Technically Speaking, April, 2005

The article below is extracted from “Inflation is Always and Everywhere a Monetary Phenomenon” by Myles Zyblock, CFA – Chief Institutional Strategist & Director of Capital Markets Research at the Royal Bank of Canada. It is reproduced as reprinted in the February 7, 2005 issue of “John Mauldin’s Outside the Box” Additional information may be obtained by emailing JohnMauldin@InvestorsInsight.com

The title of this week’s report is based on a famous quote by the Nobel Prize winning monetary economist Milton Friedman. His view, anchored in the quantity theory of money, is that excessive money creation spawns inflation. Our research suggests that there is value in adopting a monetary framework to assess the long-term inflation outlook. We have examined data from a cross-section of countries, as well as nearly a century of US data, to find that inflation usually accelerates when money supply growth exceeds the growth rate in the economy for an extended period of time.

The Equation of Exchange

Milton Friedman, a Nobel Prize winning economist, once said that “inflation is always and everywhere a monetary phenomenon.” We believe that there is validity in his statement if one examines economic trends over a sufficiently long time span.  The basis for his monetary view of inflation is anchored in the equation of exchange that is highlighted below:

M • V = P • Q

Note that M is the money supply, V is the velocity of money (i.e., the rate of turnover of money in the economy), P is the general price level, and Q is real economic activity. Transforming each variable into a growth rate and rearranging the terms results in the following equation:

• • • •
P = M – Q + V

This secondary equation says that the rate of inflation is proportional to the growth rate of money. Or, said another way, inflation will increase when money supply growth exceeds the growth in real economic activity, assuming that the velocity of money remains unchanged. We have taken these theoretical underpinnings and applied them to economic data for the US since 1918. The results are shown in the chart below.

This chart presents some pretty compelling evidence that underlying trends in inflation usually rise when money growth exceeds real GDP growth for a sustained period of time. The latter development has indeed been the case since 1997. The time we last saw a similar turn of events was back in the 1960s, which ultimately paved the way for the inflationary 1970s. So why have we not yet experienced much inflation? Well, it could be that the velocity of money has declined by enough to swamp the impact of disproportionate monetary growth. Velocity might be in retreat (e.g., cash hoarding by corporate America over the past few years) in response to a heightened sense of geopolitical and economic uncertainty. An alternative, and more accurate, explanation is that money metrics are not helpful in forecasting inflationary turning points with precision; rather, they provide a roadmap for what will probably occur at some point within the next few years.

It is important to note that the strong link between money growth and inflation is not just evident in the USA. It is a robust relationship. We have examined data from a cross section of countries and found that higher rates of inflation typically surface in countries with faster money supply growth rates (refer to the next chart).

“Countries with higher money supply growth rates typically experience higher rates of inflation.”

Why Do We Care So Much About Trends in Money and Inflation?

If we are right about the link between money and inflation, and that inflation is likely to rise (modestly) on a trend basis over the next several years, then the way to think about investment prospects needs to change. We have written about the implications of rising trend inflation in detail in past strategy reports, and will briefly touch upon a couple of key themes once again.

The previous chart shows the relationship between government bond yields and trend inflation. It’s pretty obvious from this chart that the secular outlook for bonds will change markedly if we are indeed on the cusp of a turn in the long-term inflation outlook. We will no longer be looking for opportunities to buy the dips, rather we will probably become more focused on when to sell the rallies.

A change in the long-term outlook for inflation will also affect equity market strategy. Since the early-1980s, P/E multiples have been lifted higher largely in response to the long-term decline in interest rates (refer to the chart above). This will probably turn around. Moreover, a trend reversal in inflation will point to further compression in P/E multiples, the closing stages of the relative performance advantage for interest-sensitive equity sectors (e.g., Financials, Retailers), and the beginning of a long phase dominated by value investing.

Bottom Line

Since the late 1990s, the Fed has been flooding the system with money. Our work shows that inflationary trends mirror monetary trends, findings that are consistent with the quantity theory of money. If past is prologue, then it seems reasonable to anticipate a trend reversal in inflation sometime within the next few years. This means that investors should plan for the end of the secular bond bull market, the secular increase in P/E multiples, the long-term performance advantage for Financials and Retailers, and the trend outperformance of growth – relative to value-based stock selection strategies.