Is reflation just a matter of time?
Over the last six months, investors have become more amenable to inflationary arguments or what is being referred to as the reflation trade. This in essence is the growing belief that short term interest rates are unlikely to go lower from current settings; and these enormous fiscal measures being implemented across the globe will finally result in wage cost pressures as one measure; and catapult us out of an environment of persistently low inflation that we have been in mired in for the past decade.
Now we could have a whole other argument on how inflation is being measured; and we would only need to look at asset price appreciation in the past 10 years to make a formidable argument that economists traditional measures of inflation are flawed; and have failed to recognise where inflation has ultimately surfaced, but that is for another discussion.
This mounting expectation of a higher cost of capital and inflation are shifting consensus from bonds to equities and from growth to value. A battle of investment styles if you like, but do we agree?
In New Zealand, longer dated interest rate markets have moved significantly higher in yield. Our 10yr Government bonds traded down to a level of ~0.45% at the end of September 2020 but at the time of writing now currently sit at a yield of ~1.33%. Now some of this move can be described as normalisation, whereby interest rate levels are too low in a post pandemic world and this is an appropriate adjustment back, but the momentum is still higher as interest rate curves in other developed markets continue to steepen.
However, there is a huge difference between permanent and temporary policies and between ad hoc fiscal pulses, and monetary policy. Monetary policies are flexible with limited supervision while fiscal policies are rigid, with razor sharp focus on every dollar, limited time horizon and the need for legislative approvals and supervision. Hence, fiscal policies are much harder to implement and maintain.
Furthermore, if technology and advancement as a thematic were strong deflationary pressures pre-Covid-19, why is this less so post Covid-19? Whist some form of reflation and normalisation makes perfect sense to me, this idea of rampant inflation on the back of fiscal stimulus in a post pandemic world still feels more hopeful than likely.
There is a school of thought that forecasting inflation is pointless as it is just as likely to develop from a not yet known source, equity and bond markets will be hoping this is not any time soon.