IEP Financial’s newest recruit, Jonathan Morgan illustrates the complexities of inflation
Inflation – What is it and how does it affect your investments?
When a confectionary icon like a Toblerone bar stops resembling the Alps… it looks more like the Cairngorms – as one man being interviewed by the BBC described it last week, then something is surely up. What exactly? The answer is inflation. For the makers of Toblerone it seems the choice, against a backdrop of rising raw material costs and a falling pound. It appears to have been to keep the bar the same size and up the price, or make the bar smaller and keep the same price. In effect the same price now buys you less Toblerone.
There are by common consent, two main types of inflation:
Demand pull inflation. This type of inflation occurs when demand in the economy is outpacing supply and so companies respond by putting up the prices of the goods they sell. This type of inflation usually occurs when the economy is running hotter than trend. When central banks move to raise interest rates to cool inflation, effectively reducing the liquidity within the economy, they are typically trying to cool down the economy.
Cost push inflation. This is caused by increased costs for companies, (known as input costs) rather than by increasing demand. Any increase in raw material or energy costs used to make goods will either see profit margins hit or else higher prices for customers, assuming they will pay them. A weaker currency also causes cost push inflation, because it automatically raises the price of most imports. This appears to be happening now. Cost push inflation is often, in economic parlance described as bad inflation, or the wrong type of inflation. This is because it can reduce living standards when it occurs in a stagnant economy – since consumers are not seeing their incomes increase to meet the higher prices. Sound familiar?
Have recent political dramas affected inflation?
The impact of a Trump presidency has fuelled the belief that the main thrust of his economic policies – increased infrastructure spend and reduced taxation are also inflationary. Whilst in theory true, it is perhaps too simplistic to associate the growing awareness of building inflationary pressures with the election of Trump or indeed Britain’s decision to leave the EU. The reality is that possibly the cycle is finally turning with deflation giving way to inflation, which after all has been the aim of central bank policy everywhere for the last 8 years or so.
Bond markets – traditionally the market’s pathfinder and barometers of interest rates and inflation have seen a brutal sell off in the week following the US election result with bonds globally losing over $1.3trillion in value, forcing yields to 6 month highs. In reality, bond markets have been losing value for several months now, especially at the long dated end where they are very sensitive indeed to any change in the interest rate outlook. This on analysis should hardly come as a surprise given the aim of central bank policy – over the last six years has been to stimulate growth, utilising unprecedented monetary and fiscal policy measures in order achieve this. In the last few years bond market returns have been fantastic and far from the norm. It would be too easy to blame the changing political winds for the changing outlook. The catalysts perhaps – yes, but the cause? Probably not.
How do the different types of inflation impact assets within funds?
High inflation of any sort is rarely desirable, but at least demand pull inflation is usually associated with a strong economy and high consumption. High inflation also typically erodes the real value of debt – which for an indebted government might prove useful!
In contrast, cost push inflation has few upsides for most kinds of companies, except those that directly benefit from whatever is causing it – commodity mining companies for example.
Bonds
Bonds do not like inflation. At best, and with muted central bank response – which may well be the case in coming months given the dovish nature of central bank committees, any uptick in the inflation number is going to further undermine the already very poor real returns offered by bonds. This might well continue to force yields higher to compensate and as yields move up, bond prices fall thereby destroying capital value. In the event central banks do move on interest rates then this may well exacerbate the situation and increase the pace of the sell off. After arguably the biggest bond bull market in investing history and with the spectre of higher inflation and higher rates on the horizon the investor would do well to ask themselves, in the event I want to sell these assets, who will buy them from me? Typically bonds do not, unlike equities, bounce.
Equities
Equities over the course of a full economic cycle tend to offer a far better chance of a positive real return, as do real assets, and real asset – linked investments. Typically these assets need to held over a longer term and with an understanding that they can over the short term be very volatile. However it should also be remembered that successful companies typically adapt and prevail through all sorts of headwinds and should respond accordingly if we find ourselves in a more inflationary environment. It should also be remembered that unlike the so called ‘safer investments’ e.g. cash or government or corporate bonds, successful companies offer the prospect of their dividends rising in line with inflation too. Inevitably, to reach the long term we always have to get through the short term and whatever headwinds that may bring.
Jonathan Morgan is our Eastbourne-based independent financial adviser. A chartered Fellow of the Securities and Investment Institute, he has previously worked for Hottinger and Co Ltd, Julius Baer and Rensburg Sheppards. Jonathan also boasts experience as a city stockbroker.
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