The Problem of Inflation: What it Means for You

For those of who either lived through the economic conditions of the 1970’s, or at least studied them, much of the current commentary in financial markets will seem all too familiar. That’s because the 1970’s was not only a period of dangerously high inflation, but it was also accompanied by relatively sluggish economic growth. To make matters worse, both factors were dealt with poorly by the monetary policy managers of the day.

With some genuinely eye-popping inflation numbers coming out of several of the world’s major economies over recent months, it’s no wonder that inflation is trending so strongly as a topic of conversation across social media and the internet. If you’ve been to a supermarket recently, you will have seen inflation with your own eyes.

Inflation simply means rising prices – and the official figures for it are calculated on the basis of a change in the prices of a basket of goods and services over time. For example, the average price change in those goods and services, compared with the previous month, or year.

‍

High inflation is a problem because it effectively shrinks your assets and your income over time. The annualised CPI print from the US in October was 5.4%. If your income, or your assets, grew at less than 5.4% over that year, you went backwards without realizing it.

‍

What’s currently causing all the inflation?

Inflation generally results from robust, organic economic growth and high demand. Growth in demand under those conditions tends to outstrip growth in supply, so the prices of goods and services gets bid up. That’s kinda what’s happening now, as the world recovers from 2020, but with a couple of important twists.

The first twist is that old chestnut, Covid-19. Not only has it not gone away, but it’s still out there wreaking havoc on the world’s supply chains. This is because production inputs, production itself, and transportation (eg. shipping) are all being compromised by Covid-19 related issues. If a factory in China has to pay more for raw materials, plus more for labour in the factory, plus more to deliver whatever their product is, that adds up to a whole lot of additional cost on their side. They must then pass this cost on to whoever is buying their product. The wholesale buyer must then pass that cost on to you and I as consumers.

The second twist is oil and gas. While the United States is currently the world’s single largest producer of oil and gas, the world still relies heavily on energy from elsewhere (eg. Saudi Arabia, Venezuela and Russia). Demand for energy has risen significantly as the world has emerged from Covid-19 lockdowns, but production hasn’t increased to match it. As a direct result, you’re paying a lot more at the gas pump. Businesses are paying a lot more too, which means they have higher costs to pass on to consumers.

‍

How is inflation usually managed?

Inflation is usually managed by either raising, or lowering interest rates. In an environment of rising inflation, it would be typical for central banks to raise interest rates in order to cool the economy down. Raising interest rates has this effect because it raises the cost of borrowing money. When it’s more expensive to borrow, people and businesses aren’t able to borrow as much as they could when rates were lower. The theory is that when growth in borrowing is reduced, growth in consumption is reduced – and inflation is contained.

It might not be so simple this time though.

Raising interest rates won’t clear up supply chains. It won’t induce major oil producers to increase production. It also won’t miracle more supply of things like microprocessors into existence. In other words, it might not work at all.

What it could easily do though is harm asset prices, such as real estate and more expensive stocks. The biggest concern here is real estate, since it is the most highly leveraged asset class and therefore very sensitive to interest rates.

With this in mind, you can begin to understand the difficulties currently faced by the world’s central banks (like the Fed), who are ultimately responsible for managing interest rate policy. They can raise rates in an effort to contain inflation, but in so doing, they risk harming asset prices (especially real estate). This type of monetary policy is a blunt instrument. You can’t really raise rates for only selected parts of an economy – and raising rates to contain inflation might end up being too costly in other ways.

The Fed in particular is being very shy about raising rates. They are sticking to their guns about the current inflation surge being ‘transitory’. Frankly, I’m inclined to agree with them. The longer-term factors facing the global economy, such as demographics and technology, remain strongly deflationary. Food is the only area in which I think inflation will remain a long-term trend – and this is driven mostly by increasingly lean/unpredictable growing seasons due to climate change.

‍

What’s the outlook?

I’m no oracle, or even a professional economist. I am a professional investor though – and what I see is a peak in inflation some time in 2022, followed by a tailing off thereafter (food aside). Many economic forecasters agree with me. The current consensus is that rates won’t begin to rise until some time in 2023.

Inflation could easily get worse before it starts getting better though.

Might that tip the hand of central banks and force them to raise interest rates sooner than expected? This is a real risk – and one we’re taking very seriously. Canada has already started raising rates. Australia may not be far behind. The US and the UK will be more reluctant to do so, but their ability to hold off may become limited over the coming months. It also needs to be remembered that central banks tend to move together over time.

In an environment of rising rates, stocks are likely to outperform real estate – and you probably wouldn’t want to be holding any bonds…

‍

The threat of Stagflation

The biggest fear for central banks is something called stagflation, a phenomenon first identified in the 1970’s. This simply means an economic environment is which inflation is uncomfortably high, but growth is uncomfortably low (usually associated with high unemployment).

We share that fear.

The post-lockdown euphoria seems to be fading quickly now…while Covid-19 is surging again in much of the world – and the threat of new lockdowns is beginning to weigh. Consumer sentiment, a gauge of how consumers are feeling about the future, is now at a 10-year low.

Stagflation is such a problem because it’s notoriously difficult for policymakers to manage. So difficult in fact, that I don’t think it’s ever been handled well. Lowering rates can stimulate growth, but might exacerbate inflation, while raising rates can potentially control inflation, but turn stagnant growth negative. It’s probably the most troublesome scenario an economic policymaker can encounter – and it’s starting to look alarmingly close (see below).

‍

Here’s what we’re doing at Afinitiv LLC:

We’re always looking at the market to see how best to position our clients’ money – and we’re constantly reviewing our strategy to deliver what we see as the best balance between growth and risk.

Here’s a quick look at how we’re currently positioning:

1. Zero bond exposure.

2. Zero direct real estate exposure.

3. Increasing our cash allocation and reducing exposure to more ‘expensive’ stocks.

4. Maintaining our leveraged exposure to volatility (if the market tanks amidst a surprise, this will be a very profitable position indeed, just as it was in March last year).

We’re also contemplating an allocation gold, but we’re not there just yet.

‍

What else can you do about it?

The best you can do is to tighten your belt a little – and to ensure that your investments are less exposed to areas which will be most vulnerable to any inflationary shocks, or surprise interest rate hikes. Holding a bit of extra cash isn’t such a bad idea either, since this will allow you to move on opportunities created by any nasty surprises. That’s certainly how we’re viewing it. It’s how the world’ most famous investor, Warren Buffett, is viewing it too.

The only good news here is that while inflation is shrinking your income and assets over time, it's also shrinking your debts :)

If you need help steering your retirement portfolio (or your savings) through this difficult time and beyond, we’re here for you. Just open your account here – and we’ll take care of the rest.

‍

‍