What does the future hold for inflation?
Since COVID-19 hit six months ago, Americans have dealt with shocks to our health care system, our economy, and our very way of life. Our government has responded with trillions of dollars of fiscal and monetary stimulus, the effects of which will likely ripple through our economy for decades to come.
The question on the minds of many investors is how these competing demand and supply shocks will influence inflation, the value of our currency and our prominence on the international stage?
Ironically, in December 2016, I posed a simple question on Twitter: “which will we reach first: Dow 20,000, or national debt of $20 trillion?” Fast forward three years, and both measures have increased by roughly 20%, with the Dow at approximately 28,000 and our national debt approaching $27 trillion.
Are we so much more in debt than we were three years ago, or have we simply failed to measure inflation accurately, such that our nominal gains far exceed the real results? What do the next three years hold?
Two primary factors influence inflation: our money supply and the velocity of money (the number of times that a dollar cycles through our economy in a given year). One might observe that while the Fed has injected substantial liquidity into the market, most consumer prices and wages have remained relatively constant. With so much money being printed, why don’t we see more substantial inflation?
The answer may lie in the declining velocity of money. The COVID-19 crisis has exacerbated this dynamic, prompting a decline in consumer spending and an increase in consumer savings, especially as jobs have gone remote, and fewer employees patronize restaurants for lunch or bars after work or engage in social activities in the evenings. With an unemployment rate that exceeds 10% and continued uncertainty regarding the path of our health crisis, many discretionary purchases have been delayed as well.
The result: a decline in the velocity of money, and with it, deflationary pressure. The governments’ response? Print more money to put more money in the hands of consumers, in hopes that it will drive demand. However, until there is an effective treatment or vaccine for COVID-19, travel and discretionary spending will remain muted.
While lower interest rates ought to prompt more capital spending, without aggregate demand, printing more money in and of itself cannot drive our economy. Instead, it will set us up for more significant inflation once consumer activity increases and the velocity of money returns to more normal levels.
What does this mean for the value of our dollar? In the near term, we can expect low inflation or potentially deflation, as our economy re-sizes itself. But when we emerge from this crisis, we’ll likely find that behind the scenes, inflation will have eroded the value of our dollar dramatically.
Who will benefit from this market dynamic? Holders of real assets, particularly those that can be leveraged with low-cost debt. If you own farmland or forest land, real estate, or other leverageable tangible assets, you can benefit from an ultra-low-cost of capital on a fixed nominal amount of debt, while the nominal value of the underlying asset increases as inflation takes root. The result: substantial value creation in the form of equity that grows as inflation shrinks the real value of liabilities and increases the nominal value of the underlying asset.
The longer the COVID-19 crisis continues to impact the United States, the more money we’ll need to print to fund stimulus packages, the longer the Fed will keep interest rates low, and the more the U.S. dollar will weaken against other currencies. This explains the significant run-up in the price of gold and the price of cryptocurrencies – both are a reflection of the rapidly declining real value of the U.S. dollar. Until we can control the spread of COVID-19, our dollar should continue to weaken.
What are ordinary investors to do? The combination of low-interest rates and the threat of significant longer-term inflation is a double-whammy, particularly for those in retirement. Inflation erodes our purchasing power, while low-interest rates meaningfully reduce the quality of life for those living on a fixed income.
At minimum, investors should seek a safe and high-yielding home for their cash so that they can do their best to keep pace with inflation. Remaining invested in equities —particularly those less sensitive to an inflationary environment — can help investors maintain exposure to rising nominal prices. Fixed income will likely remain a challenging asset class, as it’s difficult to bet against a Fed that is determined to keep rates low.