Bank of America today succinctly waded into what I think is the most-important macroeconomic question right now: Was the 2000-2020 period of low inflation a sign of central banks taming inflation or a historical one-off that won’t be repeated in the future.

Economist Michael Woodward writes:

In the 20th century, the average inflation rate among G7 economies was 5%. In the first two decades of this century, it was 2%. The interlude of very low rates, inflation, and growth may have been caused by factors that seem to be reversing: rapid globalization, low public debt, asset-light technology, and optimal demographics. If these reversals create conditions that are more similar to the 20th century than the 21st, it could mean a wider range of possible market outcomes than investors expect.

He understates the final point as it would represent a potentially-catastrophic change. In just one example: in the 1990s, US 30-year yields averaged above 7% and that was a decade when CPI averaged just 3% and US government debt was under control.

A return to a 5% ‘normal’ would imply at least that. Tack on a 200 bps premium for mortgages and you have people borrowing at 9%.

In terms of equities, a 7% risk-free rate would severely impair the case for the S&P 500, which trades at a 3.5% earnings yield and a 1.3% dividend yield. That also doesn’t factor in the drag to corporate profitability from higher borrowing costs.

What scares me is that globalization is objectively deflationary, demographics have undoubtedly been a sweet spot and technology made leaps in that period. We won’t repeat that and may even be unwinding it via the trade war.

Perhaps AI and automation can spark a repeat — or even an extension of that trend — but that raises fresh set of questions.

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