{"id":704,"date":"2021-02-26T01:54:37","date_gmt":"2021-02-26T01:54:37","guid":{"rendered":"https:\/\/halcyonpw.com.au\/?p=704"},"modified":"2021-02-26T01:54:38","modified_gmt":"2021-02-26T01:54:38","slug":"market-update-inflation","status":"publish","type":"post","link":"https:\/\/halcyonpw.com.au\/market-update-inflation\/","title":{"rendered":"Market Update | Inflation"},"content":{"rendered":"\n

The backbone of modern portfolio construction has been blending an allocation of equities and bonds.  This has served investment managers well for decades. Particularly since the mid-1980s, portfolios have benefited from declining inflation, which has driven down bond yields, increasing the price of bonds (and other asset classes as well, including equities).<\/p>\n\n\n\n

As the below chart shows, since the early 1980\u2019s, an exposure to US Government 10-year Bonds (blue line) would have generated strong returns as yields reduced over the decades.<\/p>\n\n\n\n

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This note introduces the question of whether markets are about to reverse this multi decade trend. We think this will be a key issue for markets in the years ahead and will form a substantial portion of the research we will undertake in this year\u2019s strategic asset allocation (SAA) review. Unfortunately, we are not yet in a position to answer definitively one way or another. The risk of a break-out in inflation seems higher than it has been in a decade. However, there are reasons to be sceptical, not least of which is the empirical experience of the past decades. Below, we present the case for and against higher inflation.<\/p>\n\n\n\n

The case for higher inflation<\/strong><\/em><\/p>\n\n\n\n

So, what could drive a shift into a higher inflation regime? The key factor would be a change to the way central banks and governments think about economic policy. After the high inflation period of the 1970s and 1980s, the case was well made that central banks should aim for low and stable inflation and governments should try and balance their budget over the cycle. While governments have generally failed in their objective, central banks have been successful.<\/p>\n\n\n\n

Recently, there have been two key developments which suggest a change in policy could be on the cards.<\/p>\n\n\n\n

  1. Deficits don\u2019t matter: <\/strong>Governments all seem less concerned with repairing fiscal deficits than they were following the financial crisis. While running large deficits make sense following recessions while the unemployment rate is high, the emergence of Modern Monetary Theory and rise of political populism more broadly mean governments are less likely to pull back on the reins this time around.<\/li>
  2. Changes to inflation targets: <\/strong>In late 2019, following a review of its policy framework, the US Federal Reserve adopted an average inflation target. Where previously they were implicitly targeting inflation at or below 2%, they now aim to achieve an average 2% inflation over time. Mathematically, this means inflation should be higher going forward than it has been in the past to make up for the previous years below target. It also gives the Fed cover to let inflation run hot for some time following economic downturns.<\/li><\/ol>\n\n\n\n

    Both of these developments are relatively minor \u2013 but they represent an important first step in what could be a meaningful policy shift in the years to come. Many argue (probably correctly) that central banks should target higher inflation so that real interest rates can be made more negative when nominal rates are bound around zero, which would help stimulate the economy in a downturn. Once you have changed something once, it is easier to change it again. Freed from a meaningful fiscal constraint, and with the implied backing from central banks (who need to keep rates low to ensure economic growth in an over-indebted world) politicians could be tempted to spend their way to victory every election cycle.<\/p>\n\n\n\n

    A period of higher inflation, if accompanied by reasonable growth and some fiscal repression (artificially low interest rates) would also help governments and households to bring their debts under control. Of course, this would be a bad outcome for savers and holders of bonds who would see the real value of their wealth diminish in such an environment.<\/p>\n\n\n\n

    The case for no inflation<\/strong><\/em><\/p>\n\n\n\n

    The case for no inflation is relatively easy to make. There hasn\u2019t been any real inflation in developed market economies for the past two and a half decades. Abstracting from tax increases, major central banks have persistently delivered inflation below their respective targets. Their track record has got worse since the Financial Crisis.<\/p>\n\n\n\n

    The key questions to ask is why this has been the case, and will it change in the future. There are a few reasons for our low inflation outcomes:<\/p>\n\n\n\n