As of the time of writing in June 2020, we are sitting in front of a future which is more unpredictable than it has been in many years. COVID-19 case numbers are falling in Canada, but ominously rising in parts of the US and China. As far as wealth and investments are concerned, some would say that the stock market is at puzzlingly high levels, while the Fed has just announced it will for the first time buy all kinds of corporate bonds directly, at a time when free money is being given out in Canada through the CERB and other assistance programs, and we don’t know yet how many businesses will never reopen. This list just scratches the surface of the pile of unknowns ahead of us.
While it’s virtually impossible to know the impact and results of the above issues, one thing we can be sure about is that the financial well being of us all will be heavily influenced by the course that inflation takes.
As Warren Buffett says, “… money represents an enormous number of claim checks on society. It’s like I have these little pieces of paper that I can turn into consumption…”. So it only stands to reason that how much each “claim check” can buy for its owner is a crucial factor in determining a person’s wealth, and knowing how much capital they will need to provide for their family’s desired lifestyle. Since the end of World War II, prices have always moved higher in Canada and the US except for 2 or 3 brief episodes when they temporarily declined (deflation). We have become very used to this seeming law of prices only going up. But what if prices actually declined persistently for many years, which has been a stubbornly important problem in Japan for years? How would our behaviour change? Who would be the winners and losers in a deflationary world?
Let us first look at some of the things that make prices move. In a relatively open economy, such as the one we have, it usually boils down to changing levels of supply and demand of scarce resources. For example, because the pandemic has caused governments to lockdown big chunks of the economy, many people are losing much of their incomes (think of all the people that work in airports, tourism, and restaurants) even after factoring in some help from the government. This would argue for prices going down, because fewer people will be visiting car dealerships, or upgrading their phones, or buying expensive cuts of meat, to pick a few random examples of what people sometimes do when they feel flush.
In the same vein, one could argue that with so many companies suffering, that workers are in no position to demand higher wages, because their employers might think workers who quit over pay can be easily replaced from the ranks of the newly unemployed. This too would be deflationary as many workers would see their pay staying flat or perhaps even going down, and therefore they would not be in a position to consume as much as before.
Another deflationary factor worth mentioning is the high levels of debt that families, companies, and governments have taken on. Debt is, at its core, borrowing money to consume today what you would otherwise have to wait to afford in the future. Today’s historically high levels of debt have brought forward investments and consumption and will reduce our ability to invest and consume down the road, which is also deflationary.
On the other hand, we can look at the same set of circumstances we have in today’s world and make equally valid arguments that prices will go up. For example, both the Fed and The Bank of Canada have created massive quantities of new money by buying all kinds of bonds, issued both by governments and corporations. Thanks to central banks lending directly to governments and companies, these entities can then take that money and spend it on goods and services, which raises demand for these things. And since the amount of this new money has never been seen before in this size and so quickly, there is a strong argument to be made that a flood of more dollars chasing the same or a declining amount of goods will cause prices to rise. Furthermore, in contrast to what the central banks did in the wake of the 2008 financial crisis when the “free money” largely went to big banks and got trapped there, this time the money is going directly into the hands of people and companies, who will spend it, which also argues for inflation.
Another valid train of thought is that since families are spending less on vacations, entertainment and restaurants, those savings will go into goods that are useful around the home, which is where we are all spending a lot more time during the pandemic. So perhaps this argues for inflation in some parts of the economy (home electronics, online education, groceries, backyard pools) and deflation in other parts.
It is easy to see that logical arguments can be made for both sides of the same coin.
Now let’s quickly examine who benefits when prices rise. One obvious group of people is those who owe money. When a person or a company borrows $1,000 from the bank, the borrower only needs to pay back that amount – rising or falling prices don’t come into the equation. So imagine a world where wages and prices doubled over night, so that everyone who was earning $20 an hour now earns $40 an hour, but at the same time every single price tag in sight magically doubles — it would seem that people in this world are no better or worse off. Except for the person who owes the bank $1,000, that is. Because in this fictitious world, instead of having to work 50 hours (at $20/hour) to pay back the loan, in the new world where wages and prices have doubled this person only now needs to work 25 hours (at $40/hour). This demonstrates how inflation helps borrowers. And by the same token, it equally hurts lenders. We can also say that if prices go down sharply instead, that borrowers suffer and lenders benefit.
Another line of thinking is that when prices rise sharply, those who gain are people and companies who have the pricing power to successfully raise the prices for their services or the goods they are selling. Examples of entities who would benefit from this dynamic might be private schools or the sellers of luxury goods, since these are things that some people prioritize highly and will pay for, even if it means sacrificing something of less importance. Or perhaps the landlords of desirable real estate properties would be able to rapidly increase rents (leaving aside the question of what properties will be desirable in a post-COVID world). Health care is another essential service that sick people cannot do without for obvious reasons, and depending on the irreplaceability of a pharmaceutical, hospital procedure or a bed in a long-term care home, the suppliers of these things would be able to raise their prices, perhaps even over and above the rate of inflation.
The corona-virus pandemic has launched us into a brave new world, to borrow a phrase. And it is highly likely that inflation has gone from a nerdy statistic that is safely ignored by most, to an important driver of future asset prices that owners and stewards of capital will need to pay great attention to in the years ahead.
Author: Wayne Edelist