If you are a retiree or planning for retirement, you need to understand inflation. And if you are wondering what will drive the direction of the stock market in the near future, it is not the historical high of the Nasdaq stock index or a new vaccine, it will be the “average inflation targeting”.
Inflation is a “taboo” word for all governments. Inflation kills purchasing power and creates unhappiness among citizens. Yet, every government knows that they need inflation because inflation is a wealth transfer process. It is used to “tax” the working class and legally write-off the liabilities of the capitalists at the expense of the regular savers.
Most developed countries have a “target inflation rate”. For example, both the Bank of England and the US Fed are required to keep the rate of inflation at 2% per year. In Singapore, MAS says that they do not have an explicit inflation target. Nevertheless, MAS concludes that “on average, a core inflation rate of just under 2%, which is close to its historical mean, is consistent with overall price stability in the economy”.
So why do the central banks want to maintain inflation when it is detrimental to the average man’s wealth? How does the US’s new announcement at the Jackson Hole symposium change the inflation regime? How will inflation affect the stock market and your personal wealth?
In this article, I will dive deeper into these topics.
Why inflation exists?
Last week, the world was eagerly waiting for the US Fed Jerome Powell’s speech at the Jackson Hole economic policy symposium (Aug. 27-28, 2020). Although the US’s monetary policy is for their own country, the financial markets know that it will inevitably affect the entire capitalist world’s monetary response in this post-pandemic period.
If you are curious about why central banks are more interested in boosting inflation instead of the welfare of its citizens, you need to understand a bit of history. Inflation is a process to redistribute wealth. It is a battle between the borrowers (the capitalists) and the savers (the labourers) and labourers have always been the losers in recent history.
Just look at what is happening now. After the initial stock market crash amidst the pandemic, the global stock market has made a swift recovery. The shareholders of the companies are making more money than ever, but at the same time, many workers are losing their jobs or having a pay cut.
That is why I wrote this article in April and I encouraged you to focus on wealth redistribution instead of keeping cash:
A recession need not be scary. You can think about it as wealth redistribution and a system cleansing process. It may make the road bumpy, but it also gives you a once in a decade opportunity to boost your wealth if you are clear about your direction and handle it correctly. – Ivan Guan
Why don’t you feel the impact of inflation?
While we all talk about how things are getting expensive, it doesn’t feel like inflation is getting out of hand, does it? The fact is that we have enjoyed not only a prolonged period of low inflation but actually a deflationary period as well. That is because the developed countries like the US and Singapore were able to “export” the inflation pressure to the emerging markets through globalization.
The $20 T-shirt you bought only cost $3.15 to produce in China, while the $150,000 car you drive cost only $20k to $30K when they are driven out of the factory.
Thanks to globalization, we enjoy the best products of the world at a fraction of what it cost 100 years ago; and we can pay $10 to watch a movie that is beyond the imagination of the richest pharaoh in history.
But in a post-pandemic and de-globalized world, everything is going to change. This may be hard to imagine. Think about it, Singapore does not have any phone manufacturer, but you can freely choose your phone from Samsung, Apple and Huawei and they compete with each other fiercely. What if you suddenly can’t buy Huawei or Samsung anymore because it contains “US technology” and “violates US national security law”, and you can only choose an iPhone or some other inferior products? What do you think will happen to the iPhone’s price?
We used to think that money can buy everything. This pandemic teaches us a lesson that even our food supply is in danger when the world shuts its door.
What is Average Inflation Targeting?
If you look back a bit further, the inflation rate was not always so low. The most recent high inflation happened in the 1970s when the US dollar lost its peg to gold after the collapse of the Bretton Woods System. People started to lose confidence in the US dollar and the US inflation rate shot up to double-digits every year. The effect of inflation quickly spread around the world.
In the 1980s, global central banks were eager to bring down inflation and so they decided that a clear and well-defined objective was easier to follow. The Fed set an internal consensus of 2% inflation, and this number was made official in 2012.
