Game of Thrones – Reflation and inequality, 2021’s macro drivers

Game of Thrones – Reflation and inequality, 2021’s macro drivers by Michael McKenna
Inflation may not be visible in central banks’ hedonic price indices but in reality it’s a different story – Q1 outlook 2021

Inflation may not be visible in central banks’ hedonic price indices but in reality it’s a different story. House prices, healthcare, education, childcare – anything you want or need to buy! Inflation exists in the real economy and is exacerbated by multiple asymmetric crisis responses in an era of monetary profligacy. 

Asset prices – housing, stocks and bonds – have all inflated as expansionary, unconventional monetary policy measures have been deployed repeatedly in recent years. Residential property prices in major cities across the globe accumulate more income in a year than the average worker. Globalisation, a debt super cycle and the rise of technology (the Amazon effect) have all contributed to disinflationary forces, but these dynamics have been overrepresented in official measures and hide the real inflation that exists today. 

As the new year begins the average US worker must now work 141 hours to buy one share of the S&P 500, a fresh record. In the 1980s it took less than 20 hours to purchase that same share. A loss of purchasing power is, by default, inflation. 

Inequality – A macro driver

Official inflation measures do not reflect the rise in the true cost of living and the erosion of purchasing power suffered by the asset-poor majority, who are hamstrung by the combination of low growth, wage disinflation and asset price inflation. This dynamic is perpetuating the systemic wealth concentration and intergenerational inequities that are fraying our social fabric. It’s also a key driver of the increasing societal polarisation and populist tide that has grown in recent years, contributing to heightened political instability and systemic risk. Despite Trump’s departure from office, the disorder in US politics and society lives on, with rising income and wealth inequalities perpetuating the unrest.

The instabilities that accompany these dynamics are undesirable and with respect to policy, moderating income inequality is not just beneficial for long-run potential growth, but also for financial stability.

Enter Covid-19, a crisis that has perpetuated these chasmic inequities, leaving deep scars and a growing bifurcation between the “haves” and the “have nots”. 

Inflation is just one of the many mechanisms through which the Covid-19 crisis is supersizing pre-existing inequalities. The most glaringly obvious is asset price inflation, but we have also seen changes in consumption patterns, increasing the cost of living in real time while the pandemic grips the world. 

A recent study by Harvard Business School economist Alberto Cavallo finds that because Covid-19 has significantly altered what consumers are actually purchasing, real inflation is actually more than double the price change reflected in many official indices. Typical “baskets” of goods and services have not been adjusted despite the fact that the pandemic has disrupted peoples purchasing habits. This has led to significant distortions in the measurement of inflation relative to the real increases in the cost of living, based on altered consumption habits.

So, inflation exists in components that official CPI measures underestimate: house prices, healthcare, education and childcare. Inflation for the asset poor exists via a loss in purchasing power. Furthermore, as the Covid-19 pandemic gripped the global economy in 2020, inflation has been mismeasured via altered consumption patterns. So, what about 2021?

Inflation overshoot – a profound regime shift

The initial impact of the crisis has been disinflationary, in price indices at least. Beyond that however, change is afoot, and we see increasing capacity for inflationary pressures to emerge in official measures over the next 12 months, in turn pushing longer-dated bond yields higher.

One only has to look at container freight costs, food price indices, ISM price gauges, PMI surveys and the recent run in commodity prices to see that price pressures are in fact already here on the supply side. Coupled with an aggressive demand bounce back accompanying vaccine rollout, the impact of Covid-related supply bottlenecks and green policy agendas, headline inflation will not be hard to achieve – especially against incoming low base effects.

A vaccine and return to growth will do little to rectify the K-shaped recovery dynamics of the Covid crisis, so the pressure for further stimulus remains. On the demand side, another driver of higher inflation comes from a shift toward fiscal primacy and stimulus focused on lower unemployment, income and demand maintenance, framed against the backdrop of righting the wrongs of past policy. 

The incumbent big fiscal MMT-lite regime will be key, with a Yellen Treasury embodying the shift toward the abandonment of fiscal orthodoxy, debt monetisation and the evolution of central banking. With money printing directed at demand generation, as opposed to asset purchases, this will bring increased inflationary pressures. A profound regime shift in western economies’ fiscal policies, combined with supply side pressures, is a perfect storm for higher inflation. 

Positioning for reflation

We sit on the cusp of a fundamental regime shift that we think will promote a change in market leadership. Low inflation underwrites record valuations across multiple asset classes and the incoming shift should not be ignored. 

As we transition toward an inflationary regime, with a synchronised global growth reacceleration coupled with unprecedented liquidity injections against the backdrop of unimpeded fiscal stimulus, portfolios must also transition. 

The prospect of a unified government with unimpeded fiscal stimulus, printing and spending trillions and monetising deficits, puts upward pressure on inflation and long bond yields while the USD is debased – good news for non-US markets (and commodities, Bitcoin, etc.). This dynamic will be difficult for multiple highflyers to navigate and has the capacity to shift market leadership toward real economy stocks, non-US markets and commodities. With Treasury yields rising and the dollar trending lower, emerging markets, Asia, commodities and bets on higher inflation are the place to be, as reflation becomes the name of the game. 

We see a shift in market leadership toward more cyclically orientated stocks, sectors (energy, materials, industrials, commodity, financials, and travel and leisure stocks), and geographies. 2020s highflyers, where gains have been frontloaded, will be hampered by rising long-end yields. The long earnings duration profiles with high forecast future cash flows rely on low discount rates to justify rich valuations. The valuation of those compounding cash flows will change as yields rise, altering the outperformance profile for this subsector of asset markets. For that reason, long duration stocks are very sensitive to rising yields.

Commodities relative to 15-year highs

As the world recovers from the depths of crisis, growth will accelerate alongside inflation, while the financial system remains awash with new money; the asset allocation to commodities must be higher. 

Huge supply deficits with structural underinvestment, green transformation tailwinds, and the engines of a weaker dollar plus higher inflation will coincide with a historic underweighting and a multiyear bear market to bring a commodity renaissance in 2021.

The focus for asset allocation in Q1 2021:

  • Inflation > Deflation
  • Natural resources > Technology
  • Cyclicals > Defensives
  • Covid Losers > Covid Winners
  • ROW > US
  • EM > DM
  • Small > Large