Submitted by One River Asset Management, authored by Lindsay Politi

“The Japanese experience has given investors the incorrect impression that sustained deflation is a likely outcome when it’s instead a unique case,” I explained. We were discussing US inflation, whether it is increasing or decreasing.

Shorter-term economic and price trends are inherently volatile, so to examine inflation properly requires greater perspective.

Which had brought us to Japan.

Implicitly, Japan decided to unwind of the excessive imbalances built up in the easy-money 1980s without burning the forest. But there was a price to pay. To avoid the social disruption of large changes in existing institutions and economic structures, they had to grow poorer over many decades, succumbing to stagnation. They could make this choice because they were wealthy enough (before their great recession, Japan was earth’s wealthiest nation on a GDP per capita basis) and had the social cohesion to make it politically possible.

Few major economies have these factors. Germany is wealthy enough but not all EU countries are, and the broad EU lacks social cohesion. The US is sufficiently prosperous, but wealth inequality leaves it divided.

No large nation can reasonably make the choice that Japan made.

As a result, we see demands for change unfolding in European elections, Brexit, and with America First policies. The change transcends political personalities.

If Trump is replaced it’s unlikely to be with a moderate, but rather with a Bernie Sanders, an Ocasio-Cortez. If tariffs and nationalism don’t drive inflation higher, increased minimum wages, socialized medicine, subsidized housing, and free higher education will.

“So you ask how we’ll know if inflation is increasing or decreasing,” I said.

“But it’s no longer a question. The people are demanding higher wages, greater equality, inflation, and they’ll keep voting for change until they get it.”

As a bonus, some observations from One River on cash flows and duration.

Duration

“An investment is something that generates cash flow or has the ability to generate cash flow,” the Investor explained. “Real Estate can be an investment but the house you live in is not — it is a consumption item. Gold is not an investment – it’s a store of value. At its core, investing is only about valuing different cash flow streams. Their worth is established first by determining the precise time and size of those cash flows and then using current interest rates to calculate the present value of that stream of future payments.”

“To think about an investment’s duration, imagine a timeline with every cash flow of a bond stacked upon it,” said the Mentor. “Now think about a fulcrum under the timeline, balancing the cash flows like a seesaw. A zero-coupon bond has only one cash flow at the far right, so the fulcrum is placed beneath the maturity date, but as you add coupon payments the fulcrum must shift left to maintain equilibrium, shortening duration. Higher yields require larger coupons and produce shorter durations, lower yields mean lower coupons and longer durations.”

“Duration is how we measure interest rate sensitivity,” continued the Mentor. “Stripped to the basics, the calculation is simple. The price change of a security resulting from a change in interest rates equals its duration multiplied by the change in rates. So, if interest rates shift 1% lower, a security with a 5yr duration will rise 5% in price and a security with a 20yr duration will rise 20% in price. Neither the cash flows nor their timing will have changed but when interest rates fall, their present value rises. And naturally, the opposite is also true.”

Quantitative easing lifted the present value of all future cash flows. The longer an asset’s duration, the greater the appreciation. Equities are the longest duration assets, so they outperformed, dramatically. But goods and services are consumption items and do not have a duration. Nor do wages. During QE, their prices stagnated relative to the present value of future cashflows, spurring political change. And as these changes manifest in higher wages, goods and service prices, pushing central banks to lift rates, the present value of cash flows will decline.