So you see, the average inflation target was not created to increase inflation, but instead was implemented to reduce it. What was amazing was that this target was never changed over the past 40 years because the US was able to maintain such low inflation for four decades.
Not so lucky for Singapore. There were two periods where Singapore’s inflation was out of control due to the sharp increase in property prices. That is why the Singapore government issued 7 rounds of cooling measures to control the property market.
What made low inflation possible?
Singapore has enjoyed low inflation due to a stable and relatively strong Singapore dollar in the region so that we can buy materials and employ foreign labourers at much lower costs in Singapore dollar terms. Have you ever wondered why the world was willing to accept the Singapore dollar? It was because Singapore had such a good reputation and gave foreign investors confidence. Singapore does borrow but the debt is used to invest instead of funding government spending. If one day, people start to question the government’s ability to pay off her debt, the currency will have a free fall.
When a currency devaluates, inflation kicks in, huge inflation. An extreme example is Argentina. The country has defaulted on their debts 9 times in history and has consequently seen their inflation skyrocket. Their 2019 inflation alone was 53.55%!
The interesting case is that the US has borrowed the most debt in the world and everybody knows that they don’t have any intention to pay it back and yet they had difficulty meeting their 2% inflation target.
The dollar dominance played an important role in the past to keep the inflation low. The gradual depreciation of the US dollar and an increase in inflation go hand in hand but they are not out of control. Today, the technology penetration, military intervention and petrol dollar made the US dollar an irreplaceable currency, yet.
In its simplified form, when you can borrow from another country and devalue what you owe to your creditor, you can write off your debt without paying. And you can use the money created through borrowing to exchange for labour and resources from other countries, so you can pass the pressure of wage increment and rising material costs to other countries.
How long can low inflation last?
If there was no pandemic and no unlimited quantitative easing, things may have continued. But the Fed’s latest announcement has painted a clearer picture for the future. They can’t keep inflation low any more.
From the US point of view, they have two important mandates to achieve:
- A controllable inflation rate and
- Maximum employment
There is a basic economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that after economic growth comes inflation, which in turn should lead to more jobs and less unemployment.
As I mentioned earlier, high inflation will increase the cost of living for the citizens which is detrimental from a political point of view.
So if you are the chairman of the Fed, you have to take care of both sides.
We all know that the pandemic has caused a very high rate of unemployment in the US. It becomes clear that the Fed has put reducing the unemployment rate as a higher priority now.
It means that the Fed is trying to move from point A to point B on the Phillip Curve diagram above, at the expense of higher inflation.
Earlier on we said that the Fed had a 2% inflation target. This meant that if the inflation rate was higher than 2%, they had to adjust the policy and take it back to 2%. But the reality is that with such big unemployment numbers, a 2% inflation rate is not going to be enough.
So the trick here, as Powell announced, was that they are going to make 2% a “long term average”. In that case, it means that the Fed can target much higher inflation, say 5%, in the short run.
In another word, the US is preparing to “tolerate” higher inflation in exchange for a lower unemployment rate. And this will change everything that was a consensus, written or unwritten, in the past decades.
Why will Asia be hit the most by US inflation?
In my earlier article, I explained that the US currency and interest rate policy has a direct impact on Singapore. If you are paying a mortgage loan, you will realize that your loan repayment has dropped a lot lately. That is because since the US cut its interest rate aggressively, Singapore’s lending rate SIBOR has crashed correspondingly.
Have you ever wondered why the EURO was born? Because the European countries wanted to get out of the dollar system and prevent such things from happening to them.
In the past decade, the world has been busy with “de-dollarization”. But Singapore, which has to keep an open economy, has little choice. Singapore and many other Asia countries have high US dollar reserves. It means that we are vulnerable to the US’s internal monetary policy. The countries that will be most affected are the countries that have the highest US dollar reserves.
You can see from the chart below that Asia Pacific countries have much higher foreign currency reserves than other parts of the world.
From the US perspective, they do what they need to do. But Asia will quickly feel the impact when the US inflation kicks off.
