So, what is going on? Either inflation is expected to collapse, or a new order has been established – one in which investors no longer expect to generate a real rate of return from the income component of bond investing. We somehow doubt the latter based upon our contacts with investors around the world but, equally, a total collapse of inflation suggests a dramatic slump in the already feeble rates of economic growth.
The problem is that central banks have manipulated interest rates to these crazily low figures and investors have followed them down. Now they have a problem. From this level returns are going to be tiny or negative but that is not the basis on which the investment world operates. Insurance companies, pension funds, bond funds, investment managers, savers and all the rest are operating on the expectation of real returns. Budgets are prepared on the basis of real returns. Actuarial forecasts are based on the premise of real returns.
Could inflation collapse? For many years central banks and others employed the concept of the Phillips Curve to assist in inflation forecasting. In simple terms this drew a link between levels of employment and wage growth and, by implication, inflation. If this was applicable today wage growth and inflation in the advanced world should be robust as average unemployment levels are generally low.
It seems, therefore, that the link, if indeed there ever was one, has broken down. Our view is that the economic “recovery” since the global financial crisis has been tenuous – based on lashings of artificially cheap money and the forced improvement in financial markets – not the genuine private-sector return to confidence that has typified the years following recessions over the last 50 or 60 years. We have previously reported that this “recovery” has been the weakest based on all the traditional measures – GDP growth, consumption, employment, labor productivity and investment.
The last time inflation in much of the world fell below zero was during the financial crisis. Demand collapsed along with trade, employment and the financial markets. In the US the annual rate of inflation fell as low as -2.1% in 2009 before recovering as quantitative easing began to bite. The previous dip below zero was in 1955.
The relatively anemic shape of world demand and growth and, to use our term again, the tenuous nature of the recovery, suggests to us that inflation could again slip below zero. The other factor is debt. Once again, the world has far too much of it and a classic form of debt deflation could occur. Central banks will fight it tooth and nail, but they don’t have the firepower of a decade ago. Their balance sheets are now bloated, and official interest rates are already very low (negative in several countries and falling in others).
Conclusion – a bond yield of zero doesn’t look so bad if inflation is -2%, although putting your money under the mattress would yield the same return. If we were betting people, we would give this scenario a 50:50 chance over the next few years. But, by definition, that means we believe there is a 50% chance of inflation rising from current levels. Either prospect is not particularly inviting.
You may have noticed the price of gold creeping up. It is now at its highest level since 2013 (in US dollars). Gold does well in uncertain times and these times clearly qualify. We’ve always liked the fact that gold has been a constant throughout all of human history. It has been a store of value for thousands of years whilst alternatives have fallen away. Since 1800, and expressed in US dollars, gold has provided an average compound annualized real return of around 0.6% (source: The Golden Constant by Roy W. Jastram with updated data by Pyrford International). Anything that maintains its real purchasing power for more than 200 years gets a tick from us. Anecdotal evidence suggests it has probably maintained its real purchasing power since the era of the pyramids.
Modern paper currencies – fiat money – are a tiny blip in gold’s history. A recent web posting by DollarDaze.org made the following comment: “According to a study of 775 fiat currencies … there is no historical precedence for a fiat currency that has succeeded in holding its value. Twenty percent failed through hyperinflation, 21% were destroyed by war, 12% destroyed by independence, 24% were monetarily reformed, and 23% are still in circulation approaching one of the other outcomes…the average life expectancy for a fiat currency is 27 years.”
It is interesting that several central banks have been adding to their gold reserves in recent years – but none so prominent as the Russian central bank.