One of the most important variables that investors have been carefully watching and trying to predict in the past few months is inflation. The massive rise money supply to avoid economies from plunging into a deflationary depression has led market participants perplex about the potential consequences in the medium to long term. We have seen that uncertainty over inflation expectations have already started to surge significantly since March as more and more investors are convinced that inflation will eventually surprise the market and start to rise unexpectedly.
Inflation is an important variable for asset allocation as some risk off assets may start to perform very poorly if we see a surge in prices. Figure 1 shows three different measures of US inflation in the past 25 years: CPI, core CPI and core PCE (CPI is more volatile as it includes more volatile items such as food or energy). Even though there were short periods when inflation overshot the Fed’s 2-percent target, it has been more or less oscillating around 2% during the whole time period and modern portfolios never experience a sudden rise in consumer prices since 1995.
Source: Eikon Reuters
In this article, we will review the dynamics of the most popular leading indicators of inflation to see if inflationary pressures have started to rise.
Short term looks more deflationary
The first popular inflation leading indicator is the Underlying Inflation Gauge (UIG, full dataset), which is reported by the NY Fed. Figure 2 (left frame) shows that the UIG has historically led core CPI by 15 months and has been constantly plunging in the past two years; UIG is therefore not pricing any inflationary pressure at this stage.
The second indicator we also like to follow is the NFIB small business surveys, which is an indicator of the health of small business in the US. Figure 2 (right frame) shows that the NFIB has also fallen down significantly in the past two years and is currently not pricing in any inflation moves in the 12 months to come.
Source: Eikon Reuters, NY Fed
Another important leading indicator of inflation that we like to use is the velocity of money (M2), which could be defined as the number of times the one US dollar is spent to buy goods and services per unit of time. Figure 3 (left frame) shows that the recently ‘printed’ money has no velocity and is therefore pricing in further decrease in core prices in the US; the annual change in velocity M2 has historically led core CPI by 18 months.
Eventually, our last main leading indicator of inflation is labor unit costs, which is used as an indicator of inflationary pressure on producers. Interestingly, unit labor costs have recently soared (up to 9% in Q2) and are currently pricing in higher core prices within the next 12 months.
Source: Eikon Reuters, FRED
Overall, most of the leading indicators are showing that the US economy is very likely to experience disinflationary / deflationary pressures in near to medium term (12 to 18 months). Investors have been more concerned about the uncertainty over US elections and the economic outlook, which could explain why there is a lot of cash sitting on the sidelines at the moment. Figure 4 (left frame) shows that the total assets held in US money market funds reached an all-time high of USD 4.6 trillion in Q2 2020, up from USD 2.8tr in Q2 2018.
Source: Eikon Reuters, Baker et al. (2016), FRED
Mind the inflationary pressures in the long run
However, we do think that the probability of an unexpected rise in inflation in the medium to long term is clearly non negligible in this new age of protectionism and isolationism; the constant central banks’ interventions to desperately try to save the economies will eventually lead to inflation. We cannot run ‘restrictive economies’ without stimulus as the new social distancing policy will clearly lead to a massive rise in unemployment.
Figure 5 shows the 5-year of the spread between M2 money growth and real GDP and inflation CPI in the past 55 years; the recent massive rise in money supply should therefore generate inflationary pressures in the medium to long term and therefore CPI should eventually rise and surprise a significant amount of investors who are currently not pricing in the risk of inflation.
Source: Eikon Reuters, FRED
We saw that the risk of rising LT inflation expectations is not only bad news for bond investors as the term premium should start to levitate if inflation rises, but it is also a risk for equity investors. Figure 6 shows the average monthly returns of US equities for different buckets of inflation since 1871; we can notice that equity returns collapse when inflation rises more than 4 percent.
Source: Eikon Reuters, RR calculations
To conclude, even though there is a lot of uncertainty coming forward amid US elections, Brexit and political risk, long term investors should not underestimate the risk of rising inflation expectations in the medium to long run.
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Disclosure: I am/we are long USDCHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.