Mackenzie Bluewater Team
Inflation or deflation?
Global inflation, particularly in developed countries, has been low for an extended period of time despite massive and extraordinary central bank intervention. Since inflation is both one of the most important factors in determining asset values (stocks, bonds, real estate) and an important factor in how certain industries perform, it is an economic variable that we pay attention to. In our view, over the past couple of years there has been pronounced differences in performance between inflation and deflation linked stocks and sectors, which has increased the importance of understanding inflation.
When thinking about the causes of inflation it is helpful to split the economy into monetary and physical (demand and supply) components. We’ll start by focusing on the monetary side of the equation. Often monetary policy is viewed as the key determinant of longer term inflation rates. This view generally comes from fairly simple models of the economy and the clearly correct view that if all else is held constant, a significant increase in the amount of money in the economy should drive prices up. Trivially, if we assume that the number of dollars everyone has doubles tomorrow (say every dollar is split into two and everyone is paid twice as much), then prices should also rapidly double, offsetting the increase. This suggests that inflation should be fairly simple for central banks to control; if they want higher inflation they simply need to increase the supply of money. The problem with this story is that the amount of money in the economy, and the level of demand for money, is heavily influenced by the broader financial system, not just central bank policies.
Think about how much money you can access at any point in time. It’s driven by far more than central bank decisions. The value of your assets and the willingness of lenders to provide financing (“tightness of lending”) is likely a greater determinant. One of the challenges central banks have faced since the global financial crisis, particularly in the United States, is that consumers and banks were repairing their balance sheets and were less willing and able to borrow and lend. This reduced the effectiveness of monetary policy relative to central bank forecasts.
There is also a physical aspect to inflation, which is often missing in simple economic models. Most episodes of severe inflation are touched off by a change on the supply side of the economy. Events like wars and natural disasters have often led to price spikes as the demand for goods abruptly exceeds the reduced capacity of the economy. More recently, we suspect that the supply side has been working in the opposite direction and pushing prices down. Post the global financial crisis, there was considerable excess capacity globally as companies had planned for higher levels of demand. Additionally, technological change (for example, the impact of Amazon.com on retail prices and the impact of Netflix and Google on media) has created deflationary pressures as has the recent fall in energy prices.
In order to forecast inflation, we would need to correctly forecast the relative strength of the monetary and physical sides of the economy, which in our minds is too complex to model. As a result, rather than forecasting, we rely on our companies to tell us what is happening with pricing and costs in their businesses. In addition we monitor wage inflation as we believe that sustainable inflation is very difficult to achieve if incomes are not rising, as consumers will be unable to pay higher prices. To date, we have not seen a meaningful acceleration in inflation in developed markets.
What about asset inflation?
There is a fairly common story in the investment world that, rather than showing up in official measures of inflation, such as the consumer price index (CPI), inflation has instead been visible in asset prices. In Canada, there has been a large move upwards in housing prices (in Toronto and Vancouver, in particular) that has coincided with ultra-low interest rates. Stock market prices globally have also been strong recently, although a portion of the move has been a recovery from the lows of the financial crisis. For example, the broad market S&P 500 (total return) index is up close to 15% a year over the past 5 years, but is up 7-8% a year over the past 10, 15, and 20 years.
Clearly, a portion of the increase in asset prices can be explained by the decline in inflation itself, which is an important component of lower interest rates. As anyone who has taken out a mortgage knows, lower rates mean that you can borrow more money with the same payment, which naturally puts upwards pressure on housing prices. The same is true in the stock market, which over the past 100 years has been more expensive in low inflation environments and cheaper in higher inflation environments. Again this likely comes down to the impact of interest rates. When a GIC is yielding 1% instead of 10%, investors will pay more for stocks and stock dividends. Regardless of whether asset price moves are fully or only partially a response to low inflation, it seems reasonable to assume that rising inflation will put downward pressure on asset prices.
From a sector and style perspective, the sector that we believe is most positively linked to rising inflation is financials. A higher and steeper yield curve should relieve net interest margin pressure for banks and provide higher investment returns for insurers, leading to potentially substantially higher earnings. In a low-inflation or mild deflation scenario, the technology sector will likely be the biggest beneficiary as technology businesses do not tend to rely on price increases. If anything, many technology businesses are actively attempting to disrupt pricing in their respective industries through innovation. At this point we continue to emphasize technology companies versus traditional financial companies, as they do not require a change in inflation backdrop to increase their growth rates.
There is an additional element to the inflation story that is worth being aware of. When we look at economic data over the past decade, there is a striking gap between the inflation rate of goods, which is near zero, and that of services which has been running at around 2-3%. We have been favoring service companies for an extended period, particularly in our non-Canadian investments. In an economy where GDP is growing around 3-4%, it is far easier for companies to grow at rates in excess of GDP when they are enjoying a mild pricing tailwind. With the rise of outsourcing, goods tend to be produced globally while services tend to remain more local in nature. We suspect that this provides more opportunity for pricing power in services as it limits competition.
In terms of valuations, we believe there is fairly compelling historical evidence that periods of low inflation have led to higher valuations. The sustainability of those valuations, in our view, is likely tied to the sustainability of the low inflation environment. If inflation begins to creep upwards, we expect that equity market valuations will come under pressure and we will work to address that risk in our funds. At this point, despite the upwards drift in market valuations we remain fully invested.
From a medium term perspective, we suspect that any significant increase in inflation risks will quickly be choked off by central banks. Despite fairly anemic global growth and weak current inflation, central banks globally, led by the US Federal Reserve, have already begun to tighten credit conditions. Given that debt levels remain elevated globally, we suspect that the economy is more sensitive to higher interest rates than in the past and that a sustained tightening cycle will slow growth and inflation, potentially tipping the global economy back into recession.
As always we continue to invest in businesses that are leaders in their respective niches, with superior free cash flow generation, strong balance sheets and the capacity to weather difficult economic environments. We have invested through many different cycles and environments in the past and continue to believe that companies with these characteristics, bought at sensible prices, will outperform over time.