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A version of this article first appeared online in Investment Week on 4 August 2021.
The debate continues as to whether inflation is here to stay and that makes bond investors understandably nervous. Inflation usually leads to higher interest rates, which erode the value of a bond’s face value and can be particularly calamitous for low-yielding assets with a longer maturity. I have little doubt that the current inflation story is a transitory one.
The first thing to bear in mind about the inflationista case is the argument that, by definition, quantitative easing leads to inflation. This is based on the classic equation you learn in A-level economics that inflation is a function of the amount of money you print and the velocity by which it circulates around the economy. Weimar Germany and, more recently (in 2007), Zimbabwe are used as examples to prove the point.
We should bear in mind that most developed nations have not printed money to the degree that we saw in Europe in the 1920s or in the last couple of decades in some African countries. And the velocity of money circulation – always given as a constant – has actually collapsed, thanks to Covid. The very neat monetarist equation has not held.
Indeed, the Japanese experience shows that quantitative easing is in many respects deflationary. When I started in this industry in 1994 people were still learning Japanese because it was perceived to be the dominant, successful corporate culture of the time. What has happened to Japan since? They are the ones that have faced an ageing demographic and a very high debt burden, which has led to slow economic growth, which requires looser monetary policy, which leads to low interest rates. That has all happened over the past three decades. They were the ones to really introduce quantitative easing.
You can translate that argument to the West now. We have an ageing population with a very high debt burden, which I think will lead to lower economic growth than that which we have enjoyed over the past 50 or 60 years, and which requires different or looser monetary policy, which will produce lower interest rates and lower bond yields.
All that financing, with government support prevents the automatic cleansing of the corporate society when the weak fail. As devastating as that is for people who work for those companies, without the creative tension created through the hardship of failure, you end up with a cycle of companies surviving that would normally fail, forcing people into more productive activity. You could argue that that is what has been happening in Japan for 25 years and it is what is happening in the Western world today. So in this respect, quantitative easing has led to lower economic growth.
What we also know from Japan and Europe is that savings rates rise when interest rates fall. It sounds strange, but it is probably because if you are saving for retirement you have to put aside more to generate the same return when you clock off for the last time.
Other factors are releasing the pressure you might expect to be building towards persistent and high inflation. If you look at the global growth rate, it has been falling steadily for 50 or 60 years. There was a huge reconstruction boom after the World War, a big increase in female participation in the labour force and then massive growth in the availability of credit. All these things were expansionary.
But female participation is now arguably falling. We have had that huge expansion of credit and that surge in population growth in the Western world, which are both tailing off – even lockdown failed to reverse the declining birth-rate trends. We now have an ageing demographic, so we are facing lower structural growth.
And finally, we should factor in technology. The replication of human skill for machine skill is hugely deflationary as well. You only have to visit McDonalds and see how some counter staff have been replaced with enormous iPads to understand how pervasive technology now is – an iPad is not going to be pinged and forced into self-isolation. This trend will only continue.
Of course, we all know that there is a lot of pent-up consumption. But, speaking personally, I cannot drink 18 months’ worth of missed pints with friends or eat 18 months’ worth of restaurant meals in a few weeks. My marginal propensity for the after-effects – hangovers and indigestion – will quickly fall to zero.
A lot of that pent-up consumption has gone on cars and home improvement (as anyone trying to buy a car or find a builder to do an extension will attest). So builders’ wages have gone up and the price of second-hand cars has risen 10% in a few months.
But the Covid crisis has had a reverse effect elsewhere in the economy. I work in Edinburgh and a lot of my clients are in London, but we all want to reduce our carbon footprint and we have established that Zoom works perfectly well for most occasions. I estimate I will do a quarter of the flights and book only a quarter of the hotel rooms I booked before the pandemic. I will not be alone.
People will continue to work from home, whether it is one or two days a week. That leads to a reduction in consumption – of spend on work clothes, cosmetics, take-out coffees. So, I can see a long tail of things that are going to decline.
And even if you look at the areas experiencing a consumption boom, for inflation to maintain its current level second-hand car price must rise not just 10% this year, but 10% again next year. That is unsustainable. People will defer consumption. The inflationista argument is cracking.
So what are the implications for bonds? We do not believe the bond market is due for imminent collapse, or a sustained sell off. Of course, it is not the perfect time to buy corporate bonds. That is when the world is in crisis and everyone is petrified about defaults; when equity markets are on their knees and risk appetite has been wrecked.
But our view is that almost irrespective of when you buy the high yield bond market, you can expect attractive long-term returns. In fixed income you are compensated for taking risk (which can be mitigated by good active management). Go back over any period and compare the returns on high yield versus investment grade versus government bonds. The longer the period, the more ridiculous the outperformance of higher yielding bonds. It is nearly always a sensible time to buy high yield if you are a long-term investor. Do not let short-term inflation concerns discourage you.
Stephen Snowden leads Artemis’ Edinburgh-based fixed income team. He is co-manager of the Artemis Corporate Bond Fund; visit the fund page for further information about its performance and current positioning.
About the author
Stephen Snowden, Fund Manager, Artemis Investment Management
With a BSc and a MSc in Finance from Queen’s University, Belfast, in 1994 Stephen started his career at Aegon Asset Management (now Kames Capital) as a US equity analyst and fund manager. In 1998 he moved to fixed income, becoming manager of Kames’ Sterling Corporate Bond Fund in June 2000. Stephen then joined Old Mutual Asset Managers and managed their Corporate Bond Fund from 2004 – 2011, when he returned to Kames. There, as co-head of fixed income, he was co-manager of the Kames Investment Grade Bond Fund, the Investment Grade Global Bond Fund and the Absolute Return Bond Fund until November 2018. In May 2019 Stephen joined Artemis as a partner, to lead our fixed income team.
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