1. The current inflationary environment
Year-on-year growth in the Euro area consumer price index (HICP ) has risen sharply to reach 7.5% in March this year from a low of -0.3% in December 2020. As the chart below shows, the latest rate marks an all-time high, by some distance, since the foundation of the Euro in 1999; for most of the past decade growth in the index remained below the ECB target level of 2%.
HICP Inflation Rate – Overall Index
A similar pattern is evident elsewhere. The US CPI registered 8.5% annual growth in March, with the UK RPI showing 9.9% for the same period.
The upsurge in inflation has coincided with the post-Covid recovery in activity. Consumer demand is exceptionally strong, thanks to the combination of policy stimulus and accumulated savings during lockdown periods. However, supply in many sectors remains constricted by the effects of Covid and other factors such as prolonged under-investment in capacity growth. More recently, the war in Ukraine and sanctions on Russia have triggered further price spikes in fuel, grain, fertiliser and other commodities.
The sudden escalation of inflation, as well as the high visibility of extreme, shortage-induced price rises in energy and the early signs of significant price increases in many foods, have resulted in strongly increased demands by consumers for protection against the impact of inflation on their living standards and in demands by workers for compensating wage increases. Such pressures, where conceded, would bring about the start of a cycle of cost-driven inflation that could sustain itself at a high level for many years.
While the current increase in inflation is alarming in many respects, the market consensus views it as a temporary phenomenon and expects it to settle back to a modest level quite soon. The ECB’s latest Survey of Professional Forecasters (Q1 2022) shows an average HICP inflation forecast of 1.8% for 2023, and remaining close to or below 2% in subsequent years. Meanwhile, the market-implied forecast of German inflation over the next ten years (10-Year Breakeven Inflation ) is a little higher than that, at c. 2.3%, but still much lower than the current rate. The equivalent rate in the US is 2.9%.
Sometimes, markets are driven towards conclusions and valuations that are unlikely to stand the test of time. This may be one of those occasions.
2. The dreadful and misunderstood cost of inflation
It is about 40 years since inflation ran at a persistently high level in developed western economies. It is natural, therefore, that its disastrous effects could be underappreciated by all but the oldest of our currently active workforce.
People do understand that inflation erodes purchasing power but when it runs at close to target levels of around 2% per annum or below, the effect can usually be overcome by income expansion, and even where it is not overcome, it takes a long time before the impact is highly significant.
Any inclination to dismiss inflation as similar to other investment risks, however, is misplaced. Equity markets display volatility, sometimes to an alarming degree. But investors can be reasonably confident that, if they allow enough time, their market losses will ultimately be recouped. There is no such symmetry with inflation. Any spending power lost through inflation is lost forever. Negative inflation does not happen to any significant degree or for any significant period of time unless, very occasionally, at times of calamitous economic ruin.
Inflation destroys the pricing mechanism of the economy. Money works successfully only if it serves as a store of wealth, as well as a unit of account. Neither is the case if money’s own value is being eroded, particularly if the erosion is variable and unpredictable. Whenever inflation increases to a higher level than was expected, it transfers wealth from savers to spenders, from investors to borrowers. That destroys the incentive to save and to build for the future throughout the economy.
In the 1970s, when inflation was high, accounting standards were introduced to attempt to express financial statements in ‘real’ or inflation-adjusted terms. This doomed experiment was a poorly thought-out desperate attempt to salvage some sort of value estimation when monetary terms stopped making sense. By the time inflation ceased to be a major problem, no-one had succeeded in getting inflation accounting to work.
People on fixed incomes can be ruined by inflation. People who have restrained their consumption and deferred their material gratification to amass some savings for a better future for themselves or their offspring lose a substantial portion of their wealth. Inflation in Ireland rose above 5% in 1969 and stayed there until 1984. During that 16-year period, the buying power of €100 fell to €14.13 simply due to the rising price of goods and services.
3. Causes of today’s inflation: real and apparent
For many years, market analysts and economist have been next to silent on the topic of inflation until early in 2021. What excited interest in inflation at that point was a series of trade and output bottlenecks caused first by the COVID-19 pandemic and trade wars and then highlighted by the grounding of the Ever Given in the Suez Canal, blocking that artery for six days and holding up the vessel’s cargo for over three months. Locally, Brexit was amplifying trade blockages between Great Britain and the rest of the world, although this was not of global significance.
