The economic destruction caused by the Coronavirus pandemic has been both profound and crippling in equal measure.
Over the past few months, we have seen many shocking economic data releases, with consumer and business confidence collapsing, jobless claims surging and growth contracting at alarming rates. Whilst policymakers had little chance of halting the abrupt decline, they have none-the-less gone to extraordinary lengths to mitigate the impact and avert longer lasting economic scarring. Around the world, central banks have slashed interest rates, eased lending criteria and provided huge liquidity injections through quantitative easing. At the same time governments have eased liquidity and solvency concerns through loan guarantees, tax payment deferrals and income support programmes.
Whilst the virus’s impact will inevitably fade (hopefully sooner, rather than later), it is still likely that this crisis will have a lasting impact on the World’s economy. In this short article we lay out our thoughts on how we expect it to effect inflation, both in the short and longer term.
It is clear that in the near term, the collapse in demand resulting from the crisis has been profoundly disinflationary. Whilst food and toy prices may have risen, the collapse in general demand has seen the price of most other goods and services, such as oil, electricity, clothing, hotel rooms, travel bookings etc, fall significantly. Indeed, recent data releases show just how dramatically inflation levels have been impacted by the pandemic, with the US Consumer Price Index (CPI) declining -0.8% in April, which is the largest monthly fall since December 2008 (another month of crisis). Elsewhere, the UK has seen a similar outcome, with April CPI falling -0.4%.
Beyond these immediate observations, there are other factors that are likely to continue to supress inflation over the coming quarters. The extraordinary level of job losses seen over recent months has created significant slack in the labour market, and even as the economy regains traction, wage growth is likely to be subdued as workers compete to find work.
The speed and severity of this crisis has been a huge shock to both corporates and consumers and exposed how little many of them hold in reserve for the “rainy day”. After this almighty scare, it seems likely that both consumers and corporates will adopt a more reserved attitude towards consumption, investment and debt. Quite simply, animal spirits will have been squashed, and the consequence of this shift will be more restrained spending patterns in the future. We last saw this in the aftermath of the 2008/2009 credit crisis, when savings ratios rose dramatically as both corporates and individuals worked to reduce their borrowings and strengthen their financial positions.
Although in the near term, there is little doubt deflationary forces will dominate, the picture is much less clear further out as there are a number of factors that could see the re-emergence of inflation.
One of the lasting legacies of the pandemic will be a dramatic increase in government debt levels. With spending up, and tax receipts down, some economists estimate that the average G7 government debt to GDP ratio will rise to a staggering 140%, before finally stabilising. In normal times, fiscal and monetary policies such as those currently being pursued would typically lead to inflation, as they tend to debase currencies, expand the monetary base and fuel excess demand. However, we live in strange times, and there is no immediate prospect of that outcome, even though it would be easy to misjudge how far these policies should be taken. History is littered with examples of governments printing money only to see it lead to a debased currency and hyper-inflation. Certainly, there will be a temptation on the part of authorities to do too much, rather than too little, as there is a general belief that it is easier to reign in excessive inflation than to combat embedded deflation. If the policy-makers of the eighties and nineties mainly feared runaway inflation, the focus of the current generation is the fight against disinflation. Indeed, some governments and central banks could well welcome a period of higher inflation as it would help erode the real value of their growing debt mountains and correct a persistent inflation undershoot.
Whilst globalisation was already in retreat, the pandemic has probably put the final nail in its coffin. For a long time, increased global trade has boosted growth and subdued inflation. As advanced economies allowed lower valued jobs to move offshore to emerging markets, the real cost of manufactured goods has fallen, even if it has not been without the social consequences of growing inequality. This negative side of globalisation has contributed to a rise in nationalist and populist tendencies, fed by slogans such as Trump’s “Make America Great Again” or the Brexiteer’s “Take Back Control”. After many years of falling tariffs, they are now re-emerging as a weapon of choice between nations in dispute. But whilst tariffs can be effective tools to punish trade adversaries, ultimately they are self-defeating as they act as a tax on consumers and raise the price of goods and services.
Another legacy of the pandemic is that there will be a degree of capacity destruction in some, if not all, industries. Many businesses may never reopen their doors, especially those in the retail, hospitality and travel industries. Reduced supply may well lead to rising prices as competitive pressures ease and survivors regain pricing power. For example, should a few airlines go bankrupt, we may well see ticket prices rise in response to less supply and competition.
The pandemic has also called into question an over-reliance on complex and long supply lines. As a result of difficulties experienced over recent months, it may be that some companies choose to realign their arrangements. The crisis seen in national health systems over simple personal protective equipment (PPE) served to highlight the risk of being overly dependent on foreign companies in distant lands for essential items. However, whilst the PPE shortage made headlines, it was not the only example of supply-chain issues. Who knew that China controls 90% of the active ingredients used in antibiotics? Whilst the pandemic has exposed the vulnerabilities of complex supply chains, many now argue that future disruption can only be avoided by sourcing closer to home. Of course, should this become widespread, all the benefits of globalisation will be reversed, and the cost of many manufactured goods would rise.
In conclusion, whilst we have highlighted a number of factors that could add to inflation over the longer run, we do not believe that the copious money printing seen in the world today is likely to lead to a period of rampant runaway inflation, such as occurred in the seventies and early eighties. Technology and changed working practices have undermined the power of unions and collective wage bargaining, making it most unlikely that double digit annual wage settlements will return. Massive shifts in exchange rates are also unlikely to have a significant bearing on inflation, since all countries are meeting the same challenges with similar policies. Exchange rates are a relative game, and it’s pretty hard to pick winners and losers when all the runners are so evenly handicapped. With bond yields at historic lows, the implications are that financial markets see little prospect of inflation rising back to anywhere near the 2 to 2.5% levels central banks typically target. In this respect, we believe financial markets are mispricing longer term inflation, and in the fullness of time, inflation will return and may be allowed to sit at higher levels than the recent past to help governments manage down the real value of their debts. For investors holding long dated government bonds that today offer either a negative or near zero yield, whilst they may not need to rush for the door quite yet, there is a risk that over time yields will drift higher, leaving them nursing capital losses. At Nedgroup, we prefer to protect against this risk by favouring shorter duration bonds that are better shielded from interest rate risk. Global equity markets are responding well to the continued reopening of economies, with the S&P500 and MSCI World indices both up more than +4% in US dollars month-to-date. In addition, the healthcare sector has made good progress on its defence against the Coronavirus. After a long silence, Merck – one of the largest pharmaceutical companies in the world - announced its plan of attack this week. Similarly, Novavax - a small-cap biotech firm – announced that it’s acquiring Praha Vaccines to increase its manufacturing capacity.