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The global policy response to the COVID-19 health crisis these past two months has carried with it the seeds for a shift in the inflation regime. This shift will start with an upcoming year-long flirt with deflation and disinflation. It will then progress with a reflation to central banks targets within two years, and eventually finish well above target inflation levels (3%-4%) by the end of 2022, or early 2023. Thanks to the steadiness of the monetary and fiscal policy response, our confidence in our higher inflation call has grown significantly. We will touch on the upcoming economic- and policy response catalysts that will push us from two decades of persistent disinflation to a cycle characterised by inflation readings above the central bank’s 2.00% target levels.
The lockdown-induced, global demand shock and the subsequent spike in unemployment rates will push central bank inflation indicators to near deflation, or to somewhere between 0.00% to 1.00%. Turbo-charged monetary and fiscal policies will only deliver meaningful effects over time. In the short-term, they act as shock absorbers when household and corporate income collapses. On the corporate side, both (supply) capacity and capital expenditures have been heavily reduced to protect balance sheets and soften the impact on the bottom line. We still expect elevated defaults figures until the summer of 2021. This will translate into a longer-than-expected risk averse attitude in the markets. The ballooning pre-cautionary savings that remain on savings accounts will get invested in short-term money market solutions, or into a diversified set of bond strategies. Institutional rebalancing activity will support equity.
The return of inflation figures which coincide with central bank targets (i.e. around 2.00%) will occur as a result of the coordinated, all-in, fiscal and monetary policy response. The global fiscal response has been extraordinary. We have not witnessed such figures since WWII. In 2020, the global fiscal deficit will rise by about 7.5%, to reach approximately 12% of global GDP. This pales in comparison to the fiscal effort in 2008/2009, which reached about 5.5% and pushed the global fiscal deficit to 8.4%. Back then, the fiscal response was geared towards saving the banking system. This time around, fiscal authorities are responding to an exogenous health crisis. Austerity policies became the norm in 2010, but this time, we will observe the exact opposite. Expect a continuation of fiscal support throughout the cycle. The realisation that fiscal policy will go into overtime will disentangle the disinflation regime. Support will be geared to lower income segments of the population, and those that have been worst hit by the pandemic. Labour’s bargaining power is unlikely to crumble, as governments have already been receptive to fair wage demands before this crisis. As the government rolls out their support programmes (e.g. credit lines, credit guarantees), we expect increased government control and guidance on inequality issues. Monetary policy was never able to turn this around. Fiscal policy is better equipped to support household demand, and address specific supply side constraints. Although many companies will default, the survivors will face a new reality of enhanced social distancing. This will reduce their ability to service customers (think about restaurants, tourism/hospitalization, airlines…most high proximity sectors). A general hike in pricing levels will ensue as debt will still have to be repaid and return on equity expectations will prove to be sticky. This episode is known under the ’inflationary bust’ epitheton.
From a macro level, the acceleration of the growth recovery will lead to reflation. The timeframe will still benefit from highly-accommodative monetary aid, and sustained fiscal support. Household or corporate deleveraging will not push back as was the case after the global financial crisis. The biggest stimulus to the markets, we hope, will come from a successful administration of an effective vaccine against the coronavirus.
Since politics will opt to keep fiscal activism in place for longer, we also expect a similar attitude from central banks. Central bank asset purchase programs will run, at a minimum, until the end of 2021. G4 central banks will lean towards prudency, as they do not want to be blamed for stifling the economic and employment recovery. This will maintain elevated levels of money supply growth. These money supply growth numbers will not be between 4% to 7% (1 to 1.5 times normal nominal GDP growth), but instead easily surpass the 10%, potentially up to 20% in 2022. The impact of sustained and coordinated monetary and fiscal activism will drive inflation away from its intended target. The adopted symmetry rule for inflation will inhibit central banks from relying on tightening policy. By 2023 we expect US-inflation expectations, as expressed by our 5y5y forward inflation swap indicator, to have normalised at around the 2.5% – 2.75% range. Today this indicator fluctuates around 1.75%. In Europe, we expect the 5y5y inflation swap indicator to normalise at approximately 1.80% (compared to today’s levels of 0.85%). Our call that deglobalisation will disrupt supply chains in favour of more domestic or regional solutions further supports additional inflation. The shape of longer-term productivity growth will decide whether we will face good or bad inflation. An increase in productivity leads to stable unit labour costs and good inflation. Sticky- to slowing productivity would remind us of the 1970s. Portfolio constructors should prepare accordingly today to shield their portfolios from potential upcoming inflation risks. Even though inflation risk is currently looked at as a tail risk, we expect a higher adoption rate and increased market sensitivity in both 2021 and 2022.
The above-mentioned inflation scenario calls for increasing and normalising global inflation expectations over a three year horizon. However, as monetary authorities will keep nominal funding levels under control through a diverse set of asset purchase programs, higher inflation expectations will be expressed through the fall of real rates into deeper negative territory. This condition will support debt sustainability across developed and emerging bond markets. Moreover, it will strengthen the inflation targeting credibility of central banks.
Reality will most likely deviate from the path we described. Still, we are confident that inflation will return to financial markets after a 40 year-pause. The resurgence of fiscal policy as a lever to combat the current recession and sustain inclusive economic growth will act as its main catalyst.