sign in sign up
<<
Home , Deflation, Disinflation, Financial crisis, Inflation, Recession, Stagflation

Coronavirus : ,June 2020 or ?

FQ Perspective

ED PETERS Partner,

Executive Summary • What will be the outcome of massive monetary and to combat the Coronavirus Crisis in the term? • Looking through the Keynesian lens of growth and inflation there are four scenarios: ○ : Low growth and low inflation/deflation ○ “Goldilocks” expansion: High growth and low inflation ○ Bubble expansion: High growth and high inflation ○ Stagflation: Low growth and high inflation • Each scenario has different implications • Since we have not had high inflation for 30 years, most investors have not experienced those environments • Stagflation is particularly difficult for bonds which become a different class • This article describes the environment under each scenario and its investment implications

The global has produced a large question mark about the future. But the unprecedented amount of fiscal and monetary stimulus by central banks and governments has added an additional layer of to the mix. While it is clear that significant stimulus was needed to avert a catastrophe, it is not clear what the long-term cost will be for such a massive response.

Many are looking to history and arguing that Depression, pointing to the recent collapse of oil this level of monetary stimulus will inevitably lead as evidence. This is also concerning, as deflation to massive inflation, with the most pessimistic typically accompanies low or negative growth. And invoking Weimar Germany of the 1920s. In this still others are warning about the resurgence of

FQ PERSPECTIVE FQ kind of environment, growth tends to accompany stagflation. Stagflation environments feature both 1 inflation, but that growth is negative on a real low growth and high , as exemplified by the basis. Others are proclaiming that the drop in US of the late and early 1980s. from shutting down the economy could All of the above analyses are attempting to cause deflation on the level of the 1930s Great forecast the overall economic climate, but few are

Past performance is no guarantee of future results. Potential for is accompanied by possibility of loss. FIRSTQUADRANT.COM 2 FQ PERSPECTIVE FIRSTQUADRANT.COM achieved “softlanding”thatrelieves inflationary can have themuch-sought-after-but-rarely- borrowing costs. If it does so early enough we typically steps into slow theeconomy byraising demand higherwages.TheCentral Bank maintain profits. Higherprices make workers costs for producers whointurnincrease prices falls. Workers demandhigherwagesincreasing expansion. As demand increases worlds: robust real growth or a “Goldilocks” inflation remains low, we have thebest ofall by inflation.Ifnominalgrowth isstrong and Quadrant 1where we have growth accompanied would beginourstory duringtheexpansion in from low to high. understanding thatinreality there isacontinuum 2x2 matrix(Figure 01)to illustrate thepoint, we can simplify the framework using a basic inflation donotmove discretely from low to high, growth and inflation. 1936) isanchored intherelationship between Classic Keynesian theory(Keynes Growth/Inflation Scenarios developing anallocation planfor eachscenario. different asset classes across environments, and now to understand theexpected of favors theprepared, itisworth taking thetime experiencing withmore thanone.Since fortune are allthree scenarios plausible, we mayendup market reactions, andinturn,.Notonly three scenarios has different implications for depending onwhere we land.Eachofthese exploring how you should adjust your allocations FQ Perspective: Coronavirus Crisis:Deflation,Inflationor Stagflation? boom/bust transition (Quadrant 4). These simple heated, giving birth to a bubble and a classic rises quickly. Theeconomy becomes over- However, if the is too timid inflation significant, we refer to the period as a depression. and low inflation(Quadrant 2).Ifthe contraction is economy slidesinto recession andQuadrant 2. the central bankstighten for too long andthe staying inQuadrant 1for along time.More often pressures withoutcausing arecession and so In aclassic Keynesian business cycle we In arecession, we have low ornegative growth Risk F 1 Even though growth and actor s examples illustrate how, for the most part, we into depression settingthestage for areturn stimulus willkeep theeconomy from sliding lock-down ends.Aggressive fiscal andmonetary will return mostly to normalonce thepandemic least over thenext couple ofyears. scenario appears to be the least plausible, at perhaps higherinflation.Butunfortunately, this we willreturn to thatstate ofsteady growth with believe thatonce theglobal economy reopens, positive, withstubbornly low inflation.Optimists Quadrant 1.Untilrecently, growth wasmostly Great FinancialCrisisinamoderate version of We have spentmuchofthetimesince the Quadrant 1:HighGrowth/Low Inflation this timearound. long wayfrom Quadrant 4,sowe’ll skipthatone 45 years. Inthecurrent environment, we’re a that thissimple flow doesnot represent thelast the implication for markets. We willalsosee could lead to Quadrants 1,2,and3,aswell as stagflation adistinct possibility. a special,rare case butcircumstances now make Quadrant 4.Quadrant 3,stagflation, is considered Quadrants 1 and 2, with occasional forays into spend thebusiness cycle circulating through GROWTH CYCLE FIGURE 01 -THEINFLATION/ The optimistic outlook assumes thatthings Below, we’ll explore theconditions that Inflation ig o Stagflation e o es 3 2

