“Inflation is always and everywhere a monetary phenomenon.” – Milton Friedman, 1970
Two alternative realities exist – one where Friedman and conventional economics are correct and one where they have failed. How you make investment decisions and what the future holds depends on which scenario you believe in.
In scenario 1, as a believer, real global growth is a pie – divisible across time and between countries. Through quantitative easing (QE), negative rates and ultimately currency wars, central banks not only attempt to steal slices of the pie from others but also move them intertemporally towards the present. However, in this scenario, inflation is a monetary phenomenon, and monetary policy cannot sustain long term real growth. Printing money does not expand the pie and QE acts as a consumption smoother, spreading growth out across the business cycle.
Transitory disinflation is not a problem if real growth persists and inflation eventually follows through into a wage-price spiral. Ironically, low inflation is a positive in this scenario, boosting real growth in the short term before it swallows it up in the medium term. In the long run, fundamentals matter and productivity expands the pie.
In scenario 2, as a non-believer, economics faces a crisis of confidence and inflation never follows through. In the short term central banks can print the pie – real growth without inflation. However over time, wages stagnate, confidence entrenches, lenders become alienated and asset bubbles burst. In this case, deflation becomes a problem. As currency wars persist, countries fight over a shrinking pie.
Where are the opportunities in each scenario?
In scenario 1, fundamentals will eventually matter as inflation kicks in, decreasing the need for currency devaluations. Increases in productivity, technology and supply side reforms can sustain long term real growth and prevent its theft. Fair values matter. Will falling US unemployment lead to rising wages? Will the UK’s productivity bounce back or will twin deficits continue to hamper advances? Will the Eurozone make its “quantum leap” towards closer integration allowing for stronger cross-border flows of human and intellectual capital? Will Abenomics’ third arrow succeed? Can Australia successfully transition away from mining investment?
In the grim outlook presented in scenario 2, central banks will persist in fighting over the shrinking pie and their actions will matter for a much longer time. The question is which central banks have both the largest motive and strongest weaponry to devalue their currency. If the global economy becomes entrenched with deflation and supply side reforms do not pull them out, look for currencies where the scope for devaluation is the largest. Who has the most room to reduce rates? Who is willing to print more money? Where are inflation expectations?
Which scenario are we really in?
You may be convinced economics has failed us after years of QE, but the sources of disinflation matter. Correlation does not mean causation and deflation may persist despite QE rather than in spite of it. Whilst spare capacity has shrunk in many economies, there is still a long way to go globally. Transitory price falls such as oil will fade out with base effects. China will export deflation as the economy slows leading to a “new normal” in global growth but the counterfactual, without QE, would probably be a lot worse.
Assuming scenario 1, identifying progress on these fundamental issues could create opportunities for macro-economic strategies, such as active currency management. The US Dollar has already benefitted from significant inflows as the US appears furthest along in process of escaping QE, and if this is confirmed by the US Federal Reserve managing to raise rates then these flows could accelerate again later this year.
Only patience will tell, but if you are a believer then eventually the fundamentals will begin to play out.