Inflation: the inevitable ticking time bomb?

24 February 2021

By Ken Rayner, Verbatim RSMR Model Portfolio Manager

Economic history is littered with economists and financial markets continually underestimating the potential for inflation. Data from 1945 to 1947 and 1972 to 1974 shows how price inflation rocketed from nowhere in the space of two years. From 1972 to 1974 it went from 2.9% to 12.3%. Even under Margaret Thatcher, who was generally viewed as a slayer of inflation, it doubled to over 20% just after she became Prime Minister in 1979, showing just how unexpected and volatile inflation can be.

Nassim Nicholas Taleb, a finance professor, writer and former Wall Street trader, invented the black swan concept. He argued that, because black swan events are impossible to predict due to their extreme rarity, yet have catastrophic consequences, it’s important for people to always assume a black swan event is a possibility and to try to plan accordingly. The pandemic itself is a black swan event that has dislocated the economy, but what’s the next black swan?

The financial firepower being thrown at the economy may lead us to believe that a sharp recovery is likely but the economy won’t naturally re-float itself as so many businesses have been run into the ground and so many jobs lost. When the country does unlock, how many pubs and restaurants will have survived? The population is in desperate need of good times after such a long year of restrictions and hardship and there is likely to be high demand for the fun experiences that we’ve missed so much. Eating out, shopping and meeting friends at the pub will hopefully be back on the agenda very soon but how will supply fare in the face of such demand?

Since the late 80’s, we’ve become used to a low rate of inflation, but we shouldn’t get too comfortable or complacent as it could easily creep up on us. Inflation is generally factored in when there are changes in policy but when inflation takes hold, it can get out of control quickly and policy makers may struggle to keep a lid on it. Market pricing of inflation would imply that we’ll continue to exist in a low inflation environment for the foreseeable future but what is priced in could easily be overly optimistic. After being missing in action for the best part of a generation (let’s be honest, not many wealth managers around today have had to cope with it), a genuine rise in inflation may be closer than we think.

Let’s consider the backdrop; the government has been borrowing hand over fist and throwing money at the current crisis to try and keep the economy afloat; capacity has been taken out of various sectors and is unlikely to re-emerge overnight and there’s a lot of pent-up demand. If this powerful blend of forces is the new reality, it will cause inflationary pressure in the system and prices may well be driven sky high. There is a very real threat that structural inflationary forces, such as rising production costs globally, the impact of changing central banks’ policy frameworks and supply side issues could swamp the deflationary backdrop that investors have enjoyed for many years. It won’t be a return to the 1970s, but it won’t take a severe inflationary shock to spook financial markets.

If inflation does rise rapidly, interest rates will have to be increased. We’re very used to low interest rates and after such a long run any tilt in the wrong direction could seriously affect equity valuations. One of the reasons why big tech stocks in the US are on such high valuations is because they’re priced in line with the low levels of interest.

How will bonds react and how will this affect the investor? Interest rates respond to inflation; when prices in an economy rise, the central bank typically raises its target rate to cool down an overheating economy. Inflation erodes the real value of a bond’s face value, which is a particular concern for longer maturity debts. Because of these linkages, bond prices are quite sensitive to changes in inflation and inflation forecasts. Bonds are often touted as less risky than stocks and for the most part, they are but that doesn’t mean you can’t lose money owning bonds. An uptick in inflation could have significant implications for investors and for the market in general.

It’s not impossible that central banks will lose their grip on inflation expectations relative to their target levels without proper policy guidelines and a clear exit strategy from current stimulus measures, which could result in a discount rate shock, particularly for equities. Many ‘balanced’ portfolios, with bonds and equities, would struggle to rely on bonds for protection, and real assets such as gold or index linked bonds may become the go-to assets to offset the impact of inflation.

For now, it’s all eyes on the unlocking of the economy…will inflation be the next black swan event? We’ll soon find out if policymakers are overly optimistic, if they’ve assumed extreme inflation is a possibility and whether they’ve planned accordingly?

 

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