Real estate paradox: Falling interest rates might actually stymie home sales. By LEW SICHELMAN Andrews McMeel Syndication. March 06, 2020 05:18 AM.

What will the end of the bull market in bonds bring?

Below is an extract of a piece I wrote that was published by Marc Faber a little more than a year back with the emphasis on the longer-term prospects for inflation, but touching also on those for real yields.

Gloom Boom Doom by Marc Faber

I think the arguments still apply.  In particular, the key thing to note as I update this answer on 22nd June 2015, is that investors are currently negative on Chinese growth (see recent Barclays and Merrill surveys) and don’t expect positive growth surprises from that region:
China’s equity market in ‘bubble’: Bofa-ML survey | The Economic Times Video | ET Now

Yet the equity market points to a very different picture, because the two best predictors of future growth are equity prices and the yield curve.  Chinese growth will accelerate from here, and that will have negative implications for bund prices, and positive implications for breakeven inflation and commodity prices.


If I had written it for Quora, I would have picked a different style.  In this case, I am afraid that I took the deliberate choice to explore the prospects for inflation and growth in a leisurely manner, because I think the problem of our age is that we are in too much of a hurry to get to the point, and this paradoxically leads to locking on to what is salient and missing the slower, more powerful developments that are truly important.  If you wish to see the investment implications skip towards the end.

As regards the consequences of the end of the bond market bull, one needs to be careful about reasoning from a price change and think about what the underlying factors might be that give rise to this shift in regime.  These are often only possible to discern fully with the benefit of hindsight, and the problem is that all the daily noise about which policymaker said what, and which economic numbers surprised is interesting, but the integral of this noise is not the same thing as what turns out to be most important in driving these longer-term developments.

For example, a bond bear market due to galloping inflation and stagnant growth has a totally different significance to one that is due to a stunning revival in growth amidst stable inflation.  One needs to go to the underlying factors to know what a bond bear market might mean.

So I beg your patience in addressing also some of the reasons why bonds might be turning, because these are important in understanding the implications of the change in trend.

One aspect that I did not address was that rising yields will put pressure on budgets of highly-indebted nations (I mean for the public sector debt) and lead, perhaps to spending cuts in real terms, perhaps not, but  in any case to a shrinking in the share of government spending as a proportion of output.  The social and cultural consequences of this will be significant, and I will address these elsewhere.
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Extract begins:

The consensus narrative is at present concerned over deflation in Europe and globally, motivated by concerns over the perceived persistent labour market weakness, policymakers have pressed further into strange territory (forward guidance) in the belief that inflation is not an immediate problem, and that the central bank knows very well how to defeat inflation once it becomes evident.  I believe that from a strategic perspective these concerns over deflation and weak growth will turn out to be mistaken, that it will be more difficult to control inflation than most anticipate, and that tactically the timing and entry level are right to take the other side of the trade and bet on reflation by entering a long breakeven inflation position. [Ed: a bit early, but there is no shame in being stopped out now and then].

This is a multi-month trade that has the potential given the supportive macro backdrop to become a longer-term position and, in any case, whatever one’s horizon or asset class, few investors can afford to neglect considering the inflation outlook and, in that context,  I hope that this perspective may be of some interest.

Over time I intend to write a piece that is more closely reasoned and supported by deeper analysis on this topic.  What follows is impressionistic in tone: I am using data to support the plausibility of a thesis, rather than to demonstrate its correctness.  In part that is due to temporary resource constraints, and in part because I believe a view informed by an interpretation of the gestalt to be more useful than reductive analysis on its own.  There is more thought behind this than I am able to set out in a piece that is short in relation to the intrinsic richness of the topic and if I can stimulate the reader’s imagination, this piece will be a success.

By gestalt, I mean an approach that considers the coherent picture of financial, psychological, and economic variables and the way they naturally unfold together over time, whereas I think it is useful to remember that analysis essentially involves breaking a problem down into pieces – a valuable component in formulating a view, but there are dangers in not putting them back together in a way that respects the natural coherence in economic life.  Starting my career as a ‘rocket scientist’ led me also to appreciate the limits of analysis.