Since then, analysts have put inflation more and more to centre stage. Companies reporting their results have cited inflation to a markedly increased extent as the data below from Gartner illustrate (for the US):
Inflation Mentions on Quarterly Earnings Calls
Policy-makers gradually turned their attention to the prospect of adapting monetary policy to the need to keep prices under control and began to implement some tighter measures during this year.
However, inflation was not caused by the bottlenecks of 2021. It was caused by the monetary and fiscal policies that followed the Great Financial Crisis (GFC) way back in 2008.
To understand why, we have to recall carefully what inflation is and what it is not. Inflation is a general increase in the price of goods and services across an entre economy. It is not an increase in the price of specific goods or services that have experienced supply bottlenecks, permanent shortages or increased popularity and demand, even in the case of essential inputs like energy . That type of price activity is part of the normal adjustment of economic activity that happens as tastes change, technology develops, resources run dry, and catastrophes or geopolitics change the pattern of trade. If these normal events occur in an environment where the money supply is held constant and the ability to grow debt is constrained, inflation cannot happen. Individual prices can rise, some very sharply, but others will have to fall so that the approximate effect is no or little change in general prices across the economy.
So, the conditions for inflation were built-in post 2008. The difficulty for a forecaster is, however, that there is no way to tell when it will materialise. Economics is useless for this purpose. Some underlying forces existed during the past decade to hold inflation at bay, including a global surplus of labour, and growing saving for retirement. These are ending at present just as the catalyst of supply bottlenecks has emerged. So, suddenly, inflation has happened. Whether it will last and thereby confound market expectations depends to a large extent on policy responses.
4. Can policy-makers fix the problem? Will they?
Monetary authorities in major economies face a serious dilemma. They have acknowledged that they must raise rates and the process has begun. They have stopped quantitative easing but, until recently, further central bank moves planned or expected were too modest to tackle inflation. The first effect of an interest rate rise is to put further upward pressure on prices as it adds to the cost of companies’ financing. So, rising rates initially feed into the circular motion of ‘cost-plus’ inflation until a point is reached where rates are high enough to choke demand. But central banks are currently nervous about causing material damage to fragile economies emerging from the pandemic crisis and now threatened by war. In the past few weeks there is some evidence that the Fed may be willing to take the necessary risks to economic growth to apply downward pressure on US inflationary forces. The same may not be true in Europe.
Meanwhile, however, fiscal deficit spending has taken off, initially as a short-term solution to the pandemic crisis, but this has now been amplified by growing capital budgets, especially in the US, and we can expect to see heightened military spending in many countries. The social supports necessary to keep businesses alive during the pandemic have a tendency to become ingrained to some extent and are politically difficult to reverse. So, fiscal expansion will continue until taxes are eventually raised sharply, but that will take some years.
As people look for measures from governments to ease their experience of inflation, supports will be introduced that will pump more money into economies, thereby only aggravating the global inflationary trend.
In my view, therefore, consensus inflation forecasts may prove unduly optimistic. Most western economies are operating at close to full employment, there is much anecdotal evidence of rapid pay increases in many sectors, and the risk of developing wage/price spiral is growing. Meanwhile, high debt levels and financial market fragility are likely to discourage the ECB and other central banks from hiking interest rates as much as would be required to tame inflation.
5. Impact of inflation on different investment markets
Inflation is very bad for fixed income securities. If we are facing a long period of moderate or high inflation while markets have discounted an early return to modest levels, then government and corporate bonds will provide negative or, at best, miserable returns from today. In terms of purchasing power, these returns will be even worse.
Inflation is also clearly bad for the purchasing power of cash balances. While interest rates are low, that is the dominant effect of inflation on cash as an asset class. However, should inflation be sustained, interest rates will increase, albeit unsteadily, to levels where they again provide a real return (at least gross of tax) and cash holders will eventually benefit from this change. It is likely, however, to happen slowly so, in the meantime, cash is a drain of wealth.
Property can suffer from economic distortions caused by inflation but eventually, being a real asset, it should hold its own through an inflationary period. Rents grow during inflation.
Inflation is also bad for some equities but, on balance, sustained inflation enhances equity returns. Of course, this varies strongly across industries and across individual companies that use various mixes of financing and that have different degrees of pricing power.
Broadly speaking, we can expect prolonged inflation to help commodity and real estate related industries, and to hurt industries that carry high inventories and that process commodity raw materials. Commodity prices rise more than other prices in most waves of inflation. Manufacturing industries, which are the main users of commodities, may be able to pass on cost increases but the timing of input and output price changes introduces volatility to their earnings and raises the cost of working capital.
