The “S” word: Stagflation. It’s a term being increasingly used in financial media. Don’t worry, it’s not a rude “S” word 😅 It suggests that inflation globally could persist for some time, certainly longer than the US Federal Reserve would care to admit… But it is also describing a period of low global economic growth.
What might this scenario mean when it comes to global equities and ETFs? Let’s break it down into its parts.
What is inflation?
Inflation is when the price of a collection of goods and services goes up over a period of time. Think about when your local café raised the price of a coffee from $3 to $3.50, or when the price of your favourite snack went up at the supermarket ☹️
The word “inflation” is often associated with a sense of negative sentiment because people often think this means items have become more expensive. But some inflation is necessary for a healthy economy, because otherwise the economy may not be growing at all.
The US Fed says inflation is likely to be transitory
Few Central Banks globally have more datapoints than the US Federal Reserve. And the US Fed has an enormous bond buying program of $120 billion each month, which it plans to slow down in the coming months towards the end of 2021. But the US Fed needs to also set the interest rates for the economy to function smoothly. The Fed Chair, Jerome Powell, has stated many times in 2021 that the Fed sees current inflation readings as seasonal or transitory, and as such has not taken the step of raising interest rates.
Other Central Banks around the world have also reported rising inflation, but no major Central Bank is yet to take the plunge and increase interest rates.
What may happen if inflation is not transitory, and persists for some time?
If inflation runs too hot, or gets too high, the Central Bank may be forced to intervene and raise interest rates, which tends to have the effect of slowing growth. But Central Banks have not exactly been trigger happy when it comes to rate rises. The last rate rise from Australia’s Central Bank, the RBA, was in 2010 😲 and the last time the US Fed Raised rates was in 2017, when Janet Yellen was Fed Chair.
What may happen if global growth is too slow?
This is the other symptom of stagflation; a slow-growing global economy. Central Banks globally have regularly turned to lowering interest rates to attempt to fuel economic growth. But interest rates globally are already close to zero or even below zero in many parts of the world, meaning this is less of an option when it comes to fuelling growth in this particular economic cycle. And few Central Banks like the idea of setting negative interest rates.
Another choice Central Banks have is to print money and push that through the economy, such as what has been happening with the global Quantitative Easing (QE) programs. But this in itself can also spark inflation, and the US Fed is talking about switching off this policy lever, having already printed more than $2 Trillion as part of QE since COVID began.
Are we stuck in a bit of a feedback loop?
To some extent, yes. The US Fed wants growth but does not want to raise interest rates even when some of the precursors of growth, such as inflation, are being seen in the economy. Normally when growth gets too strong, a Central Bank would raise interest rates, but this would really hurt the US Government’s almost $29 Trillion debt pile. One of the advantages of inflation is it naturally lowers the cost of borrowing in real interest rate terms. While the US Government and the Fed are independent, it is in the US Government’s interest for rates to remain low.
How may this affect assets like ETFs?
Given rates are likely to stay lower for longer, investors continue to look elsewhere from bonds or cash and invest in other assets, which they believe can rally in the current conditions, whether that in equities, commodities or other asset classes.
We have seen eleven consecutive months of gains on STW to August 2021, the ASX200 tracking ETF. Europe has had seven straight months of gains, its best streak since 2013, and the US markets have broken their own record highs over 100 times in 2021 across all indices.
While interest rates remain low and inflation is increasing in many parts of the world across many official readings, equities, commodities and assets like property have been on the rise. One could suggest that the breeding conditions for such a strong rise in the price of assets like equities and many ETFs have been the stagflation conditions prevalent in many major economies.
Until Central Banks like the Fed break the pattern and change the inflation, interest rate and growth trajectories in global economies, one wonders what will break the trend of increasing asset prices 🤔
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