The Coronavirus Is Neither Inflationary Nor Deflationary

Summary

• COVID-19 has seen an immediate deflationary shock, but growing supply shortages spell a problem.
• Unemployment and PPP stimulus have kept wages from declining, while there are fewer places to spend money, resulting in higher savings rates.
• With too much money chasing fewer goods, it is likely that "grocery store inflation" continues to increase, while "non-necessity" goods see much lower prices.
• Unprecedented Federal Reserve stimulus could easily cause inflation to get out of hand.
• Inflation-indexed Treasury bonds are likely one of the few lower-risk places to put money.
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There has been a growing debate regarding whether COVID-19 (and its lasting economic consequences) will promote inflation or deflation. Traditionally, recessions are deflationary, as they cause demand to decline while supply is unchanged. However, this recession is far from traditional in that both supply and demand are in decline, resulting in an unclear price impact.

Indeed, it is very important for investors to have a sense of the CPI's direction. Long-term bonds are usually a popular recession hedge, since they rise with deflation. Long-term Treasuries, such as those in TLT, have a negative correlation to stocks not due to direct causality but because downturns usually promote deflation, which is beneficial for bonds. If there were a stagflationary recession, both stocks and bonds would likely decline, which would have a jarring consequence on most investors' portfolios (not to mention the struggling pension system).

Even more, inflation is perhaps the most important factor when it comes to the performance of certain equity sectors over others. Utilities, consumer staples, technology, and REITs generally struggle to raise prices with CPI, but must still raise wages with it. Thus, the value of their future cash flows rises with deflation and falls with inflation. The ongoing period of low inflation has been a major factor supporting these sectors.

On the other hand, commodity producers and manufacturers generally see sales prices rise at a faster rate than wages during higher inflation, which benefits those sectors. As an example, the past decade's low inflation has brought commodity prices so low that many commodity producers cannot make a profit (i.e., energy, base metals mining).

So, is the ongoing crisis promoting inflation or deflation? The answer may not be so simple.

Inflation is Not Ubiquitous

In March, the prices of all goods fell by an average of 0.4% (using CPI weights), however, there was a wide range. Indeed, there is almost always a wide range of price changes that do not reflect CPI. Over the past two decades, prices of service-oriented products like healthcare and education have increased at a faster pace CPI, while those of capital-oriented products have not (i.e., energy, apparel).

As you can see below, most price-sensitive products saw considerable deflation (i.e., new vehicles), while staples saw inflation. Take a look below:

(Source: Bureau of Labor Statistics)

Interestingly, tobacco, alcohol/beverages, healthcare, staple foods, and used vehicles saw prices increase the most. This is reflective of more people remaining at home and looking toward lower-cost items like used vehicles.

On the other hand, declines in traveling have resulted in steep declines in energy prices and transportation. Apparel and new vehicle prices have also declined considerably, which suggests many U.S. consumers are cutting back discretionary spending.

April's CPI data will arrive next week, and we can generally expect March's trends to continue. Energy prices have declined slightly further, while growing supply issues in the food industry are resulting in higher prices. While price gouging is illegal, the fact is that meat prices will rise considerably if a quarter of supply continues to be off-line.

The two most important factors of inflation are food and energy, both of which have been in a glut over most of the past decade. So far, COVID-19 has caused a major decline in energy prices, which will not only promote the deflation of transportation prices but of all prices, considering energy is the main input cost to production. On the other hand, food prices have risen on higher demand and lower supply, and will likely continue to do so. Importantly, a sustained rise in food prices is generally tied to an increase in social unrest.

Going forward, it is likely that energy prices stop declining. It appears that crude oil may be stabilizing (albeit around $10-15 per barrel). After virus shelter-in-place efforts are lifted, demand for gasoline will likely rise close to previous levels. Considering top scientists believe it is unlikely the virus will be beaten anytime soon, supply issues in factories (i.e., meatpacking) will likely remain for months. This outcome would almost certainly result in lasting stagflation.

