Liam Dann: What is the great reflation … and what will it do to investments?


Forget about inflation, deflation, disinflation, stagflation or even hyper-inflation.

Reflation is the fashionable variety of economic hot air blowing through financial reporting this year.

What does that mean? How will we know if it is really happening? And is it bad news or good news?

There are plenty of questions to be answered.

Not least why so many of the variables underpinning our economy sound like the difficulties of blowing up kids’ party balloons.

The balloon analogy isn’t a bad way to explain the various ‘flations.

The balloon goes up, the balloon goes down. Economies (or specifically the value of things we trade in them) inflate and deflate.

Disinflation is simply the rate of inflation slowing down.

Stagflation is when we run out of puff altogether and are left with a floppy balloon.

Central banks aim for nice, slow inflation that ensures stability and allows maximum economic growth and wealth creation without causing everything to go pop.

Good inflation is generally considered to be around 2 per cent per annum these days.

Central banks control the money supply and the cost of credit with interest rates (and other tools) with a view to engineering that nice steady flow of inflation.

Hyper-inflation is like sticking the balloon on hydraulic air pump.

It tends to make things go pop very quickly and can make for a terrible mess – like causing World War II.

But regular old high-inflation isn’t great either, as New Zealanders who lived through the value-destroying days of the late 1970s and early 1980s will recall.

Since everything last went pop though (in the global financial crisis of 2008), the world has been dealing with persistently low inflation.

The big worries for policy makers have been deflation and stagflation.

Central banks – especially in places like Japan – have been blowing very hard for very little effect.

That generated a lot of debate about whether this is a structural change – driven by new technology – or just a longer than usual economic cycle.

In other words: Are balloons different these days? Or were we just dealing with one those tough rubbery ones you get from time to time.

Central banks were just starting to make some progress, and were finally slowing down the air supply (by lifting interest rates) when Covid-19 hit.

Then they had to take another very big breath.

But now, with the arrival of vaccines, and the pandemic looking increasingly finite, financial markets are starting to bet that we’ll soon getting back to normal – whatever that is.

We’re seeing a shift of capital out of highly inflated equity markets and back towards safer investments like bonds.

That’s the great reflation.

Frankly, when you look at the state of the world, it seems highly optimistic to assume we’ll see a rapid post-pandemic economic recovery this year.

Financial analysts aren’t famous for a moderate approach to assessing the future.

Central bankers aren’t quietly warning that they won’t lift rates anytime soon, they are shouting it as loud as they can.

But markets aren’t listening.

The net result of humans acting collectively in their individual interests tends to be either wild pessimism or wild optimism.

Financial analysts, like indulgent parents, use more forgiving terms such as over-exuberance.

Regardless, even if the Great Reflation hasn’t really started yet, the great Reflation Trade has.

Long-term bond yields have risen sharply in the past week as the so-called “smart money” decides it will be advantageous to start celebrating the end of the pandemic before anyone else.

This is a risky strategy – as anyone who ever told themselves it would be fine to start drinking early because they’d be home in bed by 10pm well knows.

What’s more worrying is that they have decided to start their early party at our house!

Financial markets have been especially exuberant about New Zealand’s economic outlook.

That’s understandable when you look at our pandemic response relative to other developed nations.

New Zealand’s economic performance – despite closed borders – has surprised everyone.

The Grand Poo-Bah of global economic assessment – ratings agency S&P – heaped great praise on us last week as it upgraded our international credit rating.

The Kiwi dollar and yields on Kiwi dollar bonds have been rising as investors bet we’ll be first in the developed world lift our interest rates to cool inflation.

Conversely, our stockmarket appears to be leading the pack in its retreat from record highs.

It hasn’t been a dramatic crash but it has certainly been rough start to the year for the NZX-50.

On Thursday it slumped into official “correction” territory – down more than 10 per cent from a high in early January.

Keen-eyed KiwiSaver worriers may have noticed that their accounts aren’t looking too bad, although there are signs the sell-off is spreading.

That’s because many other global markets are still booming.

This gentle revaluation of equity markets is actually a very good (and pretty rare) thing.

We should hope things stay this orderly as the reflation trade spreads around the world.

I doubt they will.

And of course equity markets are just one part of the equation.

The real test for New Zealand will be how reflation hits our other big asset bubble – housing.

A gentle, NZX-style, correction would probably be an ideal outcome.

But a lot of Kiwis seem to think this will never happen to property.

Unfortunately, that probably just increases the chances of the outcome being much worse in the end.

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