Thoughts through the cycle: W2 January ’21

Share on facebook
Share on twitter
Share on linkedin

A user’s guide for distinguishing between reflation and inflation

  • In a fragmentary work on the philosophy of psychology published in 1953 after his death, Ludwig Wittgenstein addressed the phenomenon of how our impressions of what we see (or experience more generally) could change even when the object in question was unchanged. He used a visual example of the duck-rabbit (see below) to help unravel what he considered to be the ‘conceptual unclarities’ around how we describe what we see. If one sees a rabbit (or a duck) when one first looks at the picture, what if anything happens when one subsequently sees the other? Is it just how we describe it or talk about it, or has something ‘real’ actually changed? Once one has seen the duck-rabbit, can one just see the duck or the rabbit as before?

Source: Independent.co.uk

  • A slightly more puerile example below shows Sesame Street’s cookie monster watching tenderly over the Madonna and Child. Once seen, not only can it not be unseen, but it dominates one’s view of the picture to the exclusion of everything else.

Source: Shutterstock.com

  • This is not just idle speculation during a slow-news week. The point being illustrated is one about inflation and how investors (and economic agents more generally) come to change their view of the world during a period of inflation, and how this change of behaviour is shown in asset price movements. While CPI or the PCE deflator measure inflation on an ongoing basis in purely numeric terms, was something ‘different’ happening say in the 1970s when inflation was running rampant?
  • The task here is to find out whether there is a meaningful way in which investors can monitor whether the market is shifting from a prevailing view of reflation (back to the way things were, good) to inflation (something happening which hasn’t really been a problem since the 1970s, bad). The question behind this is a simple one – did something happen in 2020 (or is something going to happen in 2021) which has changed the monetary status quo which means reflation is just a signpost on the road to ‘proper’ inflation?
  • As it is a market question, the starting point is a market measure of inflation, the breakeven on 10yr US Treasury TIPS. The graph below shows a current reading of 2.07%, slightly exceeding the Fed’s medium-term goal of 2% but more importantly showing a sharp recovery from the March 2020 lows when the economy and markets were in free fall following the outbreak of the Covid-19 pandemic. As it stands, this can be interpreted as a good example of reflation, and Fed quantitative easing (QE) policy has very much been aimed at effecting this outcome, not least because the Fed itself has been an aggressive buyer of TIPS and therefore its very action is aimed at giving the impression of reflation.

Source: Bloomberg, 11th January 2020.

  • A 10yr forward inflation price of 2% is quite nice; in-line with the Fed’s target and therefore nothing too outlandish. This is the sort of inflation which one might call healthy (at least as far as the target is concerned), and is the sort that has allowed stock markets (especially in the US) not only to recover but to seek out new highs as the reflationary recovery is on track.
  • But wait, that’s not all. A key component of inflation expectations is the oil price, and both Brent and West Texas have recovered back to $50+ per barrel or around their pre-Covid-19 levels. This again suggests a fairly healthy reflationary recovery, even with movement restrictions still in place.
  • The graph below shows a slightly different picture. The blue line is the Commodity Research Bureau’s raw industrial commodity price index (a broader commodity basket designed to eliminate biases from the commodity futures market) while the yellow line is the nominal yield on 10yr Treasuries. Something a bit odd seems to be happening here.

Source: Bloomberg, 11th January 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • What this shows is that while commodity prices have recovered sharply, nominal interest rates have not risen as one might have expected. If inflation expectations at 10yr have recovered to 2%, this means that the problem lies in real rates. They are still stuck around -1% when this time last year they were at 0%. Why is this? Simple really – Fed QE is suppressing real rates, and their ‘open mouth’ policy is suggesting that they aren’t going to hike rates any time soon, even if inflation rises above the 2% target. This is the new average-inflation policy explained during the course of summer 2020.
  • Negative real rates are not the sort of thing you’d expect to see if the economy was simply going to get back to normal and therefore this means this ‘reflation’ theme has a bit of a problem. All else equal, negative real rates reflect capital destruction within the economy from negative real levels of growth. This is the sort of thing you’d expect to see from a heavily-indebted economy (and one which has become even more indebted in 2020 due to the pandemic and how it was dealt with).
  • In a normal economic cycle, inflation starts to emerge at the peak as the economy reaches full employment and therefore any further growth in demand, especially if it is credit-fuelled, starts to make the economy overheat. Usually at this stage, the central bank starts to hike rates, reducing demand for credit, reducing consumption and inducing a period of balance-sheet repair, aka a recession.
  • What if there is something different going on, and this isn’t a normal cycle but one where financial assets are responding to radical monetary and fiscal policy, and therefore something is happening to the money system itself? The graph below of US M2 money shows the vertiginous rise in money from Fed QE. The difference this time (as opposed to 2008-‘9) is that 2020 saw massive US deficit spending (15.2% of nominal GDP according to the latest Fed data in November 2020) and with the Democrats now in control of the Senate and a Biden administration inbound, the fiscal driver behind the Fed’s QE is likely only to increase exponentially. This may be why US 10yr nominal yields are not tracking commodities per the graph above – too much debt weighing down the economy and therefore real rates, but also the prospect of a Biden spend-a-thon necessitating even more Fed activism, this time in terms of a yield-curve control policy similar to that operational in the 1940s.

