After the US published surprisingly robust data for unemployment and hourly wages in early February, the global stock market recorded a quick sell-off. At its trough, the Strait Times Index had a month-to-date fall of 4.5 percent, and other markets, especially the Greater Chinese bourses, had sharper falls. Hong Kong, for example, recorded its sharpest weekly fall in history when the Hang Seng Index fell by about 10 percent. In Hong Kong, the fall has since then been nicknamed the “Black Week”.
This down leg was triggered by a concern for higher inflation. The conventional thinking is that higher hourly wages may lead to higher inflation, which may trigger faster interest rate increases. The sharper-than-currently-expected rise in interest rate may increase the cost of funding, and thus lower the value of all financial assets. However, whether this chain of logic will pan out depends on a range of factors. We argue that there are reasons to doubt each step.
Inflation has been weaker than expected in the last ten years. Some of the factors, such as the ageing demographics in Europe and Japan, are negative to the overall well-being of the economy, but some, especially those related to new technology, is quite positive. For example, annual gasoline consumption in Europe, Japan and North America has fallen or increased at a moderate pace because of increased efficiency of vehicles.
As major car manufacturers begin to push for electric vehicles, the adoption rate will probably increase in the next decade or so. In fact, multiple European governments have pledged to replace all gasoline vehicles over the next two decades, suggesting that enough decision-makers believe that the technology is maturing fast enough to become the dominant transportation technology. As a new technology, electric vehicles have ample room to further increase their efficiency. This revolution is capable of capping oil demand and, when coupled with new supply technology, may turn out to be a major factor in holding oil price at half the price of the previous peak.
Other technology, such as advances in robotics and artificial intelligence, are also deflationary as they increase productivity. For example, personal digital assistants have finally graduated from being a glorified notebook to being a true assistant that can book transportation, manage the office and home supplies, and manage personal calendars and presentation decks. This frees up the human assistant to work on more complicated tasks and increase the per capita productivity in the office.
Similarly, by adopting computerised financial models, financial analysts can now focus on the big picture. Instead of worrying that the excel-based financial models may have mathematical errors, analysts can now spend their time thinking about assumption inputs that stem from more time spent on qualitative research. This is deflationary as companies are now capable of doing more with the same staff. In short, we believe that this round of economic upcycle may see significantly less inflation than previous cycles because of emerging technologies.
In addition, whether higher inflation will necessitate sharper interest rate increase is also unclear. In his first State of the Union Address, President Donald Trump announced his intention to start an infrastructure investment program that will cost US$ 1.7 trillion. This is in addition to the recently enacted tax cuts. While commentators have vastly diverse opinions over his policies and personal style, from the various laws passed last year, we note that he has been effective in pushing through his political agenda. Thus, our working assumption is that his policy plans will be enacted, and the US government will adopt a higher-leveraged, higher-growth policy stance, which is arguably Trump’s main strategy when he was in the commercial world.
A high leverage strategy is the most effective when inflation is higher yet mild and interest rates are lower yet sustainable because the true cost of debt will be lower. Thus, we doubt that a consumer price index of 2 percent or even slightly higher will prompt the Federal Reserve to adopt a much more hawkish stance than it has today. In other words, unless inflation starts to become an issue, interest rate increases may stay methodical and relatively mild.
Since both inflation and interest rate may stay accommodative in the foreseeable future, we think that the sell-off earlier in the month is likely to be an over-reaction. We do, however, believe that investors should consider investment classes that benefit from a higher-yet-sustainable inflation outlook. Within commercial real estate, such as REITs, this may mean asset classes that have shorter lease expiry and thus can improve rental income more rapidly as the market rents increase.