An important question for all investors is whether low inflation rates will persist or whether the economy is heading toward much higher inflation. The answer to that question will dictate asset class allocations, portfolio construction and ultimately the rates of return investors should expect.
Two prominent experts took sides in this debate last week at a luncheon hosted by the Boston Security Analysts Society. Ted Ladd, the chairman emeritus of Standish Mellon Asset Management, argued for higher inflation. Predicting low inflation was Connie Everson, the managing director and co-founder of the Capital Markets Outlook Group, a Boston-based economic consulting firm.
We’ll look first at Ladd’s arguments, which represent the conventional wisdom, and then turn to Everson’s contrarian thesis.
Inflation as far as the eye can see
Ladd presented a number of factors, which he said will inevitably lead to higher inflation:
- The Federal Reserve’s balance sheet has exploded, and it will have major difficulties executing an “exit strategy” when the time comes to withdraw excess reserves.
- When that time comes, the Fed will be too late because they are more focused on the employment situation, which is a lagging indicator.
- The Fed remains very fearful of a deflationary spiral, and inflation is still low relative to the Fed’s judgment of what it should be, and therefore it will continue to pursue pro-inflationary policies.
- The Fed’s main strength in protecting us from inflation is its independence from the Treasury, Ladd said. But that independence is being threatened by many in Congress, including Ron Paul (R-TX).
- There is no political will to deal with the huge federal deficit. “The American electorate wants services it doesn’t want to pay for,” Ladd said. He said that the present value of liabilities is approximately $86 trillion, of which $49 trillion is from the unfunded liabilities in Medicare and Medicaid.
- The US is a huge international debtor, having borrowed nearly $3 trillion from foreign governments. “If interest rates should ever go up back to anything we might consider normal,” he said, “the interest costs are going to eat us alive.”
“There is likely to be one direction and that is more inflation,” Ladd said, comparing the policies to those that led to the Argentinean debt crisis of the late 1990s and its subsequent defaults. “If you have Latino economic policies, you are going to have Latino financial economic outcomes.”
Low inflation indefinitely
Taking the other side of the debate, Everson said there will “low inflation indefinitely,” and she presented her arguments in three parts.
Most consumers experience inflation directly through food and energy prices, and Everson said that those prices are already increasing and grabbing headlines. What is less obvious, however, is that other prices – notably clothing/apparel and other personal goods – are declining at a rapid rate. So, claims that inflation is already on the rise are exaggerated, according to Everson.
“Families who are being asked to spend more on food and energy can delay these things,” she said. This is why the unemployment rate matters so much, because the labor market is a source of cash for consumers, and cash is what it takes to keep families spending, she said.
With unemployment still far above its “normal” level of 4.6%, and with industrial capacity utilization still far below its historical levels, Everson said there will not be enough consumer demand and cash across-the-board to allow producers to raise their prices “and get away with it.”
“That is inflation, after all,” she said. “We would all raise prices if we could get away with it.”
Part two of Everson’s argument centered on the growing federal debt. While she did not deny the enormity of those obligations, she said a more significant factor is that corporate and bank credit demand has been shrinking – at least until the end of last year. Modest increases in bond yields threaten further growth in credit demand, although Everson said that she doesn’t expect a spike in interest rates. For now, she said, there needs to be an increase in credit activity before inflation can take hold.
Her third point attacked the argument that US monetary policy is fueling inflation overseas that will eventually be exported back to the US. Everson said that increased prices in foreign markets are the result of monetary liquidity. She acknowledged that food prices rise to reflect changes in consumers’ taste and population growth, but she said the recent changes have had more to do with increases and decreases in “speculative liquidity.” “Pricing behavior is way in excess of how we were behaving at our dinner tables,” she said.
The output gap
One area where Ladd and Everson disagreed most sharply was in regard to the output gap – whether it is considered in terms of industrial capacity utilization or in terms of unemployment – and what impact it will have on inflation forecasts.
Ladd said that labor costs have been severely depressed as corporations have cut costs to push profits higher. But at some point that will stop, he said, and when it does it will lead to wage-based inflation.
Ladd noted that the unemployment rate among college graduates is 5%, yet it is 15% among those who have not finished high school. He expects this disparity to persist because it reflects a structural change in needs across the workforce. He noted that other countries facing similar problems are facing high inflation. In the UK, inflation is 4.4% despite a “huge output gap,” he said.
Everson expects an output gap to remain. She said that manufacturing activities “have been on a tear” for two years globally and deliveries are still not arriving on time, as consistently reported by purchasing managers over that time period. She doesn’t expect projected economic activity will close that gap.
What needs to happen in order to inflation to occur, Everson said, is for there to be a “handoff” to consumer spending. But that handoff won’t happen until labor markets and credit markets are stronger, she said.
Everson spoke at a similar BSAS event in the fall of 2009 and offered the same forecast for low inflation – a forecast which so far has proven to be completely accurate.
At the time, she recommended increased allocations to equities. This time, while acknowledging that the stress in Japan presents near-term challenges for stocks, she said, “we are in one of the most powerful bull markets any of us have seen. Using equities is recommendation number one.”
She went on to say that investors should not be afraid of bonds. She said we will have rising bond yields “only to the limit of what the economy can tolerate, and it is proving to be not that much yet. It has been four years since the start of the crisis, and this is still the advice we give you.”
The US dollar will be a “little stronger” than when QE1 began, she said, and low yields will ensure there will not be much room for change in either direction.
Lastly, Everson warned that investors should look out for surprises, “because with this much intervention there is surely going to be one.”
Ladd’s investment advice was a lot less specific than Everson’s. “If you really believe that inflation is a longer-term issue, don’t wait until it becomes vastly more important,” he said. “It is going to have profound implications long before tactical investors will be able to react.”
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