By: Jeff Pollock
November 20, 2017

Canada posted a yawning 1.6% annualized inflation rate during the month of October. We have yet to exceed the Bank of Canada’s 2.0% target for two consecutive months since August 2014, over three years ago. The US faces the same struggle, reporting only 1.3% growth in its core rate last month.

Following the financial crisis in 2008, central banks coordinated their monetary policies by collectively dropping interest rates close to zero (and in some jurisdictions, negative). Beyond rate cuts, the US, Europe, United Kington, and Japan employed money-printing Quantitative Easing (“QE”) programs intent on stimulating economic growth. In doing so, the US Federal Reserve added $4.5 trillion in assets to its Balance Sheet.

At the time, to predict that inflation – caused by wage growth, commodity price increases, and the expectation for future inflation – would follow a decade of loose monetary policy is far from an outrageous bet. However, the theory and the facts disagree. Even outgoing Fed Chair Janet Yellen conceded herself in September that the recently meagre inflation data is “a mystery” to her.

We expect inflation to remain subdued for the foreseeable future, and here’s why.

Technology Reduces Costs

  • Consumer are benefitting from technological advances. The internet has displaced (to name a few) CDs, DVDs, newspapers, and department stores. Cord-cutting has been an ongoing trend for years. Social media offers a form of entertainment at no cost to the user. And disruptive technology companies such as Amazon have enabled comparative shopping to be made more efficiently, allowing consumers to pay lower prices.
  • Companies are also benefitting from automation and software adoption to improve work processes. The operating margin in the most recent quarter was 17.2% for the overall S&P 500. Ten years ago, it was 13.4%. Replacing people with machines is likely the culprit for a lack of wage growth, and should artificial intelligence displace 40% of jobs by 2030, this trend is in its early stages.

 

Trade Reduces Prices

  • Though lost in today’s populist rhetoric, the rationale behind global trade is to allow each country to specialize in producing the items they’re most proficient at producing. This leads to a lower price for the end purchaser.
  • Attracted by the inexpensive labour overseas, many companies have sought to outsource production to cheaper geographies. For example, in 1980, China was responsible for a mere 1% of global exports. Today, that figure has climbed to 14%.

 

Aging Population Reduces Spending

  • Over time, the North American birth rate has steadily declined. Today it’s about 12.3 births per 1,000 people. Ten years ago, it was 13.7 births. Twenty years back, it was 14.4 births. Thirty years prior, 15.7 births. Coupled with the aging population (don’t forget the oldest baby boomer is now 71 years old), this will create a smaller work force (and tax base, which contributes directly to GDP) and higher dependency rate.

 

Dividends and Share Buybacks In Lieu of Capital Investments Reduces GDP Growth

  • Capital expenditures have drifted lower in recent years to make way for additional dividends and share repurchase programs. Last year, the S&P 500 companies collectively spent $536.4 billion on dividends and share repurchase programs. In 2015 and 2014, $572.2 billion and $553.3 billion, respectively, was returned to shareholders. By comparison, capital spending was about $0.8 trillion last year. Prior to the recession, it was closer to $1.2 trillion.

 

For these reasons, we expect inflation to remain subdued for the foreseeable future. In fact, tepid inflation data could help explain the lack of any market correction for over a year and a half. Should our prediction become a reality, rate hikes will truly be gradual, and you’ll want to stay invested in the equity market for a continued bull market.

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