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Opinion Piece: Inflation Station

To mere mortals, and to those with better things to do, an informed understanding of inflation and its benign, beneficent, or bastardly properties is hard to come by and perhaps not especially stimulating either.

Why we should all care lies in a simple financial equation: a certain amount comes in each month to pay for stuff that costs a certain amount. If the stuff that costs a certain amount starts to cost a certain amount more whilst what comes in stays the same, we have a problem: life just got more expensive and some or maybe a lot of fat, that sweet delicious fat, will have to be trimmed, but for many that fat is in fact quite thin or indeed non-existent and the consequences of cutting the household budget very serious.  

How on earth could inflation be on the rise?

Stimulus packages galore, that’s why, and who has to pay for them? Governments, ahem, well we the humble taxpayers actually. And what do stimulus packages entail for us helpless subjects of the realm?

Debt, that’s what. And what would need to happen for the debt to be less of a pain in the butt? For it to become cheaper to service, that’s what. So, without further ado or irksome and potentially rhetorical questions, The Fisher Effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, real interest rates fall as inflation increases, unless nominal rates increase at the same rate as inflation. That was a lot of ado. In simple terms, inflation eats interest rates, the cost of paying for the debt you incurred. The thing is, governments can allow the inflation rate to rise artificially.

In not so distant history, that being the 20 years between 1970 and 1990, prices rose by 10% a year on average. Post 1990, that ugly head has rarely reared above 5%. Modest inflation of around 2% is reckoned the ideal state of play and breathes extra life into the economy, although even those levels of inflation could hurt savers at a time of record-low interest rates. It’s cynical to suggest that fisco-financial manipulation on such a scale could occur, but it makes no shortage of sense.

Ok, so to put it in slightly more empirically-economic terms, conventional theory says that unemployment (economists somewhat heartlessly call it ‘spare capacity’) prevents companies from raising prices (inflating) because there isn’t as much money in circulation to purchase them. It is only when there are shortages of goods that prices really start to rise and that makes sense, right? Scarcity value. This seems intuitive, but the other camp would argue that, given the quantitative easing (massive increase in money in circulation) following hot on the heals of the global financial crisis failed to spark inflation, why should it be any different this time? It is key to remember that in a time of depressed spending such as that in which we currently exist, prices ought not to rise.

The pandemic struck and motorists were off the road, shipping vessels were anchored, planes grounded, and unsurprisingly given the inevitable slump in demand, the price of fuel (crude more broadly) plummeted. As you’ll have noticed at petrol stations over the last couple of months, the price of filling your tank has gone up since the nadir of lockdown, but the price of oil is still around a third lower than it was at the start of the year and we’re actually paying less to fill up than before lockdown was imposed. Prices and wages are going to remain depressed in the coming months because of a reduced amount of money in circulation.

Fewer people are going to pubs, restaurants, and shops because fewer people are in work and earning, or earning less than they did before, and therefore essential spending is prioritised. Once the government’s furlough scheme peters out, there will be a spate of job losses. A British Chambers of Commerce survey of nearly eight thousand firms tells us that nearly a third of businesses will look to cut jobs in the run up to Christmas. All this said, inflation will almost certainly come back in future years.

With the demand outlook very weak, companies are cutting whatever costs they can, including inventories and investment, most frustratingly from an innovation perspective including R&D departments, that would have bolstered their future growth. More money in circulation ultimately chasing fewer goods – scarcity value – prices increase.

What you can do?

The cynics may argue that only the most pedantic of us are going to notice, but on a serious note, inflation, even at humble levels, can significantly impact people’s spending power and that has very significant social consequences. For investors and savers, if you have a fair wedge parked in cash, whose value decreases as inflation rises, it might be an idea to diversify into assets with inflationary-hedging properties such as precious metals, inflation-protected bonds, and certain equities. As an asset class en masse, equities have outdone inflation by five percent a year since the turn of the century before last.

The recent increased demand for these inflation hedges implies that many investors already have higher inflation on the mind. Gold, one of these nifty inflation-proof assets, hit an all-time high in July at nearly two-thousand dollars an ounce, and as another indication of investor thinking, inflation-protected bond yields bellied to an all-time low – demand for the bonds increases, yield goes down, price goes up – endure the lower interest payments now and down the line enjoy their concomitant rise with inflation and the eventual redemption payment too.

To go back to gold, the demand for it tends to rise when compensation for holding cash or government debt is low or indeed negative. Investors may be overlooking the aureate lady’s somewhat less sparkly cousin, however. Take a look at silver – only around half its all-time high in spite of a meteoric lockdown surge.

A concluding note on equity investing in times subject to inflationary pressures – not all are equal and judicious consideration and/or sound advice will help identify those that prevail. The market will price inflationary effects into stocks before they materialise so it’s no good waiting for the headlines. Advice from this end would be that even tucking cash under the mattress can be a risk given everything herein discussed. A diversified portfolio is a prudently-held one and a risk-on approach is not necessarily an imprudent one. Balance overall but aggression when the time is right. Keep thinking and keep asking folks. Itchy feet and squeaky bums are but corporal irritants.

This piece has been written by Edward Downpatrick, Strategy Director for Fintuity.

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