Believe it or not, inflation is the most important factor driving the financial markets right now, and yet there are vastly different views on what we can expect. While some investors believe that inflationary pressure will prove transient, others believe we are on the verge of a structural shift in the financial markets. I belong to the second camp. Here’s why…

For people like us who live in the developed world, inflation is not a matter of rising food prices or unaffordable basic living expenses. Rather, for us, inflation will cause a structural impact on our investment portfolio due to the shift of monetary and fiscal policies.

In my earlier article, I explained that inflation is man-made and most governments prefer moderate inflation. But sometimes, the speed of inflation can get out of control due to black swan events such as a pandemic (which we are currently going through). The central governments will then try to moderate it by changing the monetary policies such as increasing or decreasing interest rates.

History has shown us that past financial crises are often triggered when the policymakers increase or decrease interest rates too fast or too slow. Because nobody has a crystal ball and policy-making for a nation is always a reactive action and there are many external factors, moderate inflation itself becomes the biggest risk.

Why didn’t people pay attention to inflation?

I started talking about inflation when everybody was giving it a yawn at the midpoint of last year, I said two things:

  • Inflation is man-made (an open secret).
  • The only way for the economy to get out of this pandemic is through inflation.

Additional Reading: 5 ugly truths of upcoming retirement crisis and how to deal with it.

The impact of inflation on developed countries and developing countries are vastly different. For example, while there was hyperinflation occurring in many emerging market countries, the people suffered dearly from rising food prices and living expenses. On the other hand, people who lived in the US, Europe and even Singapore had no idea why they should bother about inflation.

Some people argue that the advancement of technology has helped improve productivity and reduced the costs of goods. But to a certain extent, if we look carefully at the results of past crises, inflation was “transferred” from developed countries to developing countries through capitalism.

I will mainly use US data in this article as US inflation impacts most of the world through the current Dollar system.

Think about it, if the US wants to acquire $100 worth of crude oil from the Middle East, they just have to print 100 US dollars. But for the Chinese to acquire the same barrel of oil, they need to produce some products, sell them to the US in exchange for $100 and then they can purchase the oil.

From an economic point of view, the US had no production costs, so they should not incur inflation but rather only deprecation of their currency (due to oversupply). But inflation will happen in China due to increases in production costs such as materials and labour.

Of course, this is an oversimplified example, but I hope you get the idea of it.

If you look at the chart below, US inflation dropped to 2% in the 1990s and stayed low for 3 decades. At the time, I was still a teenager, maybe you were too. So we spent all our adult life in a low inflation environment with no idea what inflation was like.

Historical US inflation rate. Source: Bloomberg

But what we do know is that the 1990s is the time when China opened their doors and became the “world factory”. If you look at the chart below, China’s inflation was hovering at 4% for the same period, which is double the US inflation rate. That is the reason why China’s property market has had a huge bull run for the past 20 years.

Historical China inflation rate.

Why should you care about inflation now?

The natural question is “Why is inflation suddenly a topic now?”

The biggest reason is because the US debt has reached 28 trillion. The original plan of “tapering” (winding down monetary stimulus program) was disrupted by the new round of quantitative easing (more monetary stimulus) last year due to the pandemic.

US government debt level

The problem is that with the rise of China, their government is unwilling to foot the bill for inflation anymore. They want to “deleverage”. If you pay attention, China is doing all she can to break the “asset bubble” to make sure they are not the nation to “save” the US from the next financial crisis.

An interesting question is, “Who else has the same appetite to stomach the humongous inflation caused by the US money printing?”

This may be hard to understand. If the US wants to continue using “printed money” to purchase goods from other countries, the other countries must continue accepting the US dollar (willingly or unwillingly). But the two biggest countries, China and Russia, have aggressively reduced their dollar reserves in the past few years. Russia even said it will completely remove dollar assets from its wealth fund.

So if you connect all these dots together, you will understand that the crazy run of Bitcoin and other cryptocurrencies this year is not a coincidence. Speculation aside, the world is trying to find an alternative system to the Dollar system. And you can be sure the developed market regulators will do all they can to destroy or delay the rise of cryptocurrency.

Additional Reading: Is Bitcoin a good long term investment.

As I said earlier, for the developed market, the issue about inflation is not food price or basic living expenses, but a structural change of the monetary and fiscal policies from the central government.

If you recall, after keeping quiet and enjoying low inflation for decades, the US announced an average inflation target last year right at the peak of the pandemic. Why?

Inflation is a way to avoid stagflation

Assume the US has to bite the bullets of inflation this time, they must avoid stagflation. In economics, stagflation is a situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high. It is a recession!

Due to the pandemic, US unemployment is still high and people are not willing to go back to work due to the social welfare they receive without working.

US Employment Rate

From a capitalist point of view, the best scenario is that you spend most of your income, borrow money, spend your future income, and then work your ass off to pay your debt. It is good for the country and keeps the economic engine running forever.

What the FED wants is controllable inflation. That is why they have a long term target inflation. You want a smooth inflation curve instead of a sharp rise or fall of the inflation rate like now. The chart below shows how the pandemic has distorted the “expected” inflation trajectory.

US Breakeven Inflation Rate (inflation expectation)

The other aspect to consider about inflation is the US debt. We all know the US has printed unprecedented money and they are the largest debtor in the world. The financial market knows they can never repay the debt and they probably never intended to. But why do people still buy US treasuries?

Because the financial market knows that debt can be “inflated” away. The real (inflation-adjusted) value becomes smaller over time. If deflation happens, the market confidence for the US to sustain its debt will be challenged.