As an occasional contrarian and sometime student of mass psychology, I diagnose mild insanity from this perspective with regards to talk of deflation in Europe.  Headline focus has accompanied capitulation-type price action in implied breakevens.  [Ed: it’s amazing how long seemingly-obvious moves take to unfold – we saw the same in 2007-2008]


French 10 year breakevens (daily)


The mistake is perhaps to reify observed weakness in headline inflation and treat it as a phenomenon real in itself and think one is in a Fisher-type of deflation that will therefore persist, rather than just a time of possibly temporary softness which perhaps could persist, but won’t necessarily do so.  If we were seeing a genuine broad deflationary move (or prelude to one), the constellation of prices and economic data would be utterly different from what we do in fact observe.  There are in fact certain basic cognitive reasons for the tendency of mainstream economic analysts to fail to integrate the overall picture that the highly erudite polymath Dr Iain McGilchrist has set out in his difficult but rewarding masterwork “The Master and His Emissary”.

Furthermore, both inflation and real GDP tend to follow credit growth (or money x velocity) with a lag.  (The quantity identity is an identity at a point in time, but I trust you follow my point).  Given the pressure on European banks into July 2012 (and ongoing mini-stress for some time following that), one would expect soft price pressure in Europe for as long as maybe 18 months following that.  (Credit to Gavekal many years back for their work on relationship between bank stocks and velocity).  That takes us to early this year, and we have seen exactly what one would have expected at the time one would expect it – subdued inflationary pressure today is exactly what one would expect had commodity prices just remained stable.

European Banks weak into July 2012 


But they have staged a recovery in absolute terms, keeping pace with the index since then:

European Banks vs Eurostoxx relative strength


Commodity outlook overall supportive for breakevens

Summary: weakness in commodity prices into Jan 2014 only compounded European disinflationary pressure.  The outlook from a technical perspective looks very positive longer-term, and this has been, and may continue to be magnified for emerging markets by persistent currency weakness.  Food prices are critical in the wage inflation process – these have participated in general commodity strength, and there are reasons to expect further substantial upside in coming years.  Industrial commodity weakness constitutes a risk to the thesis. [You don’t say!]

Rather than stability in commodity prices, we actually saw weakness: an upside climax into fall 2012 and the weakness since then only added to the disinflationary pressure from the weak European credit situation.

For perhaps obvious reasons, there tends to be a positive, although far from perfect, relationship between commodity prices and breakeven inflation over time.  (Energy has been a particular focus of shorter-term inflation market participants, but it is not only energy that matters, especially for larger moves sustained over time).
Commodities were basing during the period July 2013 – Jan 2014, and have gone ballistic to the upside since then.  However breakeven inflation has been stable in the US, and soft in Europe.  I have noticed it’s a common mistake in markets when an intermarket relationship breaks down for idiosyncratic reasons to expect that the breakdown will continue, whereas sometimes there is no sustained breakdown – just a lag until the opposing idiosyncratic factor has exhausted itself.  We may see a catch-up and then reconnection between the movement of breakevens and commodity prices.

Previously I turned strategically negative industrial commodity prices in May 2011, with some of the key factors being increased supply, the likelihood of both slowing credit and economic growth in China, and a lower resource elasticity of growth.  With copper off 32% from the July 2011 peak, and the troubles of industrial commodity-producing nations very much in focus, the risk:reward of this view and probability of success are now much less appealing.  However further development along these lines does present a near-term risk for my new bullish breakeven view from a tactical perspective, even should the longer-term idea be well-founded; and of course we may continue to see the stop-go kind of economic recovery experienced since 2009, and short-term tension between prospectively tighter policy and rising inflation trend.

