It’s a tug of war between reflation and deflation – who will win?

Markets are conflicted – half believe inflation won't take off, and half think we’re in for some serious inflation. One of these views is wrong, says John Stepek. But which one?

Given the occasion, I was going to try to come up with some sort of contorted football analogy for what’s going on in markets right now.

In the manner of an ITV commentator, I considered lines like: “I think we can all agree that we’re at the stage in the game now where, if the market doesn’t go up or stay the same, then it’ll go down”.

I failed. Sorry.

Instead, we’ll stick with the good old tried-and-tested “tug of war”.

Who’s going to win – inflation or deflation?

The incumbents: Team Deflation

Markets are conflicted right now. They’re not sure which major trend to believe in – nor exactly which manifestation of that trend will occur. Hence the tug of war playing out in various asset classes.

On the incumbent side, we have “team deflation”. The team has had a good few decades, driven by some key fundamental trends.

One was globalisation, whereby China (not to mention all the former Soviet Union countries) joined the global economy, driving down labour costs and thus the cost of most goods.

Another was technology, as exemplified by the internet. The digitisation of large chunks of the economy has also brought down costs hugely and opened up competition in many areas.

I think most of us would argue that these were, on balance, good things. But all trends create winners and losers and our politicians and regulators have tended to ignore the losers and valorise the winners, and sweep any structural imbalances under the carpet, exacerbating resentment and fragility.

That’s a story for another day, but it helps to explain a lot of what’s happened in the last decade or so.

The “good disinflation” created by globalisation and the like then turned into “bad deflation” when the side effects of the accompanying asset bubbles bursting bankrupted the global financial system in 2008.

We then entered the “secular stagnation” phase where central banks printed money to stop the system from collapsing. Much of that went into inflating asset prices rather than into the “real” economy.

The global financial system was starting to recover (banking crises take a long time to recover from). Arguably, towards the tail-end of the 2010s, we were seeing signs of that feeding into the “real” economy.

And then Covid-19 hit. As a result, “team deflation” has now morphed into “team transitory inflation”. In this telling, coronavirus has come along and to tackle it, governments have shut down the global economy.

That would have been deflationary, but for one thing: governments spent a lot of money keeping consumption potential at “normal” levels (relative to a normal recession, certainly). Supply was defended to a lesser extent (in that more businesses survived) but you’re still not going to make things to sell if no one is around to buy them.

As a result, as economies have reopened, we’ve seen a surge in demand alongside clogged supply chains, in terms of both goods and labour.

That’ll be temporary though, says team deflation. Meanwhile, it adds, Covid-19 keeps mutating, so maybe you shouldn’t be betting the farm on a roaring recovery anyway. What if Delta or some other godawful variant puts us right back to square one come winter 2021?

They’re a cheery bunch on team deflation.

Anyway, their overall point is that inflation won’t take off, growth will remain sputtery, and thus interest rates will be able to stay where they are. As a result, negative or near-negative government bond yields make perfect sense, scarce growth opportunities are still worth paying up for (hence wild-looking p/e ratios are justified on hot tech stocks), and the current commodity spike is just that – a spike.

The challengers: Team Inflation

On “team inflation”, we have a rather bedraggled set of challengers. Team inflation was wrong when it argued that central bank money printing after 2009 would spark massive or even hyperinflation.

So what’s different this time?

Team inflation argues that even pre-Covid, the disinflationary forces were running out of steam. Globalisation is hardly dead, but it has peaked, and did so some time ago. That era was always founded on the “Chimerica” symbiotic relationship between China and the US, whereby China funded America’s consumption of Chinese goods, while it hollowed out America’s industrial heartland and gobbled up its intellectual property (a caricature but a handy one).

That’s not the case anymore. The relationship is distinctly less cuddly, and Donald Trump’s actions were merely symptomatic of that rather than the cause.

That’s before you get to all the other areas where borders have gone up again (including the return of capital controls). So in general, the free flow of labour and capital around the world, and the arbitrage opportunities that arose from that, have been milked dry. As a source of ongoing disinflation, team inflation would argue that it’s hard to point to globalisation any more.

What about tech? Tech is a more nuanced argument, but the drying up of globalisation is undoubtedly a problem for tech. Moreover, it’s increasingly obvious that the tech sector is under attack by global governments.

The minimum corporation tax is mostly aimed at tech. The various competition lawsuits around the world are driven not by fear of consumer detriment (end-consumers are arguably the biggest beneficiaries of the rise of big tech), but by fear of political power (which to be fair, has always been the driver behind competition and antitrust law).

Is that drastically inflationary? Maybe not, but it’s certainly not disinflationary – it adds to costs.

Meanwhile, post-2008, the perception, rightly or wrongly (again it’s nuanced, but who has time for nuance?) has been that the wealthy (asset owners) have made out like bandits while the not-wealthy (people who don’t have assets – houses in particular) have been left behind.

So governments are increasingly thinking about how to pacify populations with redistributive taxation policies and increased public spending. Meanwhile, central banks, having propped up markets for so long, are now fearful of letting them go or – heaven forfend – raising interest rates. So they’ve been edging away from their inflation targets and also from the idea of independence.

So team inflation would argue that the core trends were shifting anyway.

Covid? It’s just an accelerant of all these factors. Look at the jobs market. On the one hand, huge numbers are unemployed. On the other, anyone with a job is looking to leave it and find a better paid one.

Is that transitory? Maybe. Maybe employers think that they can hold off on raising wages to attract staff, reasoning that the support will run out and “business as usual” will return. But how long can employers keep premises shut down for a “lack of staff” before they do their businesses real damage?

More to the point – will governments really rein in support schemes? Particularly if Covid-19 and lockdowns do persist for longer than expected?

One of these outcomes is looking mispriced, regardless of your own view

You can see why markets are confused. There are good points on either side. I’m in team inflation, as you probably guessed by now. But a lot of that stems from a belief that both governments and central banks have decided that the path of least resistance is the inflationary one. Maybe I’m wrong.

One thing I will say though: markets seem to have already lost faith in the reflation trade. As Dominic has been pointing out, the commodities sector has had the wind knocked out of its sails in recent months.

Oil was among the last dominoes to topple, and while everyone keeps going on about how it’s all about oil cartel Opec, chances are it’s just catching up with the rest of the sector with its recent plunge. (Brent’s back down to $73 a barrel this morning, look forward to seeing that dip reflected in petrol prices...)

So with that in mind, I tend to think that markets are now betting too heavily on the gloomy outlook – probably due to fear of the Delta variant – and that if you’re looking for an opportunity to top up or get into the value / reflation trade, then now might be a good time.

You know my biases – you hopefully know your own. But in this tug of war, I think the odds on team inflation are currently a little mispriced, regardless of your take.

We’ll have a lot more on this in MoneyWeek magazine this week and in weeks and months to come. Get your first six issues free here.

Until tomorrow,

John Stepek

Executive editor, MoneyWeek


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