sion Gr owth oomu oi ansion ig 4 1

os e 3 FQ PERSPECTIVE FIRSTQUADRANT.COM We are likely inQuadrant 2asofthiswriting,in Quadrant 2:Low Growth/Low Inflation years. Thatwould benice, butitisunlikely. would gobackto theenvironment ofthelast 10 this scenario were to actually occur, investments inflation maynotbeseenagain for sometime.If later, buttheolddaysofsteady growth andlow from asupply/demand scenario we’ll describe another unlikely scenario. Inflationisplausible levels creating higher and higher prices, also arrive ifunemployment goesbackto low to little effect for almost 20years. Inflation could been usingmonetary policyto stimulate inflation Global FinancialCrisiswithoutinflation. Japanhas since we hadmassive monetary stimulus after the inflation (such as Friedman 1970) also fall flat, print more . theoriesof Germany, moderngovernments don’tactually stimulus could cause inflation,butunlike Weimar likely notoccur untilmidto late 2021.Monetary a return to pre-COVID 19 conditions would still create a“U”shapedrecovery withoutavaccine, measures oreffective treatments would help the global population. it would take for anddistribution to pushing recovery well into 2021 given the time development of a vaccine could occur in late 2020 disease. Most experts acknowledge thatatbest an effective vaccine thatmostly eradicates the from COVID-19. Suchconditions would require resume theiroldlives withlittle riskofinfection population would have to beconfident they can to normalcy. For that to happen, though, the FQ Perspective: Coronavirus Crisis:Deflation,Inflationor Stagflation? growth isaplausible near-term scenario. With no longer acommon occurrence. deflation, where prices and asset values fall, is bouts ofdisinflation(slowing inflation),butactual on asignificant scale since the1930s. We’ve had developed world hasnotexperienced deflation deflation would be considered a depression. The inflation andgrowth go? Very negative growth and growth isundoubtedly negative, how low will the midst ofasignificant recession. Butwhile While widespread useofpreventative However, deflationaccompanied bylow earnings willsoonberebounding aswell, butwe markets have been rebounding, optimistic that mostly inastagnant environment. in sporadic higherprices, butotherwise,we’re far, ofcertain foods have resulted out, atleast inthenext year to 18months.So we can expect thisscenario to continue playing are theconditions atthetimeofthiswriting, unemployment risesto highlevels. Since these consumer goodsislow, andwillremain soas declined withproduction andtravel. Demandfor scenarios. Industrial prices have also fallen to levels associated with deflationary Both -andlong-term rates have and services have dropped dramatically. re-opening), availability and demand for many inlock-down (even withsometentative other direction. Sohighinflationand low growth other hand, saps demandand sends prices in the inflationary spiral. Highunemployment, onthe workers to demand higher wages, creating an raise prices to improve profits, which causes are higher, squeezingprofit margins. Producers because theprimarycost ofproduction, wages, demand and in turn, prices. Prices can alsorise unemployment drives up wages, whichdrives up Growth leads to low unemployment. Low inflation isaproduct ofan over-heated economy. considered impossible. InKeynesian economics, “stagflation” was coined for this state. low but inflation is high. In the 1970s, the term to Quadrant 3,where growth anddemandremain A dangerous andsoberingpath would beamove Quadrant 3:Low Growth/High Inflation growth. Maybenotthistime. expect to gobackto Quadrant 1andresume follow therecession? Historically, we would only source ofsignificant returns. Butwhatwill investing, andtactical strategies are likely the to riskassets, active management,alternative though current yieldsare meager. Whenitcomes are the primary source of deflationary hedging, expect disappointmentto follow. Sovereign bonds Real will continue to dopoorly. Equity Prior to thatdecade, stagflation was 4 FQ PERSPECTIVE FIRSTQUADRANT.COM demand doesnotincrease substantially. Of businesses to stay profitable, even ifaggregate customers, prices willhave to riseinorder for store. With these restrictions on the supply of limit onthenumberofcustomers they have ina pre-crisis. stores mayhave to imposea fraction of the customers they were able to serve Restaurants willonly beable to accommodate a airplanes willhave to fly withfewer people. risk of infection. In order to keep people safer, imposed bytheneedto continue reducing the remains high.Instead, supply restrictions willbe the recovery islong andslow andunemployment the demandwillnotbeenoughto raise prices if as parts of the economy begin to re-open, but discussed. Thosepressures willabate somewhat caused thedeflationaryscenario hasalready been have adifferent origin.Thedrop in demandthat will, butitwasultimately effective. recession. Suchanactiontook significant political very highlevels andpurposely