2021 Q3 Market Commentary
Chief Investment Officer
Is Inflation Back Again?
When I was 18, my father called a family meeting. It was 1989 and UK interest rates had been raised that day to 15%. He announced to us all that the house, the schools had to go and we would have to start again. Though the crisis was real, it is, of course, never all over. We did sell the house in the end, but the furniture shop in Cobham survived and all of us stayed in school.
I mention this because if you told my father then that in 30 years’ time the UK bank base rate (which was causing his problems) would effectively be 0% he would have thought you were deranged. Nor, I think, would any of the economists or bankers or politicians of that era have entertained this as a serious scenario worthy of consideration. Yet here we are. There are two lessons for me here. The first is that life and the economy never turn out quite as you forecast – in the longer term at least. The second is that in economics you never stop learning. The global economy is a living organism continually growing and adapting to the constraints put onto it by governments and the physical resources available to it. There is no requirement that this organism has to behave as it did in the past. All we can do is watch and learn and try and make sure we are on the right side of the opportunities it throws up.
Which brings me to inflation. Inflation peaked at over 10% in 1990 and interest rates were at 15% in 1989 to slow this inflationary rise. Note that real interest rates (cash interest rates minus inflation) where around 5% in this period. You couldn’t pay your mortgage but it was easy to invest to beat inflation – today it is the other way around of course. Here are a few theories of what caused inflation from that time:
1. As the great Milton Friedman said “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The intuition here is that all you have to do is print more money and, inevitably, inflation will follow (or vice versa of course).
2. Inflation expectations are a key driver of future inflation. If firms think they can charge more for a product they will. Similarly, if workers think inflation will be higher they will demand bigger pay rises. Both of these can act like self-fulfilling prophecies causing the inflation they expect. Tracking inflation expectations and making sure they are anchored to your target is an important way to control inflation.
3. Just keep stimulating the economy with low interest rates (and perhaps running a government deficit as well). Eventually you will see full employment. If you keep the stimulus going then wages will have to rise and you will have too much money chasing too few goods. This is called “demand-pull” inflation.
Say there is a shock to the economy like the oil crisis in the 1970s or the recent pandemic. Oil costs of course rose sharply in the 1970s. In the last 18 months the pandemic has severely damaged global supply chains. Semi-conductor shortages have limited the production of new cars. Global shipping rates are up over 500% since 2019 (see Chart 1). This “cost-push” inflation is real and is here with us today. The worry is that it feeds into inflation expectations (theory 2) and creates a more permanent inflationary environment which will need to be doused by higher interest rates.
I am here to tell you that since the 1990s each of these theories have, in important ways, proved to be wrong.
First, of course, for some countries like Yugoslavia and, more famously, Zimbabwe money printing has indeed triggered hyperinflation. For developed countries, however, it just hasn’t worked. Central banks in the US, UK, Eurozone, Sweden and Japan have printed over $20 trillion (yes trillion) to buy back government and corporate bonds and so inject money into the system (see Chart 2). This has had precisely zero effect on inflation. Yes, a lot of this money ended up sitting unused on banks’ balance sheets (and you can argue it has pushed asset prices higher) but that’s not what people were forecasting at the time. The logic was that this money was real and would flow into the economy (e.g. via bank lending). Many economists and policy experts were predicting this would trigger inflation in the real economy. As an example, here is Harvard University’s Niall Ferguson writing in May 20111 about the “The Great Inflation of the 2010s”:
Yes, folks, double-digit inflation is back. Pretty soon you’ll be able to figure out the real inflation rate just by moving the decimal point in the core CPI one place to the right.
Well, he was wrong! And since he wrote that central banks have printed $15 trillion more, government debt has only gone up and the pre-pandemic inflation rate meandered around 2% in the US and UK. Milton Friedman is probably right that inflation is ultimately, a monetary phenomenon but in the real world and today’s markets it is more complicated than that. Printing money is harder than you think.
What about the idea that as unemployment falls to a certain level then inflation must surely follow. Well, unemployment fell below 4% in the US and UK in 2019 having fallen for all that decade. Inflation did, well, nothing? The ultimate example is Japan. Unemployment fell to a low of 2.3% (see Chart 3) while inflation stayed at zero or negative for (nearly) the entire time (Chart 4). If your idea was that you just had to run the economy too hot to generate inflation then this also proved tremendously hard to do in the 2010s.
You’ll notice the bump in the Japanese inflation chart. This was when the Japanese money printing program (quantitative easing in the jargon) pushed the Yen down which raised the price of imports and pushed inflation up. This brings us to the last theory of inflation that is also very relevant for today. This is the idea that an economic shock adjusts inflation expectations higher. Because firms and employees expect higher inflation they adjust prices higher and pay employees more today. This is precisely what people worry about. The pandemic disrupted the supply of goods. Government stimulus and the re-opening of economies has boosted demand. More money chasing less goods has indeed triggered inflation. As an example, used car prices are up 40% in the US today having been more or less flat for the past decade.