Source: Bloomberg, 11th January 2020.

  • Fed yield curve control in the 1940s saw real rates fall sharply and inflation rise, although nominal rates were of course controlled by the Fed, thus making the deficit manageable. Real economic growth was however very high, especially after the end of World War II, but as inflation pushed over 10% the Fed had to abandon the policy in March 1951.
  • The market often tends to do what it is used to and especially in the bail-out era, it tends to be risk-on and Panglossian in the extreme. While QE does look very much like a repeat of the asset friendly versions that have gone before, 2020 was in fact different from a deficit-financing perspective, and this factor will likely continue with the Democrats in charge in the US. The scale of the monetary intervention then takes on a different character, and one has to ask whether the old and rarely used term of debasement is now the correct descriptive term to be used.
  • Debasement of the coinage was often a wartime expedient brought on by massive government expenditure. If extreme enough, it led to something called Gresham’s law taking effect, meaning bad money drove out the good. People tried to get rid of the newly debased money they had as quickly as possible and exchange it for goods. In a financialised, fiat-money world, rampant stock markets could well be interpreted as early symptoms of Gresham’s law taking effect. The problem for markets right now though is that the assets which have been rallying are the ones which do well in periods of reflation but not during inflation. This includes growth stocks – hence the Nasdaq’s strong performance.
  • So far, financial assets have done very well, especially stocks. If reflation is to become inflation, then commodities will continue to rally but the stock market could falter, or at least its leadership could change with value factors outperforming growth. Amongst the commodity suite itself, there is one which acts as the ultimate bell-weather both for debasement and the subsequent inflation it causes, and that is gold.
  • The graph below shows gold from the start of 2020 and it did ok. It struggled in the latter half of Q3 and Q4 due to some quite market specific issues relating to the paper futures market. There have been three occasions since August of a $100 slam-down of the gold price and this has cautioned investors from adding to their holdings, even as other fiat-debasement trades like bitcoin have prospered. Gold’s failure to push on shows the market is still in reflation mode. One ought to be in doubt though that if gold starts to move, it’s not that inflation is coming, it’s that it has just arrived. At that point the commodity market will no longer be the duck of reflation but the rabbit of inflation (so to speak).

Source: Bloomberg, 11th January 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

[1] CPI = Consumer Price Index, PCE = Personal consumption expenditures

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 14th January 2021.

The term “RWC” may include any one or more RWC branded entities including RWC Partners Limited and RWC Asset Management LLP, each of which is authorised and regulated by the UK Financial Conduct Authority and, in the case of RWC Asset Management LLP, the US Securities and Exchange Commission; RWC Asset Advisors (US) LLC, which is registered with the US Securities and Exchange Commission; and RWC Singapore (Pte) Limited, which is licensed as a Licensed Fund Management Company by the Monetary Authority of Singapore.

RWC may act as investment manager or adviser, or otherwise provide services, to more than one product pursuing a similar investment strategy or focus to the product detailed in this document. RWC seeks to minimise any conflicts of interest, and endeavours to act at all times in accordance with its legal and regulatory obligations as well as its own policies and codes of conduct.

This document is directed only at professional, institutional, wholesale or qualified investors. The services provided by RWC are available only to such persons. It is not intended for distribution to and should not be relied on by any person who would qualify as a retail or individual investor in any jurisdiction or for distribution to, or use by, any person or entity in any jurisdiction where such distribution or use would be contrary to local law or regulation.

This document has been prepared for general information purposes only and has not been delivered for registration in any jurisdiction nor has its content been reviewed or approved by any regulatory authority in any jurisdiction. The information contained herein does not constitute: (i) a binding legal agreement; (ii) legal, regulatory, tax, accounting or other advice; (iii) an offer, recommendation or solicitation to buy or sell shares in any fund, security, commodity, financial instrument or derivative linked to, or otherwise included in a portfolio managed or advised by RWC; or (iv) an offer to enter into any other transaction whatsoever (each a “Transaction”). No representations and/or warranties are made that the information contained herein is either up to date and/or accurate and is not intended to be used or relied upon by any counterparty, investor or any other third party.