Continuous Commodity Index (CCI)

DB Agriculture (Returns) Index in numeraire of JPM emerging market fx index


Coffee (USD)

Corn (USD)

Corn (USD, adjusted by CPI) – long term monthly

Food prices remain cheap in longer-term context (corn is today at 26% of the July 1974 peak, but peaks prior to this – not shown on chart – have been higher than 1974 levels)
Significantly, food prices have participated in the rally.  Marc Faber has observed that every period of sustained inflation involves inflation in food prices, and that persistent food inflation tends eventually to lead to broad wage inflation.  We remember the 1970s inflation for the oil shock, but not that it was preceded by a large move higher in soybeans (and somewhat other agricultural commodities).  Whilst food today constitutes a smaller portion of developed world consumption baskets, this does not mean that its price is unimportant given the indirect impact via emerging market wages

and imported goods.  Given the general weakness in emerging market currencies (satisfying to see since my strategic bearish note of July 2011), the commodity pressure is compounded in these regions.

I find the standard long-term bullish fundamental thesis for food prices (reading suggestions available on request) to be quite convincing, but (looking past geopolitics and short-term weather) other developments not yet widely appreciated may also prove more important on an investment horizon.

Marc Faber has previously published a GBD guest piece on the influence of ocean cycles.  It may be that there are other under-recognised but important influences on food prices of astronomical origin.  In the C19, Jevons and Herschel – although leading men of their time – incurred the ridicule of their contemporaries for suggesting a putative relationship between solar activity and food prices.   Recent authors have arrived at a more favourable assessment of their work, but I raise the topic with trepidation given the politicisation in the Anglosphere of questions of climate.  (This is much less the case in Asia, Russia and Germany).  It is possible that the sun may have entered since 2000 a period of subdued activity that would endure till 2035 or beyond (the Eddy Minimum).  The interested reader may wish to explore variouspaperson this, and the implications for agriculturalproductivityvia the influence of cloud formation on the Earth’s albedo, and via a putative solar link to volcanic activity.  Integrated world trade reduces the effects of local crop failures, and in the long-run marginal land may be brought back under cultivation; I suggest that this will not necessarily prevent a long-term bull market in food.

Neither the long-term nor the tactical validity of the thesis depends on a bull market in food prices, but this would certainly be one very supportive factor, and one to which I think the consensus does not pay sufficient attention.

Labour Market
Returning to the more conventional fundamentals: I have not space to look at the labour market properly in this note.  But US quit rate continues to ratchet higher from depressed levels (the relevance being that workers do not lightly quit their job in adverse labour market conditions):

Money Hourly Earnings growth at least off the lows if, to be frank, not yet stellar (and in real terms the picture is worse):

Ratio of JOLT Quit Rate to Separations (quits+fires) Rate keeps ratcheting higher – now back at non-crisis levels:


US economic surprises have lately been very negative.  I wonder what payroll will bring tomorrow:-


There have been some signs of firming in the UK labour market, but I will not set them out here for now.

I note briefly but importantly that in the US we have just passed through peak fiscal drag, and that labour market challenges relate especially to local and state government employment more than private.

All of this comes as we leave a period when surveys show that job dissatisfaction has lately been at record bad levels – implying that many people have been holding on to a miserable job for fear of not being able to find another.  When the tide turns, we could be surprised by the magnitude and persistence of upward wage pressure.

More than a dozen years after China’s entry into the WTO, laying of fibre made offshoring of white-collar jobs feasible, and bandwidth/storage/computational advances reached a threshold sufficient to allow a wave of automation to unfold, the consensus continues to extrapolate recent pressure on the middle class out into the indefinite future.  A mere half-generation after the climax of dotcom euphoria, today being bullish on the prospects for the West and its workers has come to be seen as a highly eccentric and unsophisticated position.

