Real GDP and Inflation?

EMR June 2021

En Vogue

The economy is expected to rise as the Covid-Pandemic measures are increasingly relaxed. Inflation is feared to rise significantly. Who will play the “revitalizer of last resort”?

Difficult to compare cycles

Argument 1: Whenever economic demand, however measured, rises significantly so do inflation expectations. Concomitantly it is also argued that in such a case monetary policy is tightened, i.e. interest rates are pushed higher.

Argument 2: Differential interpretations complicate Argument 1. Does growth rise, due to domestic activity or is it due to a significant reduction of imports of goods and services?

Argument 3: What about fiscal expansion i.e., extreme intervention by the Administration e.g., in the USA?

What can be inferred from past developments?

On real output: Examining the developments of the leading economy over business cycles since 1949 is indeed intriguing. The trend in real GDP, from each cyclical low, indexed to 1, is an indicator of considerable vulnerability, which in turn complicates the comparability effort. After the second year of economic recovery, discrepancies, from cycle to cycle, begin to grow ever larger. Currently, we assume that growth will be significantly more front-loaded than in most previous upswings. This due to the reduction of the Covid restrictions as well as the extreme expansionary monetary and fiscal measures. We believe that this phase will not last for long. Rising demand speaks also for significant demand for cheaper imports. At this juncture one must take into account that each country’s growth expectations ought not to be synchronous, given the specificities of each country, regarding the domestic as well as the foreign trade actions and reactions.

On inflation: Charting the US CPI (Consumer Price index) on a monthly basis, but coherently with the respective quarter of Output (see Chart on CPI from the Trough = 1) we find significant differences.

The period before the rate of growth of inflation starts to rise significantly is somehow longer than for real GDP, even taking into account that the data of real GDP are on quarterly basis, while the CPI data are on a monthly basis. This implies that the cyclical correlation of Output and CPI isn’t as close as often and regularly reported in the media. This is particularly evident in the three growth cycles in 1975, 1970 and 1980!

Examining the chart on the level of inflation and the corresponding yearly percent change for the USA and Switzerland we face a dilemma of “comparability”. The US CPI Index rose form 24.01 on January 1949 to 266.83 in April 2021. This shows an increase of 1011.3%. Over the same period, the Swiss CPI rose from 21.73 to 100.58 for an increase of only 362,9%. What do these figures imply? Well, they simply imply that the economic, social and political dissimilarities must be taken seriously into consideration, while pinpointing the coming quarters and years. Specific new determinants of the current outlook, as compared to the historic reality (see charts) is, that the USA are now an important producer of crude oil. A further determining aspect is that the technological developments remain considerably differentiated from country to country. Thus, we ought to pay attention to the possible differential repercussions on production, prices and expectations in general. At this juncture the question remains which are the sources of the rising pessimism?

At this juncture we expect the economy to react strongly to the monetary and fiscal policy measures and thus, anticipate that the feared effects will – for some time – cause unease among consumers and producers. The consumer`s contribution is not expected to be strongly positive, and this for the following reasons. Firstly, reserves will have to be rebuilt, i.e. debt will have to be significantly reduced. In addition, we expect consumers to switch to cheaper imports, which will further exacerbate the trade imbalances, e.g. in the case of the USA. In addition, we are concerned that the impact on domestic production may not provide the support necessary for political leadership to calm market volatility and uncertainty.

From an analytical point of view, political upheavals, possibly leading to even greater uncertainty, look highly problematic to us. It is to be feared that, in the event of higher taxation, producers will not expand production domestically but in “lower-cost” foreign countries, a move that would not help to reduce foreign trade imbalances.

On interest rates: While the trend in 10-year bond rates is approaching a low point, the interest rate differentials in 3-month rates remain quite stable. Is this a necessary and sufficient reason why many analysts have now switched to inflation expectations as the most promising determinant? It is to be expected that monetary and fiscal policy measures will promote liquidity in the system. We wonder however, whether it is sufficient to rely only on the supply side as an explanatory motive, ignoring the effects on the demand side. The argument implies that one can led the horse to the well, while it remains an open question whether the horse will drink.

Implications: What we are suggesting is nothing more than how consumers and producers will react to the increase in liquidity? We doubt that consumers will increase their spending without paying attention to prices. In other words, we continue to assume that consumers will remain “price-conscious”, especially regarding cheaper imports! This “leaves” economic growth as the potential “inflation driver”. Here however, we have to reckon with a lag that is still very difficult to quantify at this juncture.