General price rises cause uncertainty for most other sectors. The biggest harm to equities from inflation, however, does not come from increased prices, but indirectly from rising interest rates and bond yields. These discount factors, when they increase, drive equilibrium prices for a given future earnings stream downwards.
The effects of inflation are far from straightforward. One of the most important things that result from inflation is volatility. The following chart shows annual US GDP growth rates in the inflationary period 1973 to 1982 (red line) and in the low-inflation period 2010 to 2019. The economic output volatility of the high inflation period is reflected throughout businesses and is seen in all economies. In the high-inflation period shown, there were three recessions in the US.
6. Investment strategies for an inflationary environment
A key step an investor should take if they are exposed to long term risk and therefore to the risk of inflation ruining the accumulated value of their wealth, is to maintain a bias towards real assets. Real assets are those whose fundamental payoffs, such as dividends or rents, will be determined in the future at rates that will take into account the future level of prices. This allows such assets an opportunity to grow under the influence of general price increases. In stark contrast, fixed income securities, which appear to have fewer ‘moving parts’ in money terms (or nominal terms, as economists say), never adjust future payments. So, wealth invested in a long-term bond is vulnerable to extreme loss of purchasing power.
Along with a real asset bias, diversification becomes even more important as a result of inflation risk. There are two reasons for this.
The first has to do with the uncertainty we always must have when we try to anticipate whether significant inflation is going to happen. The possible scenarios are very different. There may be high inflation driven by excess money and fuelled by excess demand. In that case, economic activity may remain strong, and equities, commodities and properties would eventually make good returns, even in real terms. Bonds would be expected to do badly as interest rates are pushed higher and, in real terms, as their fixed payments lose purchasing power. A second scenario involves inflation arising from shortages and fuelled by excess money supply. Economic growth might be much weaker. Inflation may not last as long as in the first scenario, but would still be very damaging. Commodities and industries whose output is in short supply might perform best. Bonds will again be very poor investments. The final major likely scenario, however, is that inflation is contained and driven away quickly by a deep recession. Bonds are the perfect investment in this environment, while real assets will, generally, suffer.
Apart from uncertainty as to which scenario may evolve, the other reason to emphasise diversification when contemplating inflation is that, if you want to have more real assets to protect your purchasing power, you should diversify within that group of assets. Real assets tend to be more volatile than financial assets. The standard core real assets consist of developed markets global equities and property. Property is always difficult to diversify but even core equities are not sufficiently diversified. They exhibit high volatility and very significant drawdowns. Frequently, leading indices such as MSCI World, display high levels of concentration in sectors such as, at present, IT stocks. It makes sense to hold as diversified as possible a portfolio of real assets. These can be constructed by using emerging markets, small capitalisation stocks, various forms of property and infrastructure funds, commodities, and strategies that diversify active positions in all these and other asset types.
Index-linked bonds are potentially useful hedges against inflation, since their coupons are formally linked to inflation rates, as are their maturity payments. However, the prices of these bonds anticipate inflation with the result that returns on these bonds, while enhanced by high inflation, are more connected to surprise changes in inflation than to inflation itself. Currently, they offer very poor (in many cases negative) real yields.
7. What if inflation is only a short-term phenomenon?
It is always wise to be humble about economic forecasts. Economics does not provide any successful way of predicting whether we will experience sustained inflation over many years and at what level. Some forecasters suggest that the current very high inflation figures are directly attributable to identifiable bottlenecks mostly related to COVID and now exacerbated by war. They expect that inflation will decline sharply soon and financial markets seem to agree, on balance.
Others, and I would be in this camp, expect that high levels of money supply, government borrowing policy, and the feedback effect of price shocks on workers wage demands in a relatively tight labour market will cause inflation to become endemic. It probably will fall from recent extreme levels at least for a while but elevated average inflation levels, above 5% per annum, are likely to become part of the landscape. This can not be modelled but I am convinced by the weakness of the prevailing methodology that focuses on what can be measured and modelled and which leads to the overoptimistic conclusion that inflation is temporary.
Not many have argued that deep recession is the likely outcome but, should the Ukrainian war be protracted or spread widely, the possibility must be considered.
The bottom line on inflation, however, is that, even when you would forecast little or no inflation, as long as it is a reasonable possibility, it poses the biggest economic risk to a long-term investment portfolio, even bigger than most recessions. So, a policy that includes the biases towards real assets and the associated diversification is usually sensible and, at present when inflation is a particularly heightened risk, is definitely the right thing to do.