Will this feed into expectations and create a longer lasting inflationary problem? Well, it clearly didn’t happen in Japan after the Yen devaluation in 2012, or in the UK after Brexit caused a similar currency devaluation and inflation spike in 2016, or in 2010 when oil rose from $37 a barrel to over $110 as we emerged from the financial crisis. Indeed, Jeremy Rudd of the Federal Reserve Board wrote a recent paper2 entitled “Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)”. In it he debunks the expectations argument all together (which central banks do take seriously by the way) and concludes:
“invoking an expectations channel has no compelling theoretical or empirical basis and could potentially result in serious policy errors.”
Or in other words, this was a nice theory but it hasn’t worked recently.
What about today’s inflation spike?
I started the way I did just to remind you (and myself) that whatever pet theory of inflation you might hear from economists and experts (or me) there is a good chance (like the expectations one) it hasn’t worked over the last thirty years. What people thought was impossible in 1989 has actually happened. However strong our view, neither money printing, nor all-time low unemployment, nor one-off inflationary shocks have generated any sort of inflation problem over the last 30 years. This doesn’t mean of course that inflation, or inflation risks are over, just that as Yogi Berra famously said “making predictions is hard, especially about the future”.
That said, the inflationary environment we are in will be an important driver of returns for your portfolios. We do have a view and have positioned accordingly. The first important point is that we think the current inflation spike is most likely transitory. Here is why:
1. In the pandemic you couldn’t travel abroad and restaurants and bars were closed. In the meantime, the government’s generous furlough schemes kept income levels up. This meant people spent their money on physical goods rather than services like travel and leisure. This has caused part of the spike we see today in, say, shipping rates, but there are good reasons to think this will prove temporary. As pandemic restrictions ease, people will travel more. At the same time, some of the extra expenditure on goods today will just reduce demand tomorrow. As the economy slowly normalises and supply chains re-establish themselves we think today’s inflation will subside. One example of this is lumber which is a core component of US housing construction. The pandemic saw a large reduction in lumber supply just as housing demand surged in the second half of 2020. Lumber prices rose over 500%. The best cure for high prices is, however, high prices. Supply and demand have adjusted and prices are back to their pre-pandemic levels (see Chart 5). We think much of the global economy will follow this pattern.
2. Why has inflation been so low (and stable) for the last 20 years? One idea is that aging populations in developed countries increase savings rates (and so buy more bonds, raise bond prices and push down their yields). Another is that the supply of attractive investments is falling as many of these investments are in the technology/software sector where you just don’t need that much capital to grow the best businesses (think of Google’s search engine for example or the software that drives Facebook and Instagram). There is a mountain of venture capital money desperately trying to find attractive technology companies to invest in and bidding up their prices. Scarcer investment opportunities should mean, all other things being equal, lower interest rates. These sort of longer-term demographic and structural forces that were in place pre-pandemic will still be there as we emerge from it. We need to respect these forces when we make investment decisions.
But what if we are wrong and inflation does hang around longer than we think? One important point is that debt levels are much higher today than they have been in the past. As an example, UK government debt to GDP is over 100% today vs 33% in 2004 (see Chart 6). This is of course the point of lower interest rates: they are designed to incentivise you to borrow more and spend and invest. But higher debt levels also mean interest rates don’t have to rise much to slow the economy down (and, you would hope, tame inflation).
As an example, when the US tried to raise rates in 2018 they got up to 2.5% before the economy started to slow again. The UK never got above 0.75%! Let’s say 2.5% or so really is the ceiling at which interest rate rises start to bite. This means we really are in a low interest rate environment and we should invest accordingly. This is, by the way, consistent with today’s longer-term bond yields. The bond market is telling you this is a low interest rate world and we have no good reason to doubt it.
What are we doing about this in our portfolios?
Though we think the current inflation spike will pass, we do expect it to carry on into next year. The container ship issues we showed in Chart 1 and the shortage of semi-conductors that are affecting new car production (amongst other things) are expected to linger into 2022. We think the effects of the pandemic will affect the global economy longer than people think. This pushes to keep our bias towards assets that benefit from more of an inflationary environment such as cheaper (so-called value) equities and to keep low holdings of bonds (and particularly government bonds).
That said, the picture on this is less clear than it was a year ago. As rates (slowly) rise, governments will also raise taxes and cut support programs. There is a risk that this is as good as it gets and after the sugar high of a recovery the economy starts to slow again. We have therefore taken some profits in our cyclical/value equities, moving back to a more neutral position. As and when we see today’s inflation spike peak we expect to do the same and start adding to our bond allocation again.
Finally, we think that even if rates rise the peak will be capped by today’s high debt levels. This means that the returns on equity markets (relative to cash deposits say) look particularly attractive and we do not expect that picture to change much over the next few years. Equities therefore look the best long-term home for your money if your aim is (as it should be) to out-perform inflation with a healthy margin over the longer term. We are overweight equities today and, while we might continue to take profits as and where we see the opportunity, our strategy continues to be to ride out the inevitable volatility that comes along to make sure we capture our fair share of the longer-term return. This has proved the right strategy over the last few years and we have no reason to think the next few years will be any different.
Now, it is time to come back to where we started. No one thought 0% interest rates were even remotely possible in the UK in 1989. The most popular theories of inflation have not worked (and in important ways been wrong). Our portfolios will continue to be as diversified as we can make them without sacrificing the returns we need to make. The fact that the future (including inflation) is in many important ways unknowable is what makes this job so interesting. Our portfolios need to be ready for a wide range of scenarios and we continue to work to try and make sure this is true.