which reduces the supply of investable funds. This happens in the face of increased demand for capital by corporations that need to embed new technologies into their production processes, as well as by governments that need to borrow to fund structural deficits. To clear the demand-supply imbalance, the real interest rate trend is pushed up.
The COVID-19 related collapse of the business cycle has pushed the real interest rate in the short run well below its long-term trend. This gives the false impression that the real rate is falling, when it is only the short-term real rate that is falling – the underlying trend is still upward.
Similarly, inflation in the short run is not going up because of COVID-19 and for reasons beyond the scope of this article, such as technology and corporate concentration, which limit price increases and wage growth. But the long-term trend may be more worrisome. We may be reaching a peak in productivity growth as baby boomers retire and are replaced by less-experienced workers who will nevertheless be in high demand. These workers will demand higher wages. This means higher inflation down the road. Consider, also, the effect on inflation of higher taxes to mend systemic inequalities and to fund the enormous COVID-19 induced deficits.
In addition, there may be secular changes in place that will fuel inflation (and higher interest rates). Globalization and outsourcing have kept inflation and consumer prices low since 1990. COVID-19 has raised serious questions about the security of supply chains. U.S. corporations may not be willing to manufacture their products in far-off places much longer. If globalization is interrupted, the disinflation unleashed by it will end. Moreover, repatriating production to the United States will increase demand for American labour and push wages – and inflation – higher, as companies pass such increases on to consumers. There is historical precedent to this. As financial historian Edward Chancellor observed: “When trading links frayed at the close of the 19th century, the great Victorian bond bull market came to an end.”
Are trading links unravelling nowadays, considering the U.S.-led trade wars and a possible re-election of Donald Trump?
If secular trends are in place, there will be little governments and central bankers can do to keep interest rates low. Efforts to fight the trend will not end well.
What will this mean for one’s investments?
The worst affected securities will be nominal bonds. Real estate benefits from higher inflation, but it is hurt by higher interest rates and so they will not be affected as severely as bonds. As for stocks, higher interest rates and higher wages will have a double-whammy negative effect.
However, the impact will not be felt as severely in all sectors of the economy. Good quality companies that can pass on costs to consumers will be mostly fine; smaller stocks and growth stocks will be adversely affected the most. The lower inflation and lower interest rates of the past 10 years have benefited growth stocks the most and affected value stocks adversely. Will the scale tilt now on the side of value stocks? I believe under this scenario, we will see value stocks outperforming growth stocks
*First published Juli 06, 2020 in the “The Globe and the Mail”.
