[More than a year ago, John Butler warned you that inflation was coming. Within weeks of that warning, the inflationary nightmare began. But what is he saying now? Find out below…]
One would have to be living under a rock to be unaware of the huge rise in inflation that has taken place over the past year. Hardly a day goes by without more talk of the “cost of living crisis” as prices soar and wages try to keep pace.
The government is under tremendous pressure to “do something”. On the one hand, there are those pushing for tax cuts, such as a reduction in fuel duty. On the other, there are calls for targeted spending – to assist needy families, for example.
The irony seems lost on many. After all, it was the government that got us into this mess in the first place. You can’t increase public spending year after year at a rate higher than the underlying rate of economic growth without causing prices to rise.
Children are known to deny responsibility for their occasional misdeeds. On almost no issue is the government more childlike in its denial of responsibility than in how it tries to explain inflation to the public. It more or less claims that some bogeyman hiding in the closet and makes an occasional, unpredictable, frightening appearance is responsible.
No, to paraphrase Milton Friedman, “Inflation is, always and everywhere, a government phenomenon.”
Nor is the inflation bogeyman going back into the closet anytime soon. Workers in one part of the public sector after another are getting organised to press for higher wages. Teachers, nurses, doctors, public transport… The list is already long, and growing.
How likely is it that the government will somehow resist the pressure? A government that has already been weakened by a no-confidence vote and one facing another possible secession referendum from a major region?
How about “zero”?
Higher public-sector wages are going to place further upward pressure on prices. In what appears more and more like a repeat of the 1970s “wage-price spiral”, inflation is likely to remain elevated for some time. To make matters worse, as wages begin to catch up with inflation, growth is likely to slow. Unemployment is likely to rise. “Stagflation” will become embedded in the economy.
So, what on earth should the government do? Well, what does one say to the man who complains of being stuck in a deep hole?
Stop digging. Stop constraining supply with costly regulations and excessive taxation. Stop growing the public sector, which requires higher taxation, at the expense of the private sector, which provides it. Stop feeding the beast, as it were.
Politically, this is easier said than done. Few post-war politicians have succeeded in slowing the growth of the public sector relative to the private. Fewer still have reversed it, even a little.
To make matters worse, long before the recent rise in consumer price inflation, financial-asset valuations had already inflated. Stocks, bonds and property prices had all been propelled higher by the strong tailwind of historically low interest rates.
Stagflation can wreak havoc on financial assets, the returns on which tend to trail behind the rising cost of living. When stagflation arrives amidst generally overinflated assets, the underperformance is likely to be all the worse.
Cautious investors might consider sitting in cash and bonds, rather than shares, but both are virtually guaranteed to lose value in real, inflation-adjusted terms.
Where, then, is an investor to hide or, rather, “hibernate” through the coming “Winter of Discontent”?
In brief, investors need to go where the inflation is. If widgets are rising in price, and everyone needs a widget, you want to be invested in companies that produce widgets.
Economists call this “pricing power”: when companies can easily pass input price increases along to their customers. This tends to be the case in basic industrial sectors such as energy, mining, materials, chemicals agriculture and non-discretionary consumer products.
For years, such sectors have been mostly out of favour. They’re relatively old, mature industries. They’re not particularly “green”, although sometimes they try to appear so. They’re not sexy, or cool, or trendy.
But they tend to make money. They tend to be highly cash-generative. And they tend to pay high dividends. They might have low margins, but those margins are stable. Where there’s inflation, it gets passed right on through to customers.
I wouldn’t claim they’re “stagflation-proof”, but they’re certainly more “stagflation-protected” than the high-flying growth sectors, such as technology, which powered the most recent bull market. And, unlike bond coupons, the revenues they receive, profits they make and dividends they pay out are likely to rise along with inflation over time.
But what about diversification? Should investors go all-in on the stagflation sectors listed above?
No. They should also own some gold. In a stagflationary world, gold preserves purchasing power better than bonds. And it also diversifies a portfolio of stocks.
Gold doesn’t pay an income, but then bonds paying interest below the rate of inflation pay, in effect, negative coupons. And, over the longer-term, gold has an excellent track record in keeping pace with inflation. In gold terms, petrol is no more expensive today than it was in the 1960s.
A classic example of gold retaining its purchasing power is that one troy ounce allows a gentleman to purchase a Saville Row bespoke suit. I haven’t walked along Saville Row recently, but I suspect £1,500 would at least get me started there.
Investors today need to be realistic and practical. They don’t call it a “Winter of Discontent” because it’s going to be easy. It’s going to be hard to preserve wealth over the coming few years.
We would do well to learn from the bears and other hibernating animals: when there is only a little food to eat, it’s best to sleep the winter through, conserve the calories we’ve stored, and await a more fruitful season. It will come. And when it does, those investors who have preserved their capital will likely enjoy the best investment opportunities for many years.
John Butler
Contributing Editor, Fortune & Freedom