Conclusions for investors

Our conclusions are to be seen as a specific consequence of an extraordinary accumulation of governmental indebtedness. We are not aware of any comparable past period, thus have difficulties in being specific about future developments. Our view is that we remain confronted with a highly difficult to quantify financial landscape. No doubt, the financial sector remains crucial for a smooth functioning of the world economy. Consequently, we assume – as a working proposition – that the measures ought to have an impact on inflation preponderantly over a longer period of time. In our investment outlook we also focus on the change in international trade flows, as we must reckon with a new fact, i.e. that the U.S. will increasingly cease to be the “buyer of last resort” (i.e. the importer). In our scenario domestic economic growth gains in importance as an indicator for the financial markets’ whereabouts.

Consequently, we do not expect a sharp increase in inflation, as it cannot simply be passed on, neither domestically nor to foreign countries. As a working consequence we continue to see potential in the stock markets compared to fixed income and money market investments. Currency hedging will have to be considered in the international portfolio diversification approach.

Any suggestion is highly welcome.


Will interest rates go up?

EMR Mai 2021

The high level of monetary and fiscal policy interventions by the USA and also by European countries are the cause of rising inflation and interest rate expectations. They cloud the prospects for the long-awaited economic recovery. The corona pandemic also unsettles market participants and the state. Many analysts therefore believe that both inflation and interest rates will rise, which in turn will darken the stock market outlook. In contrast, we do not expect any significant increases in inflation and interest rates. There is therefore still potential on the stock exchanges. We explain why in this issue of the EMR.

What’s behind it?

Fiscal policy measures are intended to inject liquidity into the economy and to bring the economy back on track for growth by stimulating consumption. On the one hand, it is assumed that the manufacturing sector will benefit greatly from the easing of fiscal policy. On the other hand, announced tax increases are hampering local investment activity. We analyze expectations and possible or feared shocks.

The general assumption is that the economy reacts strongly to monetary and fiscal policy measures. In our case, however, it can be assumed that the effects of the government measures will tend to cause unrest among consumers and producers. A contribution to growth from consumption is hardly to be expected, since debts have to be reduced first. In addition, we expect that consumers will initially turn to cheaper imported goods. In the case of the US, this would further worsen the trade imbalance. This has an impact on domestic production and this in turn will unsettle the political leadership. The longed-for reassurance will not materialize. Political upheavals can lead to even greater uncertainty and, with higher taxation, cause companies to increase their production not domestically but in cheaper foreign countries.

What do we learn from the development so far?

While the interest rate trend for 10-year bonds is approaching its lowest point, the interest rate differential for 3-month rates has remained relatively stable since the 2008 financial crisis. Is this one reason why many analysts predict rising inflation and interest rates? Monetary and fiscal policy measures will further increase liquidity in the economic system. As is well known, however, you can lead the horses to the well, they have to drink themselves. So it is not enough just to look at the supply side. The question is, will both consumers and producers react to the increase in liquidity? We doubt that consumers will increase their spending without paying attention to prices. We assume that consumers will remain price-conscious and buy cheaper imported goods. That leaves entrepreneurs as a potential driver of inflation. Here, however, a delay that is difficult to determine must be expected.

A comparison of the development of consumer prices in Switzerland and the USA shows that it is difficult to derive future inflation developments from this. The difference between the development of the consumer price indices and the inflation rate is obvious. It is striking that the inflation rate has tended to decrease since the 1990s!

The inflation rate in Switzerland has been slightly negative since November 1919 (average -0.57%) while it has remained positive in the USA (average 1.49%) and was 2.64% last March. At this point in time, one could well imagine that the US inflation rate will continue to rise in the same way as in 2007-2008 and could rise to over 5%. Such an increase would, however, have a strong negative impact on economic development. But that cannot be assumed given the currently extremely expansive monetary and fiscal policy. In such a situation, a dramatic currency adjustment would probably be expected, which would result in strong reactions not only in terms of economic policy but also in terms of investment policy.

What does this mean for investors?

In our context, the enormous increase in national debt should also be mentioned. In Europe as in the USA, the debt ratio is rising steadily. In the USA, it rose from 63% at the end of 2007 to 105% at the end of 2019, only to skyrocket to 131% at the end of 2020, mainly due to Corona measures. We are not aware of any similar period. We therefore assume that the measures will only really come into play over a longer period of time. We focus on changing international trade flows. The USA will increasingly no longer play the role of the buyer “of last resort”. Thus, domestic demand growth should gain in importance for the financial markets.

Based on the considerations mentioned above, we expect that inflation will not really pick up and that the financial markets will not be subject to any major changes. We therefore continue to see potential on the stock exchanges compared to fixed-income and money market investments.