The longer cycles are usually not analysed in any detail, with the common assumption that the most recent trend will continue.

Most people in the financial industry today have never experienced an inflationary boom nor an inflationary bust. The last time we had sustained high inflation was in the late 1970s, and since then it’s been one big disinflationary cycle that led to a bull market in both equities (P/Es rose in the last four decades from single digits to the current 28x) and bonds (interest rates dropped from 20% to their lowest point of 0%). Buying ultra-long dated US government treasuries in 1980 would have yielded a return similar to equities.

Over the last twenty years, interest rates have averaged 1.41% a year. This trend leads many, including the Federal Reserve, to believe that inflation will remain contained at the 2-3% level as it has for much of recent history, and that current interest rates of 5.5% are at the upper end of their long-term range.

This assumption is a potentially dangerous one for investors. I still remember my father fixing his investment cash deposits at rates near 20% in 1980, back when I had no idea what an interest rate was. I just remember his happy face over dinners at achieving such a high return with ‘no risk’. Back then the fear was that higher commodity prices and inflation coupled with a high fertility rate globally meant we would all run out of food.

The exact opposite happened. World fertility rates dropped drastically, agricultural yield surged from technological breakthroughs, and central banks got inflation under control by aggressively hiking interest rates.

Fast forward to today, while investors were expecting up to six interest rate cuts from the US earlier this year, these expectations have been pared back significantly as recent economic reports showed much stickier inflation. Investors may be making the same mistake from 1980, but in reverse.

What would cause inflation to be much more sticky? Cycles like these have historically lasted a minimum of a whole decade. The disinflationary boom that started in 1980 resulted in a four decade bull market for bonds.

A possible reason for sustained higher inflation comes from Japan’s recent experience after experiencing three decades of deflation. The new governor of the Bank of Japan made a key speech in December where he outlined his thoughts on how Japan was going to face a reflationary future, citing demographics as a contributing factor.

The narrative since 2010 was that the world was following Japan’s experience in a sustained deflationary cycle. The combination of an aging population, too much debt, and low birth rates would cause continued deflation and low interest rates globally. A counter-intuitive argument that refutes this was put forward by independent research analyst Dario Perkins of TS Lombard last month, and he titled it: A Big Thing Everyone Got Wrong.

How could Japan’s future suddenly become more inflationary, despite continued weak demographics?

Dario’s argument is that it is not just about demographics; it’s about the relationship between savings vs. investment. He argues that if savings decline more than investment, the equilibrium interest rate moves higher. As baby boomers hit retirement age and drop out of the labour force, this is exactly what is happening as retirees spend more and save less. As more and more Boomers retire, this trend will accelerate causing structurally higher inflation.

The deflationary pressures of the last three decades started just as baby boomers needed big increases in investment after World War II, and entered middle age after 1980, raising savings just as population growth dropped and longevity increased, reducing investment demand while boosting savings. All this caused the equilibrium interest rate to fall dramatically. Dario argues this trend will not continue.

The Bank for International Settlements (BIS) already warned about this back in 2019, before the pandemic, where they estimated that the demographic structure of inflation from developed markets shows a U shaped pattern. The population of young and old are inflationary, while the prime working-age cohorts are disinflationary. We are in the process of seeing the working-age cohort shrink significantly across developed markets. The BIS conclusion predicts a sustained inflationary impulse over the next twenty years.

Disinflation over the last twenty years accelerated from global productivity gains and China’s entrance into the WTO, exporting deflation via cheaper goods. China is no longer a low-cost labour market, and geopolitical trends and the US-China trade war are all inflationary in nature.

We have just experienced significant bullish action of commodity prices, particularly in gold that hit an all-time high this year. But it’s not just gold, it’s a broad move across many commodities.

While everyone follows Nvidia’s stock price, the price of cocoa has actually outperformed Nvidia’s massive +77% gain, surging by 142% this year.

A deflationary counter-argument to the baby boomers retirement leading to a sustained inflationary impulse in the US is the continued inflow of immigrants. There were over 3.3 million foreign born workers entering the US in 2023 in one of the largest demographic moves in one year in US history. This influx of workers is helping to keep a lid on wages and supplying workers to areas of need. If this continues, the ongoing migration will continue to expand the labour force and potentially counter the inflationary impact of too tight a jobs market. It also helps to explain the extraordinary jobs creation in the US in 2023 and so far this year.

Investors should keep an eye on whether future economic data releases continue to point to higher inflation in the future, which would warrant a consideration to further diversify their portfolios away from just equities and bonds.  We had a taste of an inflationary boom in 2000-2007, when gold, oil, and emerging markets had significant gains, as US equity markets struggled. An inflationary bust, where high inflation is coupled with weak growth last happened in the 1970s. The possibility of such a stagflationary environment in the future has increased; investors may want to start thinking about additional diversification in their portfolios by adding commodity exposure, especially if bonds and equities continue to be highly correlated going forward.