Is it inflation or negative real rates that matter now for investors?

I participated in a Euromoney conference on investing in inflation this afternoon. I was on a panel of five right before the closing remarks by keynote speaker Dennis Gartman and I wanted to make a few remarks about what I learned.

First, Dennis Gartman is a wonderful speaker, very gifted. He had a lot to say that I agree with and I will get to that in a later note. What I want to write about now is the basic premise of the conversation that inflation is the problem. I have three thoughts on this, two of which I proposed during the panel.The backdrop ere is that we are in very unusual times, with crises in almost all of the major developed economies. The majority of their central banks are adding liquidity in the form of base money and low rates as a salve. Investors in this environment rightly wonder what this means for their portfolio,particularly regarding the potential for inflation. Here are three thoughts, the first two I went into detail on today.

1. Time horizon. The first question is on timing. Pretty much everyone agreed that inflation isn’t a problem right now, but for varying reasons. The question is whether the policies being pursued now by monetary authorities are inherently inflationary, meaning that they will precipitate consumer price inflation down the line that erodes the value of one’s portfolio.
2. Real return. The second question is whether it is inflation that matters at all. The reality is that while measured CPI is relatively low in most developed economies, interest rates are even lower. With central banks holding base rates low and promising to do so for an ‘extended period’ the yield curve has flattened. Investors, therefore, are holding wealth destroying government bond assets right across the curve.
3. Asset prices.In thinking about inflation, one must distinguish between asset price inflation and consumer price inflation because the stated aim of the Federal Reserve is asset price inflation. They want to create inflation – and they have done so. But this is a different kettle of fish in that it skews inflation horizon perspectives because it is more about risk-adjusted returns than inflation hedging.

On the first topic, I agreed that CPI-measured inflation is not a grave concern right now. But that there is the potential for problems down the line. Because I see this episode as fundamentally deflationary in nature because of the reduction in nominal GDP and/or credit growth across a broad swathe of countries, to me the question is about the tension between tight fiscal and loose monetary policy. Tight fiscal (in relative terms) guarantees to cap inflation and inflation expectations by creating a drag on nominal GDP that is a deflationary force. While state and local governments in the US are re-awakening from their fiscal tightening, I don’t believe their pension systems will allow then to loosen substantially in a way that has a meaningful impact on nominal GDP. So the only sure of inflation over the near term is monetary policy – and this will act almost entirely through asset prices and changes in portfolio preferences.

I said at the conference, we were talking a minimum of two to three years of subdued inflation and inflation expectations, meaning the TIPS market break-even would not revert to mean yet. After those two to three years is where the disagreement lies. I said that the inflationary impulse would have to come via credit growth and that adding base money reserves was not inherently tied to credit growth. We see this as money velocity has declined along with credit demand. It’s a classic tail wagging dog scenario where everyone is concerned that the huge reserve stock will be inflationary in three years when the Japanese episode tells you that’s not the case. The dog is private credit creation due to robust capital positions amongst lenders and an abundance of credit seeking and creditworthy customers. The tail is the reserves, which are simply a device used by central banks to target a specific base interest rate. The reserves do not create the opportunity for more lending as we all learned in economics class.

My conclusion: beyond the two year horizon, the mean expectation for inflation is liable to come down. But, of course the dispersion of outcomes from the mean is huge. And that matters when rates are so low because small chafes in nominal yield create magnified gains and losses when nominal rates are low.

Given the foregoing, what investors should be concerned about then is protecting themselves from a potentially adverse outlier biflationary shock – i.e. either deflation or 4-5-6% inflation only down the line. Right now and into the forceable future, the primary worry is not inflation at all, it is financial repression and negative real interest rates. The reason gold or REITs or agricultural commodities look interesting is because cash earns nothing before inflation and loses you money after inflation. People want and need alternative asset class exposure to counteract this loss of real return. And to the degree you as an investor have nominal targets to hit because of actuarial accounting driven reasons, this is all the more reason to reach for yield outside of your traditional comfort zone. And, of course, that’s what the Fed wants you to do. My conclusion, therefore, is that alternative assets are a hedge against financial repression and not inflation.

The only inflation that should be on investors’ minds is asset price inflation because this will be the dominant type of inflation that comes from excess reserve accumulation. People will be pushed into riskier asset classes due to financial repression and this should buoy those assets artificially. The problem is that when recession hits, there will be a mean reversion and many of these assets will be revealed to be duds and sell off violently, precipitating a wave of deleveraging, disinflation and potentially deflation. In my view, this is a big missing piece that I did not hear anyone else talking about. Everyone was narrowly concerned with inflation-linked products or the potential for CPI-measured inflation down the line.

The real risk is resource misallocation from asset price inflation that is unwound down the line as malinvestment, savaging investment portfolios in the process.

P.S. – Asked for a trade of choice with a one-year time horizon, I said long US government bonds and short European and Japanese European ones. I think the US is the clean dirty shirt here, to use Bill Gross’ phrase. When the economy turns down, I expect US government bonds to outperform.