Inflating Expectations

It’s Groundhog Day again at the European Central Bank. Was it only nine months ago the ECB declared an end to its easy money policy of Quantitative Easing (QE)? Well, trade wars and a manufacturing downturn have raised the imminent spectre of German recession and forced the ECB to embark on a new round of QE purchases and even more negative interest rates. And…we haven’t even mentioned Brexit.

It all sounds so painfully Japanese and this can easily conjure up images of a lost generation of low-interest rates, large debt mountains and stubbornly low inflation. However, there is a suspicion the central banks already know this new round of QE will be as equally ineffectual as previous monetary interference. The new ingredient in the stimulus mix could be governments willing to initiate fiscal spending programmes and abandon budgetary discipline. Do we dare imagine the return of a long lost financial phenomenon which we touched upon in a previous article “Five Market Risks”? Yes, whisper it here…. Inflation could make a comeback. It’s a possibility rather than a nailed on probability but we see a number of conditions and indicators which suggest business owners and investors should have inflation on their risk radar.

We are fans of data here and financial markets are excellent real-time indicators of investor expectations. So, let’s start with gold which has traditionally been used as a hedge against the dwindling purchasing power of currency; in other words, inflation. The gold price has been hitting six-year highs in recent times which is interesting as one would have thought the collapse in interest rates and a whopping $16 trillion worth of negatively yielding bond yields would be pointing to a very subdued inflation environment. What is noteworthy is that when bonds were last seen at very negative yields in 2016 the gold price did not break out as they have on this occasion.  Note, inflation kills the value of bonds as well as the purchasing power of cash.

Another data point from industry also caught our eye. There is no doubt global manufacturing is in quasi-recession so it is somewhat surprising wage inflation in the US is now hitting a 4% cruising speed. There is a growing sense that income inequality needs to be urgently addressed as the rise of nationalist populist politics reflects restless electorates being “left behind” by technology, asset inflation and urbanization. Wage inflation can be expected to pick up as the 1% try to quell a political backlash.

A less constructive type of inflation can also be expected to raise its profile. Supply chain management and global trade has been the driver of the global economy for decades but messy trade wars and Brexit will introduce new costs into global logistics. These costs will inevitably be put through to consumers/customers and drive inflation statistics.

A more difficult data point to quantify at this point is the effect of potential fiscal stimulus by governments in dealing with a slower economic cycle. Arguably, the US with its ballooning budget deficit and the UK in Boris-electioneering mode have already embarked on a “bread and circuses” campaign which even Caligula would appreciate. All that’s missing in these campaigns is horses being appointed to senate and cabinet positions, albeit this can’t be ruled out just yet. For a bit of Teutonic sanity and the critical piece in the fiscal pie the world waits for Germany to finally spend. Early soundings from Berlin are encouraging and lead us to our final indicator of  ‘something different this time’.

As the ECB confirms further cuts in interest rates one would expect European bank share prices to be on a firm downward trajectory this week. We couldn’t be more wrong. The European banks’ index is up almost 10% in September! That is noteworthy and like the gold price was not the experience in 2016 when global interest rates were plunging. The most dangerous words in the investment lexicon are “this time it’s different” and this writer has no doubt central banks acting with monetary policy alone will confirm Einstein’s theory on repetition and insanity. However, governmental interference for good(fiscal stimulus) and bad(trade wars) could change the outcome this time. Gold and bank share prices are already behaving differently but it will take time for political and trade mists to lift and reveal the new world order and change expectations.

“We changed again, and yet again, and it was now too late and too far to go back, and I went on. And the mists had all solemnly risen now, and the world lay spread before me.” ― Charles Dickens, Great Expectations


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