But, just as the painful effect of emerging market integration and technological change for workers in the West was foreseen at an early stage by very few mainstream commentators (Marc Faber stands out as a notable exception, but in those days his following was more select), it may be that a shift to a more positive outlook for wage growth also comes as a surprise.  Many years before Schumpeter wrote about the role of creative destruction in a market economy, another German-speaking genius (Hölderlin)expressed a cognate insight in poetic terms that captures the essence of change in nature at a perhaps more profound level:  “where the peril is greatest, there lies thesaving grace also

Concrete explorations of the specific factors supporting an upturn in economy-wide nominal wage growth lie outside the scope of this piece, but I recommend thestudiesby BCG on US manufacturing (free e-book from Amazon hereHow Shifting Global Economics Are Creating an American Comeback eBook: Harold L. Sirkin, Justin Rose, Michael Zinser: Amazon.co.uk: Kindle Store)

It is no longer a no-brainer to move production to China (or Vietnam).  For a certain class of products, developed world relative unit labour costs are pretty competitive, bearing in mind the longevity of plant, emerging market wage inflation and recruitment difficulties, that labour costs form only part of the total costs of a product, and that costs for co-ordination, quality control, and the protection of intellectual property are not to be neglected.  (The US, especially, benefiting from domestic shale gas production as well as a high level of productivity).

And in the longer run, from a practical perspective (setting aside past  interminable although intellectually interesting past debates over Austrian capital vs neo-Ricardian theory) the attractiveness of replacing labour with capital is likely at this juncture to be heavily influenced by the cost of capital ie the interest rate.  Very simplistically: when rates are 1% it may be appealing to replace a worker with a $2mm piece of machinery; at a 5% cost of capital, it is much less appealing.  I have a couple of pieces on this topic that may be of interest.

It is human nature to predict the past based on an extrapolation of recent experience, the awareness that one is extrapolating being only somewhat realised at a conscious level.  In 2007, after 25 years of falling macroeconomic volatility, the policymaking world experienced a pandemic of self-congratulation over the Great Moderation (attributed in substantial part to the excellence of modern central banking) – this was not to prove a terribly effective guide to future experience.

Similarly, one is struck by the pessimism that resulted from the financial crisis – the prior extrapolation of good times indefinitely was followed by a new extrapolation of bad times indefinitely.  Whereas, although the macroeconomic experience has been difficult, it’s proved to be much more favourable than expected by most analysts in March 2009 (and for quite some time after that).  For all our sophistication in macroeconomic modelling, the pattern of errors in expectations is quite in accordance with the observations of Keynes’s rival, A.C. Pigou, about post-crisis psychology:
“The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant”.

Even should interest rates remain at present subdued levels (something that is very far from what I expect), first order a sharply lowered cost of capital will lead to a one-shot adjustment in the desired capital stock in relation to labour – of course this plays out over a period of time, but this period is not infinite.  Over time, as rates stabilize at a low level, then conceptually at some point the adjustment will be complete.  Viewed quarter by quarter in terms of the flow of substitution of labour by capital (automation specifically), this might perhaps play out as the first derivative of an S curve (looking like a normal distribution with time on the X axis) – and, certainly, rising rates will tend to subdue any further adjustment.  Incidentally, I am far from bearish on capex overall, but that is better addressed in a future note.

Of course, in a more complete model, not to mention in the real world, it’s very much more complex than this, and one needs to study at a sectoral level the degree to which these waves have played out or have further to go, but I wanted to remind you of some basic economic reasons why one might be cautious about presuming automation and offshoring mean that recent experience will inevitably prove to be a good guide to the future.

Furthermore, in what remains even today a reasonably flexible economy, workers displaced by new technologies do find new jobs over time, and the new enterprises created by emerging technology combinations (cloud computing, certain high quality open-source software, emerging credit market innovations such as crowdfunding, big data, tablets, social media, broadband everywhere, private sector space projects, cheap drones, 3D printing to name just a few) tend in the beginning to be too small to be picked up in the macroeconomic aggregates, but their rapid pace of growth means that this is only temporary.  A couple of years ago, there was a cheap shot of a meme asking rhetorically “how many jobs has Twitter created?”  Increasingly, this is a difficult stance to maintain if one examines carefully the growth of new enterprises.  One might as well have asked in the mid-90s “how many jobs has Netscape created?”
There is pessimism too over the outlook for productivity, with a paper by the luminary Robert Gordon published in August 2012 asking “Is US Economic Growth Over?”.  Whilst I do have concerns on a multi-decadal horizon relating to factors not discussed by Gordon (see Michael Woodley’s workon certain controversial aspects of demographic change), it’s worth noting that there is a strong cyclical element of pessimism in views about productivity.

