Inflation or Deflation?
Of the interesting characteristics defining the Covid-19 economy, one is the simultaneous worries of both deflation and inflation because there were concurrent supply and demand shocks. Which of those sides recovers more rapidly/more strongly will probably be the main driver of whether inflation or deflation materializes. Spoiler alert... in my opinion, probably light inflation.
When we talk about modern deflation we are usually talking about Japan-style deflation and it's worth noting that the consumer psychology that took root in Japan is not shared in the U.S. An economic mindset took hold in Japan that was/is hard to break… that delayed gratification is rewarded with lower prices and a that an increase in prices by many businesses is unacceptable. America doesn't suffer from that deflationary expectation and the self-fulfilling outcomes that ensue.
The ability to spend money online which has been steadily expanding, and the data on retail sales from May 2020 (a jump of 18.2% after a 22.3% decline in March/April) and June 2020 (up 6.4% from May) seems to show pent up demand and a willingness to spend amid uncertainty, though this wouldn’t be sustainable without either job recovery or governments replacing incomes. Yet that spending might demonstrate that the inflationary consumer mindset remains intact. This combined with the realization that new money supply (which more than a little of has happened recently and which has clearly been justified by the circumstances) finds its way into some combination of prices or production, looks to tilt things away from deflation.
The Fed is also becoming more permissive of inflation, learning from our experiences of the last decade, increasing the chances of lower rates for longer and lowering the probability of deflation.
Because of these reasons it is reasonable to argue in favor of at least modest inflation over deflation, but very hard to say when with any level of useful precision. It will probably be delayed by unemployment absorption and then the hidden slack in the labor market after unemployment shrinks.
It should be noted, however, that inflationary pressures will have strong headwinds until the virus-driven uncertainty is reduced. From Randy Kroszner, former member of the Board of Governors of the U.S. Federal Reserve System:
I think this is the key point: whether it is Japan, where the BOJ’s balance sheet exceeds 100 percent of GDP and continues to grow rapidly, or the ECB with a balance sheet of more than 50 percent of Eurozone GDP and growing, or the Fed with a balance sheet of just over a third of U.S. GDP and growing, inflation has been below the 2 percent target, and expectation of inflation over short and long horizons remain low. Even when the U.S. was growing at 2-3 percent pre-Covid we didn’t see an uptick in inflation or inflation expectations. As long as there continues to be a very large demand for super liquid safe assets like bank reserves and cash, the central banks can maintain large balance sheets- and even increase them- without a sharp increase in money supply that ignites inflation. The ongoing uncertainty over the course of the virus and the policy responses will undoubtedly keep the demand for safe liquid assets high for some time.
To preserve real returns and purchasing power in an inflationary environment, you want to be holding assets that can "float" higher on the tide of inflation. Apartments typically fare well under inflation.
We operate in the workforce segment of apartments and think that segment stands to benefit more so than higher priced new product. Inflation will also increase costs of construction (these have been driven higher much more rapidly than general inflation) which will drive rent requirements for new product. On average, we buy workforce housing about 50% below the cost of replacement. This allows the workforce housing segment to ride coattails when new product rents are rising yet creates the flexibility to remain affordable to a much larger population of renters.
Rates will likely stay low for quite some time. Low rates pose risk of inducing renters away into home ownership, yet this risk is most prevalent in Class A product where most renters choose to rent but largely have the means to buy a home. There is much more insulation from this loss of demand within workforce housing, which also simultaneously benefits from lower rates via lower financing costs.
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