In a nutshell, the US needs inflation to tackle its debt problem, but it is a thin line before a tighter monetary policy (raising interest rate at the wrong time) to trigger a market crash, loss of confidence and stagflation.

How does inflation affect property prices?

Inflation seems to be an economist’s coffee time topic, but the “inflation expectation” affects the asset prices.  Just a few days ago, Singapore announced another $1.1 billion Covid-19 support package. But the ironic thing is on the same day, “Pasir Ris 8”, a new launch in Pasir Ris town seems to have had a fantastic sale at a record high price ($2,000 PSF!) for the region.

Pasir Ris 8 is nearly fully sold on the first day of launch.

So in hindsight, was allowing the deferment of mortgage loans last year really necessary? Do rising property prices cause inflation or do inflation cause rising property prices?

Additional Reading: Is Singapore spending too much on national reserves?

If you read between the lines, it is no coincidence that the MAS started to talk about a wealth tax to tackle wealth inequality in Singapore.

How does inflation affect stock prices?

Inflation has complicated relationships with stocks and bonds. Last month, I talked about how asset prices react to the 3 stages of inflation. Let me recap:

  • Early and mild inflation – It is good for value and stable dividend stocks as investors will rotate out of growth stocks due to poor future valuation. Bonds will be dumped as the low yield is not able to compensate for the loss of inflation.
  • Medium-stage inflation (less than 4%) – The dividend incomes and stable returns from value stocks can no longer compensate for the loss of purchasing power due to inflation. Thus, people will look for high-quality companies which have the potential to continually grow in the long term.
  • High inflation – When inflation reaches an unbearable level, all assets will crash, companies close down, people start losing jobs. The economy enters into a recession and the financial system will be reset.

If you look at the chart above, you can see that the speed and magnitude of inflation this year has surpassed anything that has happened over the past 20 years.

Source: Bloomberg

It is my belief that inflation has reached the medium stage. Therefore, inflation is not a consequence but the cause of all the kneejerk reactions in the stock markets.

How does inflation affect bond markets?

From a policymaker point of view, smooth and gradual inflation is the best for everybody. But the market doesn’t always perform the way policymakers hope.

Inflation affects bond yield and bond yield affects every other asset. For example, the bond yield has dropped in the past 3 months and you can see that the financial stocks have performed poorly during the same period. Global bond prices rose for the same period.

But bond yield should not be lower than inflation. It doesn’t make sense. Because a bond, as an investment, must give investors’ positive real returns. If you look at the chart below, the 10-year bond yield is lower than the 10-year inflation now. It means either inflation will go up or the bond yield will come down, or both.

Bond Yield vs Inflation Expectation

Let’s think about this further. If the bond yield continues to be lower than inflation, it gives bonds little investment value, which means investors have to invest in equities, even if the valuation is high.

But the stock market is at an all-time high

So far, all the evidence points out that we should continue investing in stocks. Yet the stock markets are at an all-time high. And any honest investment professional will tell you that the US market is probably overvalued. So much so that it has surpassed both the Global Financial Crisis and the dot-com bubble era.

The only reason the market can sustain this level is because of the near-zero interest rate environment. Global investors have nowhere to put their money and are therefore “squeezed” into the stock market. So if the interest rate goes up, there will be a herding effect on bonds.

This is no secret and every investment professional knows this. That explains why the stock market is so choppy this year. It’s because everybody wants to be the first one who gets out the door when there is a fire, but the interest rate is not giving a clear signal of directions.

Let me summarize…

It is very hard for a person who spends his entire adult life in a low inflation environment to visualize what will happen when real inflation haunts us. But we can get a feel for this by studying the historical data.

Inflation is a man-made process, so it will kick in when the “man” decides it is the time.

Historical financial crises happened when the US FED raised the rate too fast or too slow and lost control of the market. If the US decides to let inflation run, they need to manage the interest rate well. It is a challenging job for them to do.

In my view, the US will eventually let inflation take off because of two reasons:

  1. to avoid an economic recession due to deflation and
  2. to ease their debt burden.

And this action will affect asset prices around the globe. If we assume this will occur, then the bubble will continue to build up. If you recall, I started the year by saying “not to avoid a bubble, but to stay sober”.

From a stock investor’s point of view, we need to be prepared that equity, especially the developed equity market, will continue attracting money flows if China is closing the door for foreign capital. However, research shows that the second year of a bull market is typically choppy. So do expect your investments to run up and down in a range over the next few months.

It will probably be a more challenging time for bond investors. I believe a traditional 60/40 global balanced portfolio will do poorly compared to a well-structured and diversified equity portfolio.

Well, this article is longer than I thought. There is just so much to discuss. To sum it all, here is what I believe:

  • The direction of inflation will impact central governments’ decision of the timing to tighten the monetary policies.
  • The stock, bond and real estate markets will “anticipate” and move before that happens.
  • Anticipation can change gear swiftly and cause knee jerk reactions in the financial markets.
  • Eventually, higher inflation and the rise of interest rates are inevitable. It is a matter of time.

What is your view? Comment with your ideas below.

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About the Author

Ivan Guan is the author of the popular book "FIRE Your Retirement". He is an independent financial adviser with more than a decade of knowledge and experience in providing financial advisory services to both individuals and businesses. He specializes in investment planning and portfolio management for early retirement. His blog provides practical financial tips, strategies and resources to help people achieve financial freedom. Follow his Telegram Channel to join the FIRE community.
The views and opinions expressed in this article are those of the author. This does not reflect the official position of any agency, organization, employer or company. Refer to full disclaimers here.

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