How does inflation affect the stock market?
You may ask, is inflation good or bad for the stock market? Well, it is very hard to say at this time. The wild card is the interest rate. Finance 101 tells you that the interest rate affects everything, from stock prices to bond prices, from commodity futures to inflation rates.
Basic macroeconomics tells us that high inflation is supposed to lead to a high-interest rate. This is because the central banks tend to raise the interest rate to adjust the money supply in order to control inflation. The interest rate will also affect how stocks are valued as you need to discount future earnings to the present value as shown by the interest rate.
But this time, something is very “fishy” because the Fed has signaled that they are intending to keep the interest rate “lower for even longer”. So we have an unprecedented situation:
- Expected high inflation
- Expected low-interest rate
- Continued historical high valuation for growth stocks (such as technology stocks)
- Sluggish valuation for value stocks and income stocks such as high dividend stocks and REITs
- Looming economic growth due to the pandemic
Will high inflation leads to high-interest rates? Or will low-interest-rates keep the inflation low?
If it is the first scenario, the asset price will collapse due to the high discount rate (I will talk about the impact of the “discount rate” in the future). If it is the second scenario, the Fed will fail to achieve the inflation target. It means that the consumer will have no confidence in spending and the economy will stay sluggish.
Can the Fed achieve its inflation target? This reminds me that in 2013, the Bank of Japan announced its ambitious plan to target 2% inflation. Back then in 2013, I have already expressed my low confidence in Japan achieving its inflation target.
After more than 7 years, Shinzo Abe’s stepped down draws to a close with Japan’s economy right back at square one. Japan’s inflation stays at zero today.
But one thing is for sure, bond prices are going to suffer. Investors of traditional low risk fixed income investments are going to suffer. You need to be aware that the largest investors of fixed income are not just the ordinary retail investors, but your insurance companies and pension funds as well. That is why I believe it will have a structural impact on our CPF interest rate and insurer’s future bonuses.
Let me summarize…
Most people have vague ideas of the word “inflation”, but few understand the real causes and implications. We were taught that inflation is a norm of life; but, in reality, it is a wealth re-distribution process.
People who live in the developed world have enjoyed a long period of low inflation, but it doesn’t mean that we can have such privilege forever.
Inflation was supposed to catch up at some point in our retirement life, but de-globalization and the global shutdown due to the COVID-19 pandemic have just accelerated it.
Inflation is not an issue in and of itself. For example, if you have a 3% inflation rate in your country but you earn 2% interest on your savings account, the net effect is still manageable. But inflation will become a nightmare if the return on your savings is not able to keep up. You need to re-evaluate your investment portfolio and see if it is inflation proof.
Lastly, I want to caution you that you need to be wary of herd opinions and interpretation of market information at face value. People tend to repeat what they hear without first verifying it or knowing if they have repeated it correctly.
Recently I heard a lot of people recommending buying gold to “combat inflation” because the dollar is going to devalue. While I did caution the dollar to debase since June, I also highlighted the danger of investing in gold in early August. Refer to the chart below.
Additional Reading: 5 ugly truth of the coming retirement crisis and how to deal with it.
Additional Reading: Gold price surging: is it too late to buy gold now.
The shorting dollar trade has become too obvious and overcrowded and the risk is enormous. The US will not give up their dollar domination so easily and there is no such easy money to make if you are betting the collapse of the dollar system.
If you are an investor, you need to ask yourself these questions:
- Is the recent market rally a stock price rally or stock currency devaluation rally?
- Is it possible that the Fed raises its interest rate unexpectedly sometime in the future?
- Will Trump allow inflation to happen just before his election?
- If inflation does happen, what will be the new investment risks and opportunities?
- Which sectors are the winners and losers of inflation?
Your answers to these questions will determine how you invest. I am happy to discuss these questions with you if you leave a comment.
As you may know that I help my clients review and manage their investment portfolios. If you want to request an investment discovery meeting to discuss your personal portfolio, please submit a request using the form below.
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