Central bank printing presses might be in overdrive, but inflation is not the real threat here

Martin Pelletier: Many are underestimating the real risk that the economy may not return to pre-crisis levels for some time

A few weeks ago I thought it would be a great time to upgrade my SUV, so I listed it as a private sale. A couple of days later I had a bite, but it was quite unusual and a very surprising offer — a bag full of 1 oz gold bars. Since I didn’t have a testing kit on me, I decided to pass but it really got me thinking: would the next offer be a digital wallet full of bitcoin?

The inflation narrative has been on Main Street for some time now, but judging from not only my personal experience but also the current table pounding by strategists it is getting a lot more attention lately.

On the surface, this makes sense. Central bank printing presses are in over-drive, interest rates are flirting with going negative, the daily spending announcements by government leaders continue racking up tremendous amounts of debt and stock markets appear to be well on the road to recovery.

For example, the U.S. Federal Reserve has seen its balance sheet grow to nearly US$7 trillion since the outbreak, 10-year Treasuries yield a paltry 0.65 per cent, the U.S. deficit was $738 billion in April alone, and the S&P 500 is down only 9.5 per cent this year, well up from its lows in March, when it was down 32 per cent. On a 12-month basis, the S&P 500 is actually still up more than three per cent.

As a result, many are naturally questioning the disconnect between the latest economic figures and the stock market. The inflation hawks, meanwhile, are taking it a step further, warning of hyperinflation when the economy returns to where it was pre-crisis and we have all of this fiscal and monetary stimulus in place.

In my opinion, this is becoming a rather tired story, one that hasn’t made anyone money in the past 35 years and likely isn’t going to do so in the near future either. We’re more worried about the potential for deflation ahead than anything else as despite the massive fiscal and monetary stimulus, there is the real risk that the economy may not return to pre-crisis levels for some time.

Jose Maria Barrero, Nick Bloom and Steven J. Davis of the Becker Friedman Institute for Economics at the University of Chicago recently published an alarming working paper entitled “Covid-19 Is Also a Reallocation Shock,” which shows the potential for some long-lasting economic impacts, a situation many are underestimating.

“Drawing on our survey evidence and historical evidence of how layoffs relate to recalls, we estimate that 42 per cent of recent pandemic-induced layoffs will result in permanent job loss. If the pandemic and partial economic shutdown linger for many months, or if pandemics with serious health consequences and high mortality rates become a recurring phenomenon, there will be profound, long-term consequences for the reallocation of jobs, workers and capital across firms and locations.”

So ask yourself, if we didn’t see inflation with record low levels of unemployment over the past few years and numerous rounds of monetary stimulus, what will happen if the aforementioned scenario plays out, especially once the government rescue money comes to an end?

Actually, when digging a bit deeper into return allocations, the stock market is signalling some of this risk already given its rewarding of companies operating in those segments of the economy either benefiting from or not being as affected by the shut-down.

According to Alicia Levine, chief strategist at BNY Mellon Investment Management, in an interview with BNN Bloomberg, 75 per cent of the S&P 500’s move off of the March lows was driven by just five stocks. In particular, Apple, Amazon, Facebook, Alphabet and Microsoft have outperformed the rest of the S&P 500 by a whopping 10 to 40 per cent this year with year-to-date gains ranging from 2.5 to nearly 30 per cent.

Compare this to those sectors with downside exposure to the shift to the stay-at-home economy, such as energy, financials, industrials and real estate, which are still down anywhere from 15 to nearly 35 per cent this year to date.

That said, if careful, there is some money to be made in these segments of the market even in a low-inflation environment. For example, many companies are already looking at ways to rapidly transform their businesses to the new digital paradigm, which if successful could provide a healthy return to their investors. Traditional sectors such as oil and gas will also have to adapt by consolidating, with the lowest-cost producers surviving.

This is good news for those wondering what to do with their bags of gold.

Martin Pelletier, CFA, is a Portfolio Manager at Wellington-Altus Private Counsel Inc. (formerly TriVest Wealth Counsel Ltd.) a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax and estate planning.