By Mike Aked
A future bout of inflation may prove to be the politically acceptable side effect of today’s experimental economic medicine. As investors, we should consider the opportunity provided today by declining inflation expectations to protect our investments from rising inflation down the road. Property trusts, small-cap stocks, and commodities are all very interesting investments, and domestic and emerging market value stocks are great buys.
We approach the eve of reconnecting to our former way of life, professionally and personally. We hope the resumption is smooth, and our normal spending ways return swiftly. The Australian Treasury estimates that the economy is running approximately 20% below capacity. Half of this fall-off comes from the shutdown of social activities, global trade, and school closures. The other half comes from all of us, nervous about the future, saving more by spending less.
Government support of the unemployed, or the underemployed, makes great sense. People need cash now to pay bills and buy food for themselves and their families. We learnt a century ago that capitalism’s Achilles’ heel is that precautionary savings can turn a well-intentioned action into a spiraling tragic depression. The savings paradox shows that if a large portion of the population desires to save more, the goods and services spending we forgo leads to someone losing their job. The newly unemployed cut back on spending, which leads to more job losses, and ultimately less money saved in aggregate.
Capitalism untethered can lead to socially unacceptable cycles of unemployment. As a remedy, we look to government to be the big spender in times of need. Currently, our government is expected to underpin 16.4% of Australia’s annual GDP with deposits into the bank accounts of Australians and their businesses. The size of the spend must fill the hole left by the private sector, which was caused not by our own actions, but as a means to save lives threatened by the spread of the coronavirus. The government can maintain the nominal value of output and consumption by depositing funds into our accounts, but it cannot prevent the real value of consumption from declining.
Surely, we should be able to consume more than we produce during this unprecedented crisis. But how do we do so in aggregate? We are not an agrarian economy. Eating our seed corn and prepper rations won’t substitute for today’s lost production. Nor will we be able to replace the lost output of goods and services by consuming imports from the rest of the world. All other countries’ output is falling too.
How will the government fund this extra expenditure? By issuing debt and borrowing from the future. And who will buy this new debt if interest rates stay low? The RBA will, using newly printed money! Money printing is inflationary by definition. If the central bank rapidly prints a lot more currency and immediately puts it into circulation, more money will be chasing the same amount of goods and services.
If that money printing succeeds in maintaining the nominal value of consumption spending, many more dollars will be chasing a smaller amount of goods and services. The difference—the change in prices required to match the level of expenditures—is the driver of inflation. Inflation is ultimately a political choice. History teaches us that if government sends large quantities of cash directly to people for too long, inflation is the result.
Inflation affects the value of our investments differently. Financial assets that have done so well in the last few decades, such as fixed income and the equity of large mature countries such as the United States and the larger nations in Europe, will suffer in an environment of structurally higher inflation. Alternately, investments in so-called real assets, which tend to move with long-term inflation, have been shown to perform better during periods of structurally higher prices. The current drawdown in property and commodities has opened up great buying opportunities for both direct holdings of these real assets and equity-linked investments, such as resource stocks, emerging market equities, and both local and global property trusts.
Will inflation, the dark dog of economists everywhere, visit us soon? Not as yet, because we must first pass through the current period of precautionary savings. Later, when we spend our savings in the stores, too much money will be chasing too little goods and services. Inflation will then ensue. Inflation is the accepted cost of saving lives. The current period, however, offers us an opportunity to insure our portfolios against these future inflationary pressures.
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