Writing from a perspective informed by an understanding of mass psychology, I view confidence not as based on an essentially purely rational calculation of local prospects, but reflecting in part certain vast psychological tides that influence consumers, entrepreneurs, central bankers, and street economists – the latter two not escaping the tidal influence in spite of their analytical sophistication.  In accordance with the behavioural finance phenomenon of misattribution of mood, when people are feeling gloomy there is a tendency to arrive at rationalisations for their state of mind, which although often soundly based in fact, may not actually prove a good guide to future prospects.

Even within the more conventional approach, some rigorous academic work does suggest that rising confidence tends to foreshadow productivity booms.  In other words, holding an apparently rationally pessimistic belief about growth prospects on the basis of what appear on the face of it to be weak fundamentals has a circular aspect to it that nonetheless is unable to sustain itself indefinitely: an NBER working paper of 2011 by Beaudry, Nam, and Wang suggests the sequencing of events is typically that one will see confidence shift first, and then total factor productivity will follow over the succeeding 8 to 10 quarters.  (They find that in excess of 50% of business cycle fluctuations in hours and output can be explained by mood swings).  I have some ideas about why this might be, but discussion of these lies outside the scope of this paper.

Consumer confidence certainly has improved since the worst period of Feb 2009 (although for now it remains at somewhat depressed level) and may continue to do so, and this might be expected possibly to anticipate an improvement in total factor productivity growth in the years ahead.  I do not claim in this short note to have demonstrated in a rigorous way that this scenario must necessarily unfold this way, but perhaps it may open up the possibility to the reader of imagining that the future may unfold differently from the consensus gloom.

US Conference Board Consumer Confidence


At a remarkably similar point in the cycle – five years after the major bear market bottom of 1982 -Solow joked that “Computers are everywhere but in the productivity statistics”, but the perception a decade later was quite different.  As the work of Erik Brynjolfsson shows, for technology to feed through into real gains in productivity one needs not just a wave of complementary innovations at a technical level, but also certain organisational adaptations.  Humans being what they are, this takes time, and involves a period of experimentation and social learning as to how to adapt to the new possibilities – and this applies as much to creating new revenue models as to productivity gains.  Newspapers were initially devastated by the loss of revenue from advertising, and the unwillingness of people to pay to read on a PC, but the outlook today is rather more positive to that of past experience.  Might healthcare, and other more economically significant industries be next ?

New York Times – a renaissance?

My thoughts here relate to much more than just the outlook for productivity, but productivity is an important part of the question.  Although within a standard macroeconomic model, being positive on productivity growth would naturally seem to lead one to be less positive about the prospects for inflation, the world is a more complicated place than can be captured by such models, and recent weak productivity experience is one factor supporting pessimism over economic prospects, and it may be that the influence of any future less pessimistic outlook on labour market perceptions and bargaining will dominate the mechanical effects of higher productivity on unit costs.

The implications of the above broader discussion might be important primarily for the prospects for real growth rather than inflation if the labour market were at a different juncture, and the backdrop of money and credit were different.  However given the setup we have, it is my judgment that the implications for wage inflation (in excess of productivity growth)  are more immediately important from a macro investment perspective.  I will try to elaborate the reasons for this judgement in another piece but note that changes in velocity can be explained reasonably well by payroll growth, interest rates, and the strength of financial stocks.

So I suggest that wage growth has been depressed by fear: fear of the economic environment, fear of being replaced by a machine, fear of one’s job being offshored.   Euphoria may be sustained for a while, but for humans it’s hard to stay scared for an extended period.  Prolonged despair did not serve our ancestors very well, no matter what the challenges.  The point is that viewed from certain perspectives, the fundamentals have been shifting slowly against the doomed-middle-class thesis for some time now, but perceptions of the situation have been stuck in a gloomy mode.  However, perceptions of value and the inflationary mentality do have an emotional component, and the sentiments of a crowd can shift quite abruptly, especially during somewhat chaotic times when conventional anchors have been disturbed.

