Addressing the inflation question (through the language of burgers)

15 September 2020

By John Husselbee, Co-Fund Manager DMS Verbatim Portfolio Growth Funds

On the surface, the link between burgers and inflation might not seem obvious but The Economist’s Big Mac Index, first published in 1986, has become a global standard and the focus of many pricing studies.

With seven ingredients, the Big Mac offers a simple solution to the difficult business of finding a basket of goods to compare across regions. In short, the Index tracks the cost of the signature burger in a number of countries around the world, created as a way of exploring rudimentary exchange rate theory: in essence, purchasing-power parity (PPP) suggests rates between countries should eventually move to levels where identical goods and services cost the same.

As we all know, that has not proved to be the case and the Index therefore provides an insight into levels of both currency strength (or weakness) versus the US dollar and inflation. For those interested, the price in the latest iteration is $5.71 in the US and the vast majority of currencies are ‘undervalued’ in comparison, at $4.28 in the UK, $3.10 in China and, in the key finding for economically challenged burger lovers (when free to travel), just $1.86 in South Africa.

It has been close to 40 years since the US and most of Europe faced serious inflation and for much of the last decade, the greater risk has been that prices would fall, with factors such as globalisation having a clear deflationary impact. Given the scale of Government intervention during the current Covid-19 crisis, however, growing fears about a pick-up in inflation are understandable and, with rising unemployment levels, concerning for many as they worry about making ends meet.

As an early warning signal, gold’s recent ascent, given its long-time safe haven and inflation hedging role, will not have gone unnoticed by seasoned market watchers, although other ‘haven’ options are clearly less attractive at present: inflation-adjusted yields available on benchmark government bonds, for example, have slumped well below zero.

In the UK, CPI is currently still  well below the Bank of England’s 2% target and many have predicted a drop by the end of the year, with lockdown bringing down spending levels as well as demand for oil, which is feeding into lower costs of production for a range of goods. Inflation actually jumped to 1% in July however, its highest level in four months, largely due to a recovery in fuel prices from the slump in March. Another – potentially transitory – reason for this rise, according to the Office for National Statistics (ONS), is that people have started buying goods included in the CPI basket that were not available during lockdown. The number of such unavailable items was 90 in April and May and fell to 12 in July, with the few still remaining including swimming pool admissions, live music and theatre tickets. CPI collapsed to almost nothing in August, however, with economists debating whether the month’s ‘Eat out to help out’ scheme was behind this or the fall signals a slide towards deflation.

While short-term fluctuations can be discounted for the most part, there is a case to be made for longer-term inflation concerns and looking back to a previous period of government largesse, in the wake of the Global Financial Crisis, is instructive here. At that point, there were similar worries that quantitative easing would spark a spike in inflation but, ultimately, the forces of globalisation and technology were enough to keep it in check.

Those deflationary drivers have been at the heart of a generational pulldown of prices, alongside central banks setting more explicit inflation targets, but there are signs of all three changing. Technology is obviously still a huge factor but far more embedded than it was a decade ago and perhaps less disruptive, at least in driving down prices. As for globalisation, we would highlight the ongoing trade war between the US and China as exhibit one for a changing picture there, with the trade situation around the world increasingly moving to a more populist beat. With Covid-19 still accelerating, we may also see companies eschew global supply chains and seek more local suppliers, and both these diminishing factors could put pressure on inflation looking further out.

In terms of governments and central banks, we have seen a swift shift from austerity to whatever it takes in policy terms as countries have tried to counterbalance the effects of the pandemic, building up huge debt piles and implementing lower or even negative interest rates in the process. Rising inflation is well known as a way of dealing with a large debt mountain —inflating it away has typically proved politically easier than upping taxation — and we have already had central banks including the US Federal Reserve relax targets as they are willing to run economies hot.

As a counter to that however, lower interest rates means governments can finance their debt piles more easily and there is a feeling many may just keep rolling them forward, at least as long as it takes for a genuine recovery from Covid-19. The idea of ‘independent’ central banks has also evolved, with many clearly working in harmony to maintain a lower for longer rate environment.

For many economists, unprecedented intervention to keep economies going means the largest inflation risk is actually fiscal dominance, where countries have such large debt and deficits that monetary policy targets keeping the government from bankruptcy as opposed to inflation, growth and employment. To quote from a recent FT article: “Central banks often take credit for bringing prices under control, pinning it on another feature of the low inflation era: their independence to set policy as they see fit. Less well acknowledged is the degree to which that independence chimed with the political mood of the day. The tide is showing worrying signs of turning, notably in the US where Donald Trump has used Twitter to take aim at the Federal Reserve. When the time comes for central banks to raise rates, this generation of policymakers — like their forebears — will face pressure. If they buckle, then inflation could finally return.”

There are obviously a huge number of moving parts to consider and in terms of preparing for higher inflation, index-linked bonds and potentially real assets such as gold can offer a hedge. We maintain exposure to the former throughout the cycle in our portfolios and recently upped our position in global index-linked debt to introduce long-term protection and get ahead of any rise in prices in what look set to be challenging months and years ahead.

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