Since life has started to get back on track and most countries have tried to exit lockdown and return to routine, macro numbers have been indicating a shrinking economy.
GDP (gross domestic product) fell sharply in the first quarter, and few countries will not experience recession this year; unemployment is rising, and despite the good news from the US at the end of last week, it is still at historical highs there. Imports and exports, consumption and industrial output are all at lows. In the light of all this, it is surprising to discover that inflation expectations are on an upward trend. So what does the bond market see that consumers don't yet see?
Last month, index-linked bonds considerably outperformed shekel-denominated bonds. 2-5 year index-linked government bonds, for example, have risen 1.76% in the past 30 days, six times the return on shekel-denominated government bonds with a similar duration. Large gaps have also opened up in corporate bonds, with indexes such as the TelBond 20 and the TelBond 40 rising by more than 1.5%, while the TelBond Shekel A and TelBond Shekel 50 indexes, for example, posted negative returns.
The conclusion from the strong performance of index-linked bonds is a rise in inflation expectations, particularly in the past three weeks. If three weeks ago inflation expectations as derived from short-term government bond prices were minus 0.2%, now they are almost at zero. For the medium term, they have risen from 0.7% to over 1.2%, and in the view of Harel Finance they still have room to rise.
The rise in inflation expectations Is not just a local phenomenon. It has been seen clearly around the world in recent weeks. We see at least five main factors supporting a rise in inflation.
The fall and rise of oil
The rise in inflation expectations in Israel came mainly after the publication of the April Consumer Price Index (CPI) reading, which showed a fall of 0.3%. This was the first time since 2003 that the CPI fell in April. The main reason was the sharp fall in fuel prices, slicing nearly 0.6% off the general index. This was the result of the collapse of the price of oil to below zero, because of plummeting demand, with countries in lockdown, together with a substantial rise in supply. At one point this led to a technical distortion in the market, in which the price of a barrel of oil plunged to minus $40.
Since then, however, oil prices have risen dramatically, economic activity around the world has started to recover, and the OPEC oil cartel has agreed a reduction in oil production in order to boost prices.
The price of oil is now back to $40 a barrel, and this is with civil aviation still mostly grounded, with many consumers yet to return to work and to the shopping malls, and before the summer season of vacations and travel (at least by car if not by plane), so the oil price may well continue upwards.
Printing money, lots of it
The government aid packages and the money-printing by central banks around the world because of the coronavirus crisis are of unprecedented scope. The US Federal Reserve announced bond purchases in amounts never seen before, not even in the crisis of 2008, and not in the expansionary programs since then. So far, the Federal Reserve has bought government bonds to the tune of $1.5 trillion, and it could carry out corporate bond purchases and various loan programs for businesses amounting to a further $1.5 trillion. In addition, the administration has allocated $2.7 trillion for aid, partly in the form of direct grants to citizens.
These incomprehensible numbers, providing huge liquidity to the markets, very quickly removed the fear of a liquidity squeeze. But printing money on such a scale usually has a price in the shape of higher inflation down the line.
In the next few years, all over the world, we can expect huge government deficits, and, together with the substantial growth in money supply, it will clearly be convenient for governments to erode these debts in the coming years through higher inflation than we have seen lately, and so it makes sense that they should choose to raise inflation expectations.
Less competition, higher prices
The lockdown, empty malls and shopping centers, and the switch to online purchasing, have only just started to leave their mark on businesses. The dry numbers do not yet show a rise in business insolvencies. They usually arrive with a considerable delay, and we project more substantial numbers only in the second half of 2020. But the situation can already be seen in the rise in provisions for doubtful debts by the banks, and in newspaper headlines about the collapse of retailers such as JC Penny and Neiman Marcus in the US.
In an environment like this, it is clear that many small and medium-size businesses, and even large ones, will find it difficult to survive the crisis. Many will have difficulty in adapting to the new trends, in coping with a fall in customer numbers, and in repaying debt. On the other hand, large, strong companies, with plenty of cash and no large bank debt and bond repayments weighing on them, will only gain in strength from this trend in the foreseeable future.
Just as proliferating competition and greater supply of products led to falling prices in recent years, the reverse trend will in time lead to rising prices. This is a trend that we shall see in the medium term, not immediately.
Less globalization, more inflation
The shortage of vital medical equipment for dealing with the coronavirus pandemic prompted calls around the world for independent production of emergency supplies. In the US, President Donald Trump explicitly called for local factories to be set up so that the US would not be dependent on others at times of crisis, particularly not on a country like China, the workshop of the world, with which the US has been engaged in a long-running trade dispute.
The US is not the only country encouraging the construction of factories within its territory. In Israel too, the manufacture of masks and ventilators was encouraged, and it seems that every country is determined to revive local production in many areas. The desire to encourage local production generally results in import duties and protectionism. And so, just as globalization was one of the factors that contributed to the suppression of inflation around the world in recent years, less globalization will mean more inflation.
Financing the deficit will require inflationary measures
According to all the signs, the new government in Israel will be less able than its predecessors to take action to reduce the cost of living. This is not for lack of will, but because the public purse is emptier than in previous years, since the fiscal expansion for dealing with the coronavirus pandemic will widen the deficit yet further. It is already at 6% of GDP, and the ratio is expected to reach double figures by the end of the year.
Although widening government deficits are a global phenomenon, and although the rating agencies will probably take a forgiving attitude to this given the global crisis, over time, the Israeli government will not be able to take on extra expenditure with the aim of reducing costs to consumers, as it did in past years with measures that reduced inflation.
The government's withdrawal from various programs is likely in the medium term to lead to renewed rises in the price of housing and in everyday items. Some of the government's extra expenditure will have to be financed through higher indirect taxation, though probably not in the current budget.
Although there are many reasons for a rise in inflation, we will probably not feel the jump in the next few months, because of the economic recession, but only afterwards. The capital market, however, is known for anticipating developments, and so even if not all these risks materialize, a decent degree of exposure to index-linked instruments in the investment portfolio looks like a good investment decision for now.
The writer is vice president of business development at Harel Finance, part of the Harel Insurance Investments and Financial Services Ltd. (TASE: HARL) group. The writer or companies in the Harel group and parties at interest in them or controlling shareholders in the group may hold or trade in securities and financial assets mentioned in this article, on their own behalf or on behalf of others, or manage investment instruments in the field mentioned among whose investments are securities and assets mentioned in this article. This article should not be regarded as marketing of investments or as an alternative to marketing of investments that takes account of the position and personal, individual needs of each investor.
Published by Globes, Israel business news - en.globes.co.il - on June 14, 2020
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