Economists have not historically demonstrated outstanding prowess in their ability to anticipate such shifts.  Fed officials have recently had to endure a degree of taunting over their misplaced inflationary concerns in July 2008 (we had a slightly different view at that time!), but I do not see that their track record can be seen as egregiously poor when compared with other purely economic practitioners.  Forward guidance today would have merit if the central bank had superior insight into the real economy to the market.  If however, the market has superior insight in anticipating future developments then forward guidance based on a model that lags behind must be seen as inevitably destabilizing, and the doctrine of Mr Carney as failing to benefit from the preceding, although admittedly not peer-reviewed,insights of Mr Cnut.

I have written before about the problems of the Reinhart-Rogoff thesis.  How about the specific argument that the excess credit growth we have seen is unlikely to be translated into inflation given the typical post-crisis experience?  Samuel Reynard at the Swiss National Bank has made a study of post-crisis episodes and finds that contrary to prevalent perception, the “empirical relationship between money and subsequent inflation developments has remained stable and similar in crisis and normal times”.  Short-term, inflation may undershoot what is implied by excess monetary growth but, as risk appetite recovers, the relationship normalizes.

In other words it simply isn’t the case that the central bank can just raise rates and defeat inflation – by the time they start to act (and they have made a big fuss about their commitment to raising rates late), there is a lot baked in the cake and it’s tough to endure the loss of output required to get back to inflation target quickly – and in AD 2014, mass democracies in the West do not do tough well, and this, too, is something that will be obvious to market participants once the inflationary cycle turns.

Investment Implications

To make a necessary statement of the obvious, one is not betting on imminent headline inflation by owning breakevens at this level – just that the market will start to reprice implied expectations.  By the time one has all the evidence one needs to be sure headline inflation is going higher, breakevens will certainly be at less attractive levels to enter the trade.  Embracing in a controlled way the possibility of being wrong may prove safer than waiting till one can be certain one is correct.

Many of my somewhat-impressionistic thoughts above are rather longer-term, and of course I recognize that timing is key.  This being said, the allocation of attention in our era places inordinate emphasis on trying to identify fundamental catalysts for short-term moves (is this not the loser’s game?), whereas truly powerful fundamentals unfold quite slowly in the beginning – often too slowly for those glued to the ticker to be able to make sense of, and yet quickly enough once they build up a head of steam that they ought not to be neglected even by an investor measured by monthly or quarterly performance.

People often seem to have the view that there is a basic divide in the investment universe between on the one hand awe-inspiring but volatile highly-cerebral, thematic Great Macro Thinkers, and on the other, prosaic, relatively inarticulate and more instinctual yet more disciplined directional Traders.  Whether or not this perception is justified, I do believe that there is an ecological niche in the ground between the two categories.  It is worth noting that Soros, who often seems to present himself as basing his views on a philosophical framework, turns out to benefit much more from somatic insight than is commonly recognized.  Writing as a student of those who have gone before me, I believe that this somatically-informed approach fits much better with an organic perspective oriented towards reflective coherence in perceiving the gestalt than that of pure reductive Cartesian analysis.  (Longer explanation available on request).

So I do have strong reasons for favouring the trade at this time and level, but do not feel it is appropriate to lengthen this piece by setting them out further here for now.
Cautionary note: whilst I am bullish on the real economy in the West, the implications of rising implied inflation expectations accompanied by a pickup in nominal wage growth and higher commodity prices are not clearly unambiguously ultra-positive for equity markets –especially for bond proxies, or for many of the real assets that have been in demand as inflation hedges in the post-2003 period.  Financial assets tend to move in anticipation of future developments, and generally do much better when credit growth is abundant with subdued inflation and real growth positive but subdued – the actual arrival of a proper inflationary episode has often been a less pleasant experience.  Beyond the relative pricing, that is my reason for focusing on breakeven inflation as a trade expression.