A Look at the Financial Data

The markets are generally uncertain regarding the direction of inflation. We can measure inflation expectations by taking the difference of the 10-year Treasury yield (64 bps) and the 10-year inflation-indexed bond yield (-.43 bps), otherwise known as the 10-Year Breakeven Rate. This rate initially dropped to 50 bps during the March crash, but has since stabilized around 1%. The inverse is true for the U.S. dollar ETF (UUP) (which gains from deflation), as you can see below:

Data by YCharts

These signals are much less clear than they were during the past recession. During the initial phase of the 2007-2009 crash, the U.S. dollar was actually depreciating, while inflation expectations were nearly constant at 2.4%. However, once it became clear that there would be a significant recession, inflation expectations collapsed and the U.S. dollar rallied. The recovery thereafter was much slower, as you can see below:

Data by YCharts

The primary difference between the last recession and this recession on financial markets is the Federal Reserve's policy stance. In 2008, the U.S. government and Federal Reserve took aggressive actions to promote liquidity. However, the ongoing round of QE pales in comparison to the initial round of QE during the past recession. See below:

Data by YCharts

Without this aggressive stimulus, there would almost certainly be extreme deflation as companies and individuals struggle to make debt payments. With debt at extreme highs, even a month or two of forbearance could create a deadly deflationary liquidity spiral, as "one man's liability is another's asset". However, the Federal Reserve has essentially guaranteed repayment through its "Unlimited QE" policy.

Disconnect Between the "Real" and "Financial" Economy

The primary economic issue today is unemployment, which is expected to be around 16% today and likely rise to over 20%. If 20% of workers are not working, production will likely be at least 20% below normal. Importantly, many who are claiming unemployment are seeing their income rise due to the $600 weekly addition. This means their demand for goods and services is unlikely to decline considerably, if at all.

This is where there is a substantial disconnect between the real economy and the U.S. government's monetary stimulus. With PPP loans and unemployment, incomes have not declined, but production and the ability to spend money have collapsed. In other words, there is more cash available and fewer places to spend it.

As an example, the production of vehicles is down, as factories are shut and many dealerships are closed, so giving out money to encourage vehicle purchases is pointless. Thus, there has been a tremendous rise in the savings rate for most Americans, with the rate nearly doubling from 8% in February to 13% in March and likely higher in April.

In the short run, this will not promote inflation. However, there will eventually be too much money chasing too few goods. For example, the average American spends around $83 per month on meat, with demand rarely changing month to month. Soon, it is expected that 10-25% of meat will not be available, so many will go without. Most have the ability to spend much more on meat products given their disposable income, so they will outbid each other until prices reach extreme levels.

While this is one of many examples, it has been seen many times before. In major cities with limited vacant apartments, rental rates tend to rise until little disposable income is left to the median renter. With saving rates up, disposable income is higher, meaning prices could rise significantly.

Bottom Line

In the short run, it is likely that normal recessionary deflationary forces will continue. Supply shortages are currently beginning, while demand for non-necessities is collapsing. Prices for those non-necessities (i.e., new vehicles, apparel, travel, possibly education) will likely remain low for a much longer time frame. However, competition among consumers for necessities such as those in grocery stores is on the rise. With the U.S. government making efforts to keep income levels from dropping, there is a rise in available money for consumers to compete for fewer goods. I believe this will likely result in a substantial rise in prices for staple products unless food rationing is strictly enforced.

Even then, a major reason for the decline of inflation over the past few decades has been increased imports from lower-cost countries like China. Supply shortages stemming from this crisis have alerted the public that dependence on foreign imports can backfire. If the U.S. looks to increase tariffs after the crisis is over in order to boost U.S. manufacturing, it will likely result in a secular shift toward higher inflation.

To put it all together, inflation is of little concern over the coming few months. However, I expect a substantial lasting increase, particularly as restrictions are lifted. This will be very negative for long-term Treasuries and the U.S. dollar. Further, despite the stimulus, I do not believe the Federal Reserve can stop a recession, so this may portend the rare occasion where both stocks and bonds decline together. However, inflation-indexed Treasuries and precious metals will likely remain safe.

If you're curious about inflation-indexed Treasuries, I recommend reading "TIP: As Coronavirus Spreads, Investors Would Be Smart To Buy Inflation-Hedged Bonds". I published the article on January 28th (before COVID-19 was well-known to the public) and warned about shortages/panic-buying in the U.S.

Analyst’s Disclosure: I am/we are short TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.