RWC uses information from third party vendors, such as statistical and other data, that it believes to be reliable. However, the accuracy of this data, which may be used to calculate results or otherwise compile data that finds its way over time into RWC research data stored on its systems, is not guaranteed. If such information is not accurate, some of the conclusions reached or statements made may be adversely affected. RWC bears no responsibility for your investment research and/or investment decisions and you should consult your own lawyer, accountant, tax adviser or other professional adviser before entering into any Transaction. Any opinion expressed herein, which may be subjective in nature, may not be shared by all directors, officers, employees, or representatives of RWC and may be subject to change without notice. RWC is not liable for any decisions made or actions or inactions taken by you or others based on the contents of this document and neither RWC nor any of its directors, officers, employees, or representatives (including affiliates) accepts any liability whatsoever for any errors and/or omissions or for any direct, indirect, special, incidental, or consequential loss, damages, or expenses of any kind howsoever arising from the use of, or reliance on, any information contained herein.

Information contained in this document should not be viewed as indicative of future results. Past performance of any Transaction is not indicative of future results. The value of investments can go down as well as up. Certain assumptions and forward looking statements may have been made either for modelling purposes, to simplify the presentation and/or calculation of any projections or estimates contained herein and RWC does not represent that that any such assumptions or statements will reflect actual future events or that all assumptions have been considered or stated. Forward-looking statements are inherently uncertain, and changing factors such as those affecting the markets generally, or those affecting particular industries or issuers, may cause results to differ from those discussed. Accordingly, there can be no assurance that estimated returns or projections will be realised or that actual returns or performance results will not materially differ from those estimated herein. Some of the information contained in this document may be aggregated data of Transactions executed by RWC that has been compiled so as not to identify the underlying Transactions of any particular customer.

The information transmitted is intended only for the person or entity to which it has been given and may contain confidential and/or privileged material. In accepting receipt of the information transmitted you agree that you and/or your affiliates, partners, directors, officers and employees, as applicable, will keep all information strictly confidential. Any review, retransmission, dissemination or other use of, or taking of any action in reliance upon, this information is prohibited. The information contained herein is confidential and is intended for the exclusive use of the intended recipient(s) to which this document has been provided. Any distribution or reproduction of this document is not authorised and is prohibited without the express written consent of RWC or any of its affiliates.

Changes in rates of exchange may cause the value of such investments to fluctuate. An investor may not be able to get back the amount invested and the loss on realisation may be very high and could result in a substantial or complete loss of the investment. In addition, an investor who realises their investment in a RWC-managed fund after a short period may not realise the amount originally invested as a result of charges made on the issue and/or redemption of such investment. The value of such interests for the purposes of purchases may differ from their value for the purpose of redemptions. No representations or warranties of any kind are intended or should be inferred with respect to the economic return from, or the tax consequences of, an investment in a RWC-managed fund. Current tax levels and reliefs may change. Depending on individual circumstances, this may affect investment returns. Nothing in this document constitutes advice on the merits of buying or selling a particular investment. This document expresses no views as to the suitability or appropriateness of the fund or any other investments described herein to the individual circumstances of any recipient.

AIFMD and Distribution in the European Economic Area (“EEA”)

The Alternative Fund Managers Directive (Directive 2011/61/EU) (“AIFMD”) is a regulatory regime which came into full effect in the EEA on 22 July 2014. RWC Asset Management LLP is an Alternative Investment Fund Manager (an “AIFM”) to certain funds managed by it (each an “AIF”). The AIFM is required to make available to investors certain prescribed information prior to their investment in an AIF. The majority of the prescribed information is contained in the latest Offering Document of the AIF. The remainder of the prescribed information is contained in the relevant AIF’s annual report and accounts. All of the information is provided in accordance with the AIFMD.

In relation to each member state of the EEA (each a “Member State”), this document may only be distributed and shares in a RWC fund (“Shares”) may only be offered and placed to the extent that (a) the relevant RWC fund is permitted to be marketed to professional investors in accordance with the AIFMD (as implemented into the local law/regulation of the relevant Member State); or (b) this document may otherwise be lawfully distributed and the Shares may lawfully offered or placed in that Member State (including at the initiative of the investor).

Information Required for Distribution of Foreign Collective Investment Schemes to Qualified Investors in Switzerland

The representative and paying agent of the RWC-managed funds in Switzerland (the “Representative in Switzerland”) is Société Générale, Paris, Zurich Branch, Talacker 50,

P.O. Box 5070, CH-8021 Zurich. In respect of the units of the RWC-managed funds distributed in Switzerland, the place of performance and jurisdiction is at the registered office of the Representative in Switzerland.

Explore more

INVESTOR TYPE SELECTOR

Please confirm your investor type

Professional

Non-professional

By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER

This website uses cookies. A cookie is a small data file placed on your computer which captures information about your choices which allows us to improve your experience of the website, for example, by remembering your country of residence. By continuing to access this website, you agree to be bound by our Cookie Policy. You can accept and/or block at any time by changing your browser settings.

SELECT YOUR REGION

Where are you located?

Europe

Asia-Pacific

Rest of world

By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER

INVESTOR TYPE SELECTOR

What type of investor are you?

Professional

Non-professional

By clicking Submit, you agree that you have read and accepted the terms and conditions detailed in the DISCLAIMER