Every inflationary episode is unique, and undiscriminating generalisations are certainly dangerous to one’s wealth.  This being said, although we are unlikely to see this level of inflation imminently, and neither shall we likely see a repetition of the political turmoil and industrial strife, real asset bulls who base their case on the cumulative inflationary effects of money-printing may find reacquaintance with the 1970s inflation in England to stimulate some further thought.  Equities proved a horrible inflation hedge, with the broad index falling c. 80% peak to trough in real terms (and not faring so much better in money terms) as inflation rose.

UK FTSE all-share adjusted for RPI, and RPI (inflation) yoy

This time around, the implications are not clearly negative for stocks overall, but certain sectors (eg high-dividend defensives) will get hit very hard.  As regards real estate in particular, the Wadhwani effect is critical for understanding the impact on real estate of higher inflation, and therefore eventually of higher nominal rates.  Consider a scenario where the real rate is 2% and inflation is zero – a $2mm apartment will cost $40,000 per annum to finance, and this may be seen as eminently affordable for a certain set of potential purchasers.  Consider on the other hand a scenario where the real rate is -2% and inflation is 12%, implying a nominal rate of 10%.

Surely an excellent scenario for the owner of such an asset who has financed it with debt, and who will repay the debt with depreciated dollars!  Unfortunately, this would imply a financing cost of $200,000, which will push the asset out of the affordability of many of the original set of purchasers and is likely to serve to depress its price on the relevant investment horizon.  Now this illustration was entirely theoretical, since I don’t expect inflation in the developed world to reach this level for some time – but it ought to be quite clear that there are circumstances in which real estate may not serve as effectively as an inflation hedge as many today believe.  Somewhat perversely and counterintuitively, it may be that falling inflation (and therefore falling nominal rates) has been a bigger driver of the post 1982 bull market in real estate than is always realized.  One sees this dynamic playing out in a manner easier to recognize in the recent experience of Brazil as inflation stabilized and nominal (also real) rates fell.  And so I wonder what will happen over the years to all real assets as the inflation dynamic in the West reverses?

Real rates
Real rates in the West have experienced a bull-market (falling yields) since c. 1980.  There is a long-term relationship between real rates and real GDP growth.  It’s therefore not just unsurprising, but entirely characteristic of how markets unfold that at the culmination of a long bull market in real rates, pessimism about the prospects for growth should be high.  I shall leave discussion of tactical opportunities in real rates for another piece.

It is also worth noting that there is a strong consensus that Janet Yellen – the new Fed Chair – is an ultra-dove.  Whilst I once had this view, I now wonder if it is well-founded.  She is distinguished from her predecessors by her emphasis on the labour market, her belief in her model, and her relative neglect of financial markets and also of public opinion except to the extent they feed through into her model.  We knew that Greenspan and Bernanke would ease policy if equities suffered too much.  In a future situation in the years to come where inflation is firm and rising, and the labour market is in good shape (clearly, not yet of immediate relevance), will Yellen will be as friendly to equity and credit markets?  If not, then there will ultimately be intriguing implications for the pricing of the yield curve.

It is a peculiar feature of the investment landscape that amidst a proliferation of ETFs and other specialist funds, and considering all the attention placed in public discussions on various, often extreme, scenarios for inflation, there is no single liquid instrument or fund that allows non-specialist investors to benefit from an environment of rising breakeven inflation.  Substantial assets are devoted to real bond funds, but these have the unattractive characteristic of losing money when real interest rates rise, as is also likely under the scenario I describe.  As a contrarian, I find this intriguing, and perhaps supportive of the longer-term view.

Beyond the longer-term structural outlook, one must remember that eras of higher inflation also tend to be those of more volatile inflation, and this creates opportunities for those able to navigate these shifts.  There may also be an opportunity for an entrepreneur here…