David Bowie’s classic, Scary Monsters (And Super Creeps), is a dark, claustrophobic song about love gone awry.
Scary monsters, super creeps
Keep me running, running scared
She asked me to stay and I stole her room
She asked for my love and I gave her a dangerous mind
Written in 1980, it now reads as a metaphor for the end of a decade of malaise (to borrow from Jimmy Carter), punctuated by such scary monsters as Watergate, the Iran hostage-taking, soaring inflation and a loss of American leadership. Japan was number one and German Chancellor Helmut Schmidt relished in lecturing the US about economics and diplomacy.
Beneath it all, impervious to all but to the cognoscenti, a revolution had begun to unfold in macroeconomics. Nixon’s 1971 observation that ‘we’re all Keynesians now’ ironically marked the apogee of Keynesianism, which was already under assault from a Chicago-led neoclassical revival, one that anticipated the inconsistencies of macroeconomic policy fine-tuning and the arrival of soaring 1970s inflation.
Today we have our own scary monsters—pandemic and populism, inequality and intolerance, tariffs and Trumpism. Yet revival may not be far off. Vaccinations in record time, growing schisms between conservatives and nativists, and revitalization of multilateralism all point to hopeful new beginnings.
Yet, some old monsters may never be vanquished. They lie dormant awaiting an opportune time to torment again.
In the minds of investors, one potential re-awakening monster is inflation.
In the first six weeks of 2021, US long-term inflation expectations, as measured by Treasury Inflation Protected Securities (TIPS), have risen 20 basis points, extending a near year-long climb that has seen US long-term expected inflation rates double. A similar pattern is evident in government bond markets in the UK, Europe and Japan. Meanwhile, the prices of many cyclically sensitive commodities, such as copper, oil and even foodstuffs, have jumped in recent months.
Investors are beginning to take note, as well they should. Accelerating inflation is not yet the ‘base case’ among the consensus of economists, but investors know that inflation is a portfolio-wrecker. If inflation rises, the price of bonds must fall to offer compensation via higher yields. Higher bond yields raise the discount rate on future cash flows, reducing the present value of assets such as global equities or real estate. And if higher inflation changes expectations for monetary policy, doubts about future levels and rates of change of short-term interest rates and the implications they may have for growth and earnings will boost the equity risk premium, resulting in a further erosion of valuations. Importantly, given prevailing high valuations, still-low bond yields and continued unbridled faith in accommodative monetary policies, financial markets could be dealt a jolt by the mere arrival of worries about inflation.
All of which brings us to the question, does inflation have the potential to emerge as a scary monster? Or, alternatively, can the latest market moves be safely ignored?
Before examining a few factors in detail, it is worth underscoring the degree of uncertainty involved. For one, macroeconomics, as a discipline, has largely failed to explain the arrival of low inflation that has prevailed in recent decades. How much of that outcome was due to central bank credibility, i.e., the promise to deliver low inflation? How much was due to technological change? How much to globalization? How much to lost worker bargaining power? In truth, the only known is that the debate over these unknowns remains unsettled.
That ought to give us pause. If we can’t satisfactorily explain how we got here, how can we tell where we are going?
Yet we should not be discouraged from trying. The circumstances, and the consequences, demand we do.
If we begin with a standard view of inflation, namely that rising prices and wages result from aggregate demand exceeding aggregate supply, it is possible to take comfort from the observation that ‘output gaps’ remain large and ‘full employment’ elusive. According to the Federal Reserve Bank of St. Louis, for example, the gap between current national income and its potential amounts to about 3.25% of GDP. Ample slack, as it were, to prevent a rapid acceleration of prices or wages.
Yet the Biden Administration is now pushing for Covid-relief stimulus worth $1.9 trillion, or approximately 9% of US national income (GDP). Even if not all of the bill amounts to fresh, immediate spending, the package is nearly three times the size of the output gap. And typically, government spending is accompanied by multiplier effects that amplify its impact on the economy.
Moreover, if the arrival of US fiscal stimulus coincides with large-scale effective vaccination, which permits greater economic re-opening, private sector spending could surge just as the public purse is opened. And US households have cash to burn—the personal savings rate is currently 13.7%, roughly double its twenty-year average. As restaurants, bars, gyms, movie theaters and hospitality re-open, a consumption boom could ensue.
Nor is it clear that supply could quickly respond to demand. Many small businesses have closed their doors. Workers have moved on. And those businesses that are open may use stronger demand to lift prices in order to recoup losses suffered from nearly a year of pandemic-related shutdowns.
Recall, as well, that the pandemic is both a demand and a supply shock. Fear and lost jobs contributed to a fall in spending (demand), while shuttering businesses and falling investment curbed supply. A slew of economic papers written since the onset of the pandemic have attempted to estimate the size of the demand and supply shocks. Some of the early work, which focused on declines in hours worked across various sectors concluded that up to two-thirds of the drop in US total employment was supply driven, with outsized impacts seen in construction, manufacturing, retailing and leisure and hospitality services. Those findings have been replicated elsewhere.
If those adverse supply shocks, coming on the heels of others jolts (such as a slowing pace of globalization in recent years), are not readily reversed, then expansionary fiscal and monetary policies could overheat the economy by inducing more demand than can be met (in the short run) by production.
Investors don’t have many great options. Genuine inflation hedges are scant relative to the sizable stock and bond holdings of most portfolios. Inflation protected securities, commodities, real estate and perhaps cryptocurrencies are candidates.
There are indeed scary monsters out there, but few seem ready to leave the financial party just yet. Indeed, investors seem to have skipped the playlist to Bowie’s 1983 hit ‘Let’s Dance.’ Fun times, perhaps, but it reminds us of that (Chuck) Prince quote: ‘As long as the music is playing, you’ve got to get up and dance.’
Yeah, we all know how that ended.