This article is a complete rewrite of two existing sections of my manuscript. I was unhappy with the sections and they were blocking my progress. I decided to throw in the towel and keep the text to a minimum. The text probably needs some work, but it will no longer be a black hole for revisions.
The beauty of the Cantillon effect is that it establishes a simple relationship between inflation and financial asset markets. Apparently, people who somehow get “new money” first rush to buy financial assets, which drives up their price. This then affects consumer prices. The problem with simple rules related to financial asset prices is this: why do those who discovered them get rich using them?
What complicates matters is that different financial assets behave in different ways in response to inflation trends. Since the author does not believe that there are magical ways to make money in most financial markets based on inflation expectations, I will just make general comments about the different asset classes.
Inflation Linked Bonds
The only market where one can use correct inflation forecasts to make money is the inflation-indexed bond market. I talked about this market in my book Breakeven inflation analysis. The problem with inflation-indexed bonds is that being right about inflation over the next few months may or may not impact profitability; you should in theory be right about your predictions until the bond matures. Since trading inflation-linked bonds is the domain of specialists, I will simply refer readers to this earlier work.
Raw materials
Another relatively simple asset class is industrial commodities and raw materials (like grains). Energy price spikes are often associated with increases in overall inflation rates. If there are supply shortages globally, they will likely manifest themselves in commodity markets. Thus, commodity prices increased in the 1970s as well as after the pandemic.
Where things get tricky is far from these peaks. The old adage of traders in commodity markets is that “the cure for high prices is high prices.” If there is a surge in the price of a product, this leads to finding alternatives to the consumption of this product, as well as to calling on new sources of supply. We may then see a brutal bear market as excess supply is eliminated. This process is largely a global phenomenon, while countries’ local economies can overheat for whatever reason, leading to rising inflation despite low commodity prices. (This was the experience of the mid-1980s and 1990s.)
Gold
During the Gold Standard era, owning gold was a simple way to preserve purchasing power against inflation. But since President Nixon closed the gold window in 1971, currencies have been decoupled from gold. It is very difficult to see how a return to a link between currencies and gold would be important for a major economic power. Nonetheless, there is a vocal contingent that fantasizes about a return to gold, and the gold market may respond to inflationary vibrations.
The figure above shows the price of gold in dollars from 1990 to 2018, which reflects the end of the secular bear market, as well as the rise that began in the early 2000s. The bear market followed an earlier bubble that peaked in the early 1980s, and central banks slowly offloaded their gold reserves, replacing them with interest-bearing bonds.
Gold is an unusual commodity in that consumption of gold (such as jewelry making) is quite small compared to gold held in inventory. The primary determinant of the price of gold is how it is valued relative to other assets, with physical supply and demand being secondary. As a financial asset, its value is something of a conundrum: it costs money to store it, while generating no cash flow (without lending it out). As such, its value is determined by the “animal spirits” among gold traders (including central banks).
Looking at the chart above, it is difficult to see a clear link with inflation. The 1990s were the decade when inflation generally converged toward inflation targets in the developed world, but gold slowly lost its value. The bull market of the early 2000s does not correspond to an increase in inflationary trends. One could perhaps manipulate the data to discover a short-term relationship, but these relationships tend not to persist.
Obligations
The high-level relationship between bond yields and inflation, higher inflation tends to result in higher bond yields. (Note that a bond’s price moves inversely to the yield, so a higher yield means a lower price.) The difficulty is that the relationship is less mechanical than market folklore suggests. This relationship is based on the conventional action of central banks. For example, it is possible for the central bank to fix bond yields, thereby breaking the correlation.
The best way to understand bond yields outside of market crises is to consider that they represent an “average” estimate of bond market participants of the movement of the overnight rate, which is controlled by the central bank . In turn, the central bank attempts to control inflation by raising and lowering the policy rate. As such, the relationship between inflation and bond yields is that the bond market reacts to data that might cause the central bank to change its policy rate – and the inflation rate is an important variable. However, inflation tends to lag behind the business cycle, while bond market participants are expected to lag ahead of the business cycle. Thus, statements that the bond market must reacting to an inflation release ignores the fact that inflation news may have already been priced into the market.
The reader is free to squint at the graphs above to validate my assertions. The top panel shows US core inflation and the overnight rate (Fed Funds). We can see that the overnight rate tends to follow inflationary peaks – even though inflation was relatively stable between 1990 and 2020, we still have policy rate cycles. The second panel shows (again) the overnight rate and the 10-year Treasury yield. The relationship may be less obvious, but it makes more sense if bond market investors tend to expect the policy rate to return to its historical averages. During the period 1980-2020, the policy rate experienced a sustained downward trend, while the bond market anticipated a return to its previous levels (which only happened in the 2020s).
Since bond prices move inversely to inflation, the Cantillon effect does not apply to bonds.
Actions
Stocks (and real estate) are usually what people think of when discussing the Cantillon Effect. While it’s possible to ascribe some plausibility to this concept, the problem is that it’s necessarily difficult to guess where stocks will go: you’re competing with many other investors trying to do the same thing.
There are two main ways to analyze stocks.
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You buy shares if you think you can sell them relatively quickly to someone else at a higher price. (Where “relatively quickly” depends on the investor and can range from milliseconds to a few years.)
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You don’t try to guess what others will pay for shares. Instead, you simply buy if you believe the underlying companies will generate enough profit/cash flow to justify the purchase price over the long term.
The difficulty in analyzing stocks is that there is only one long term, but many short terms. As such, stock analysis is dominated by analysis of what is happening in the short term. Unfortunately, in practice, stock investors are unbalanced and many crazy things can happen in the short term. If stock investors are convinced that “money printing” can cause stock prices to rise, there is little that can stop them if so-called “money printing” occurs .
The story of the Cantillon effect is misleading in that it seems to imply that “money printing” is something external to the stock market. Stock markets are not static, waiting for outside capital to flow into them. Equity market participants can adjust prices instantly in response to news (e.g., a bad earnings report) and can use leverage (either by borrowing or using derivatives) on their own. leader if they think stock prices are about to rise. Using flows to explain stock prices clashes with the accounting reality that for every buyer, there is a seller (otherwise someone in the back office is going to have a bad night). In other words, what matters is the belief about “money printing”, not the “money printing” itself.
On the fundamental analysis side, inflation has a somewhat mixed effect. To the extent that higher inflation raises interest rates, the present value of future cash flows decreases. Against this is the hope that companies will be able to raise their prices in line with inflation, thereby increasing their nominal cash flows. (If income and spending scale by the same factor, profits also scale by the same factor.) At the same time, higher inflation is generally associated with faster growth in the real economy, which is beneficial for profits. It’s not incredibly surprising, then, that stock prices and price levels tend to rise during economic expansions – and reverse during recessions.
Concluding Remarks
Commodities, real estate and stocks are pro-cyclical and therefore we should expect them to benefit from economic expansion. Inflation is also procyclical. We should therefore expect a correlation between these asset classes and inflation.