inducingasevere the inflationary spiral by raising interest rates to on. TheFed underChairmanPaul Volker broke followed bydemandsfor higherwages,andso with inflation,leading to even higherprices, ensued asemployers raised wagesto keep pace costs andreducing demand.Aninflationaryspiral ofoil.Thishadthedualimpactincreasing Arab Oil Embargo that dramatically increased the reasons. The1970sstagflation was caused bythe it happenagain? in the1970sstagflation happenedanyway. Could were mutually exclusive inclassical thinking.Yet, FQ Perspective: Coronavirus Crisis:Deflation,Inflationor Stagflation? years. , bondsand would environment we have notseeninalmost 40 a stagflation scenario to create amarket a drastic measure thistimearound. spiral, even ifthepolitical willexists to take such inducing arecession would endtheinflationary returns. In this scenario, it is not clear that growth alongside higher prices. Stagflation demand, as well, resulting in continued sluggish course thehigherprices maycontinue to depress COVID-19 stagflation, ifitoccurs, willlikely The answer isyes, butlikely notfor thesame We expect theinvestment climate in have different causality thanapotential 2021 blueprint. Aswe said,the1970sstagflation will definitions. Plus,history isonly aguide,not a subjective judgment in addition to numerical Defining theseperiodshistorically requires some Historical Returns for positive real returns. strategies would likely offer thebest opportunity a difficulttime.Active, tactical andalternative likely behigh,buyandholdstrategies willhave in theUSexcept REITs. Since yieldswill asset classes produced positive real returns as equities.Inthestagflation year of1981,no sovereign bondsbecame almost asvolatile different asset class. In the 1970s, 10-year particular, would become analmost completely become highly correlated. Sovereign bonds,in stagflation goldappears to betheonly inflation positive and negative returns. Note that during equities having very high as well as large most ofthelast 30years). Bondsactmore like than Quadrants 1and2(where we have spent that periodisalsoincludedinQuadrant 3. displayed thatinformation separately, though very highinflation years of1978–1981 we have ’s definitionof stagflation covers the monthly real returns. Finally, since the classic actual returns andriskwere calculated using years bythefour quadrants from Figure 01.The returns. Usingthisframework, we can define All theotherassets are alsodisplayed asreal or negative onareal basis(inexcess ofinflation). annual MSCIequityindex returns were positive simplicity, growth isdefinedasyears where upon itsaverage annualizedvalue of3.69%.For years covered. Highandlow inflation are based since we have reliable numbers over the45 is based upon the CPI-U or headline number, not used,asthiscycle isjust starting. Inflation the Quadrants. Thefirst quarter of2020was calendar year data from 1975to 2019to define source ofinformation. variety. Nonetheless, history can beauseful Quadrants 3and4have very different behavior In Table 01(next page)we have usedannual, 5 FQ PERSPECTIVE FIRSTQUADRANT.COM negative real return inthefullstagflation period. well inthe1978-1981periodthoughthey hada in 1979 when returned 110%. REITs also did though there was a true speculative bubble World (local). WGBI isFTSEWorld Government BondIndex. CPI-UisConsumerPrice for AllUrbanConsumers. REITS istheFTSENAREITAllREITIndex. BasicMaterials Stocks istheS&P500Materials Sector Index. MSCIis 1997. CommoditiesistheBloomberg CommodityIndex (Total Return).GoldisthegoldbullionNew York spotgoldprice. hypothetical return ofTIPSthrough thecombination often-year interest rates andthe12-monthtrailing CPIpriorto March DEFINITION: TIPSisBofAMLUSInflation-Linked Treasury Total ReturnIndex from March 1997 to present andthe Sources: Global FinancialData, St.LouisFed, Datastream 1978-1981 4 (Boom12Yrs) 3 (Stagflation 11 Yrs) 2 (Recession 6Yrs) 1 (Expansion16Yrs) Annualized Risk 1978-1981 4 (Boom12Yrs) 3 (Stagflation 11 Yrs) 2 (Recession 6Yrs) 1 (Expansion16Yrs) Annualized Returns Quadrant (1975 -2019) TABLE 01: FQ Perspective: Coronavirus Crisis:Deflation,Inflationor Stagflation? (JANUARY 1975-DECEMBER2019) FIGURE 02- Sources: Datastream, Global FinancialData, St.Louis Fed RISK AND RETURN OVER THE INFLATION/GROWTH CYCLE Q THE INFLATION/GROWTH CYCLE OVER TIME 12.92 10.21 -4.60 -1.63 TIPS 8.72 6.15 5.87 4.65 1.86 3.58 Q D 14.36 16.41 21.63 15.46 13.16 -5.12 -1.20 -7.19 -2.11 Commodities 2.79 24.07 23.27 16.34 14.62 16.24 11.36 Gold 35.73 -6.81 Q 3.77 2.99 see theperiodofhighinflationwhichgenerally returns oftheMSCIWorld equityindex. We can listed intheabove table vs. thelog cumulative 17.58 15.11 19.67 15.89 17.44 16.71 REITS 18.24 -3.79 7.79 0.83 Figure 02shows thescenarios over timeas D -11.90 20.00 22.67 24.63 17.77 20.85 20.85 20.74 -4.56 -2.14 Materials Basic Q -11.92 14.26 16.24 16.19 12.69 15.82 17.43 15.04 -5.19 -7.09 MSCI -10.99 MSCI 12.02 11.08 16.11 D -3.68 WGBI 4.66 6.91 9.11 1.74 5.48 . . . . . . .

