- Economists and market participants have debated for several months whether inflation or deflation is more likely in the aftermath of massive government stimulus and the great recession.
- A surge in the monetary base, combined with a rise in raw material costs are, historically, early indicators of higher inflation levels; high unemployment, limited pricing power and declining unit labor costs are consistent with a deflationary environment.
- We, however, do not see any significant risk of inflation for the next 18-24 months; pricing power is muted, excess capacity remains and unit labor costs show no signs of rising
The current economic environment juxtaposes two starkly contrasting themes. Consistent with inflation, debts are heavy, deficits are large, the monetary base has expanded rapidly, the strong growth in the developing economies has fueled a rise in raw material costs, and finished goods producer price inflation on a year-over-year basis has accelerated. Consistent with deflation, unemployment is high, capacity utilization is low, pricing power has been limited, housing inventories are heavy, unit labor costs are declining, productivity is strong, the core inflation readings are decelerating, and the velocity of money has remained subdued.
Most data points to muted inflation. Most recently, the consumer price index fell 0.1 percent in April. This tempered the year-over-year gain in consumer prices to 2.2 percent, from a recent high of 2.7 percent in December 2009 and represents a significantly moderation from the 5.5 percent year-over-year increase in the producer price index. Core consumer inflation posted its second consecutive unchanged monthly reading in April. This, in turn, lowered the yearly gain in core consumer prices to just 0.9 percent, its smallest increase in over four decades, dating back to January 1966. The modest consumer inflation readings, combined with a drop in input costs and signs of continued excess capacity in several components of the U.S. economy, suggest that fears of building prices pressures and a structural acceleration in inflation in the U.S. are very premature. We continue to see signs of disinflation over the near term and expect that the excess capacity for labor and production, combined with the surge in productivity and the associated drop in unit labor costs will keep inflation low in the U.S. over the near term.
Fiscal policy, debts and deficits
High government debt levels are problematic for sovereign debt investors, with the current challenges in Greece and southern Europe representing a real time example. Emerging economies have often defaulted at relatively modest debt to GDP ratios. Part of this reflects institutional weaknesses such as poor tax collection ability. Russia (1998) and Argentina (2001) defaulted with debt to GDP ratios at 27 percent and 30 percent, each. Today many European countries have much higher debt to GDP ratios, raising concerns about developed country default and even the durability of the euro. The most extreme case, Greece at 115 percent government debt to GDP, has been the epicenter of the debt challenges this year. Moreover, in some countries, the challenge is not about the amount of public debt, but instead is centered at the amount of private debt. Total debt – public and private – in Spain, for example is approaching 180 percent of real GDP.
Excess capacity—May serve to keep inflation in check near term
The great recession of 2008 and the first half of 2009 helped to create excess capacity in the U.S. economy that at this juncture should continue to offer inflation-reduction benefits. Many developed economies witnessed about a 3.5 percentage point increase in their unemployment rates during the recession. In contrast, the unemployment rate in the U.S. spiked by 5.7 percentage points from May 2007 to its 10.1 percent peak in October 2009. The decline in U.S. economic activity sparked more aggressive action by U.S. companies to shed workers than in the rest of the world. However, this action may now be producing a positive side benefit. The sharp drop in employment in the U.S. during the recession was a sign of a more flexible labor market. Firms were able to shed workers, preserve profits and workers were driven to find employment in more productive sectors of the economy. The reserve army of unemployed people is likely to keep a lid on wages for many years as the excess capacity of labor in the U.S. was more than 10 million people at the start of 2010. The sharp drop in U.S. employment in late 2008 and early 2009 was also a major factor that helped sow the seeds to a turnaround in corporate productivity, a greater reduction in unit labor costs, and a faster rebound in both corporate profits and the overall U.S. economic activity.
The Productivity Surge Further Tempers Inflation Risks
Name something uniquely positive to the U.S. that has helped to keep inflation here under
control? It is the surge in productivity and the associated reduction in unit labor costs. We have just completed the strongest annual improvement in productivity since 1962 as witnessed by the 6.3 percent gain in nonfarm productivity in the year ended March 2010. And at the same time, unit labor costs have been reduced (-3.7 percent in the year ended March 2010) by a combination of wage cost controls and strong productivity gains. These two factors have been a driving force behind the sharp rebound in corporate profits and may help U.S. companies weather the storm of the debt challenges in Europe.
On the production front, the need to meet the expanding demand for U.S. products in the emerging economies, combined with the drive to replenish depleted inventory positions, has lead to a sharp rebound in industrial production, which in many cases has lowered the marginal cost of production for companies as plants are now able to operate more efficiently at slight higher output levels. This, in turn, may also help to keep domestic inflation under control over the near term.
Implications for Investment Strategy
The debt crisis in Europe will slow global economic growth and, combined with the gulf oil spill, could slow the rate of economic recovery in the U.S. for the balance of 2010 and into 2011. This, in turn, will likely give the deflation story some legs over the near term and argues for continued low interest rates and a focus on taking stock specific risk, e.g., a mid-sized company whose earnings are not dependent on a strong global economic recovery.
Longer term, the very tall wall of sovereign debt, including the UK and our own U.S. Treasuries, which need to be refinanced, increases the risk of rising interest rates – necessary to clear the market – and a devalued currency. Both reduce purchasing power, increase the risk of inflation and argue for investors maintaining some form of hedge to protect their portfolios against this possibility.
Statements concerning Commonfund Group’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group’s policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information.