Most of the time, financial markets ebb and flow like the tide. All boats are lifted or fall together. On occasions, however, different assets part company, responding to the same influences in divergent ways. The first three months of 2021 has been such a period.
Last week, the S&P 500 rose above 4,000 for the first time as investors decided that a rapid roll-out of vaccinations, the consequent re-opening of the economy and unprecedented fiscal and monetary stimulus will deliver strong growth and rising profits. The US economy is forecast to be 8% bigger in the last three months of this year than it was in the final quarter of 2020. Companies most exposed to a strong cyclical upturn have fared best of all. Commodities, too, have built on last year’s strong gains, with copper costing almost twice as much as it did last April.
Over the past three months, however, the bond market has moved in the opposite direction. Long-term government bonds have just delivered their worst quarterly fall since 1980. Fixed income investors are worried about precisely the same things that are pushing the stock and commodity markets to new heights - recovery, growth and inflation, leading in due course to higher interest rates. In anticipation of tighter monetary policy, bond investors have pushed yields higher. Thanks to the arithmetic of the bond market, that means lower bond prices - 13.5pc lower in three months, a huge move by the usually placid standards of fixed income investing.
Inflation is the key to the diverging fortunes of equities, commodities and bonds. But partly because it’s been so long since we had to really think about spiralling prices there are a lot of myths to bust. It’s time to dust off our understanding of inflation’s causes and what it means for our investments. Because if, as seems likely, the first three months of the year are an indicator of what’s to come, then many portfolios may need a rethink.
The past 12 years has seen some spectacular financial asset price inflation but very little in the real world. That’s because physical inflation is a consequence of demand exceeding supply, which you do not create by making wealthy people wealthier. You create inflation by increasing the incomes of people who are most likely to spend their new-found wealth - lower-income households. It is no coincidence that income equality and inflation both peaked in the 1970s. Rising prices follow when you increase the incomes of as many people as possible. We are about to rediscover the link between populist, redistributive policies and rising prices.
First, let’s dispel some misconceptions. The first is that inflation is caused by supply shocks and cost-push pressures. The opposite may actually be the case if shock leads to recession and so lower demand. As Jeff Currie, Goldman Sachs’s commodities guru, has pointed out, OPEC’s first attempt at an oil embargo in 1967 failed because of a lack of demand for energy at the time. Six years later when Lyndon Johnson’s ‘war on poverty’ had increased annual oil demand growth from 4pc to 8pc the Sheikhs were pushing on an open door.
A second misconception is that inflation is a consequence of excessive money creation. Here too the evidence points the other way. High debt levels in Japan after years of money printing have failed to generate any inflation because the money never made it to the people who might actually have spent it. Instead, it gathered dust on corporate balance sheets as excess cash. Greater equality in Japan meant there was never any need for inflationary, populist policies and an ageing population kept demand stagnant and prices subdued.
If you want to understand the key driver of general price inflation in the 1970s and of commodities in the early 2000s you need look no further than what was happening in the labour markets in America and Europe in the first period and in China thirty years later. The US participation rate rose from 58pc to 68pc between the 1960s and 1980s, massively reducing the poverty rate, increasing household formation and driving up demand for commodity-intensive goods. In China, joining the World Trade Organisation created the outsourcing boom that delivered a massive redistribution of wealth to millions of low-income Chinese labourers. Like their low-income predecessors in the West in the 1960s and 1970s the first things they looked to buy were metals-intensive physical goods.
So, the key driver of inflation in the months ahead will not be excessive money printing or a shortage of supply after years of underinvestment, or higher wages. Rather it will be, in the short run, post-pandemic populism, targeting US$1,400 cheques more precisely at the people with a greater propensity to buy food, fuel and capital goods than the higher-income households who benefited from the post-financial crisis spending 12 years ago. That helicopter money won’t last for ever, but new ways will be found to keep the populist spending flowing - most likely the new ‘New Deal’ of green infrastructure, the politically acceptable promotion of income redistribution under the guise of addressing the climate challenge.
What do these trends mean for our investments? Almost certainly that the divergence hinted at in the first three months of 2021 is just getting started. Shares and commodities will continue to outperform. Bonds will remain under pressure. As Currie notes, the last time the Democrats kept hold of a clean sweep through mid-term elections was during that war on poverty under Lyndon Johnson. People like populist policies. Highly indebted governments like inflation. Once you set off down this path, it’s hard to turn back.