10.32

CPI-U 5.67 6.83 2.66 2.08

R C M MSCI 6 FQ PERSPECTIVE FIRSTQUADRANT.COM and the3-year annualizedinflation . Bond rolling correlation between bondsandequities, 3-year rolling annualizedbondvolatility, 3-year Fed contained inflation.Figure 03shows the inflation (greater than9%)lasted long after the the 1970sstagflation andtheeffects of very high though itwasquickly contained. inflation didgetawayfrom the central banks evident asthere is only one time, 2007,when of from 1991 onwards is also inflation period from 1991-2019. The effectiveness lasted from 1975-1990, and then a mostly low FQ Perspective: Coronavirus Crisis:Deflation,Inflationor Stagflation? is likely to reoccur. stagflation with very highinflation,suchbehavior of 1987andGulfWar I.Ifwe have anotherboutof only pausewasinthelate 1980swiththecrash the late ,whenthetech bubble burst. The stocks andbondsstayed inthe60%range until 10% untillate 1989.Thecorrelation between early 1984,bondvolatility stayed well northof while inflation finally fell, dropping to 5% by between stocks andbondswasover 60%.But after inflationpeaked at11.9%.The correlation volatility peaked at 20% in early 1982, just DEFINITION: BondsisFTSEWorld Government BondIndex. Stocks isMSCIWorld (local). Sources: Datastream, First Quadrant, L.P. (DECEMBER 1975-DECEMBER2019) FIGURE 03- Bonds became a different asset class during r nnuaie Inflation an oatiit De 0 20 2 0 BOND CHARACTERISTICS AND INFLATION r ug0 on r Inflation oatiit r onStoCorr De will becrucialinthenext few years. possible, keeping investment strategies flexible and investors differently. Since eachscenario is high inflation.Eachscenario impactsmarkets continued negative growth accompanied by and Quadrant 3,encompassing slow oreven stay into 2021, followed bya move to Stagflation case scenario would be a deflationary Quadrant2 moderate growth and muted inflation. The worst by amove to Quadrant 1in2021withslow to in Quadrant 2withactualdeflation,followed pessimistic scenario would seeaprolonged stay Quadrant 1to Quadrant 2andbackagain.Amore returns to normal–basically atransition from a quick“V”-shapedrecovery, where everything optimistic scenario seesarecession followed by So whichscenario shouldwe anticipate? The What’s to come? inflation significantly accelerate. experienced over thelast 30years should prepare for very different markets than we’ve Based upon the historical record, we should r0 eation  ug2 De

00 00 000 00 00 20

n eatio Corr onSto r 7 FQ PERSPECTIVE FIRSTQUADRANT.COM it down to thesebasicideas. dimensions, butfor thepurposesofthisnote we willboil ¹I know there’s alot more to Keynes thatthosetwo Endnote Endnotes andReferences Copyright ©byFirst Quadrant, LP,2020,allrightsreserved. SERVICES FIRST QUADRANT,L.P. |800E. BLVD. SUITE900, PASADENA, CALIFORNIA 91101 obtained from sources believed to bereliable, butitsaccuracy isnotguaranteed. through this period and are subject to change based on market and other conditions. All material has been This material isfor your private information. Theviews expressed are theviews ofFirst Quadrant, L.P.only For index definitionsandtrademark languageusedinthishandout, please visit [email protected] | OFFICE 6266834223| Daily, Ludwigvon MisesInstitute, October 2006 Shostak, F. “Did Phelps Really Explain Stagflation?” Mises Money, Palgrave, London1936 Keynes, J.M.,General TheoryofEmployment, Interest and Theory,” Institute ofEconomic Affairs, London1970 Friedman, M.“TheCounter-Revolution inMonetary References https://www.firstquadrant.com/index-definitions WEB FIRSTQUADRANT.COM for furtherinformation.