In mid-2020, inflation was a certainty – even if few people (including Southbank Investment Research) saw this at the time. In mid-2021, inflation had become a certainty – and increasing numbers of people were beginning to realise it. In late 2022, everyone is talking about – and suffering the effects of – inflation. But what does this mean for you as an investor?
If you are an investment writer or editor, it’s always useful to look at your analysis one or two years later.
Broadly speaking, two outcomes are possible.
Your analysis will have turned out to be correct… or it will have turned out to be incorrect.
Most of this report is taken from an essay entitled The Inflation Survival Guide…. It was written in mid-2021, when its title included the words “in 2021-22”.
The title has been shortened to avoid confusion and to recognise the passage of time.
The essay included a provocative forecast from one of Southbank Investment Research’s editors.
In mid-2020, or one year previously, our editor had been one of very few analysts to foresee that inflation would become a serious problem – at a time when most other people were focusing on the implications of the Covid-19 pandemic.
His call was a big one, and it was based on hard numbers.
The essay also put the latest bout of inflation into a historical context, and explains why inflation has not been a problem for most people in the developed world since 1993.
Some 18 months after the original essay was written, we are pleased to be able to say that the analysis has been proven right.
The big question for you, today
As an investor, it has been much harder to make money over the last year or so than it was in the 12 months leading up to, say, December 2021.
Stock markets have been falling. Bond markets have endured sharp rises in yields, which means declining prices.
The gold price has basically tracked sideways, in US dollar terms at least. (Admittedly, it has performed better in other currencies.)
You can probably guess what the big question is for you, today…
… where should you invest?
It has in fact been possible to make money since the beginning of 2022– provided that you had the right allocations to gold, commodities, energy and some other assets.
Although remember, past performance does not guarantee future results.
In May 2022, we provided an overview of markets and opportunities, drawing on several of Southbank’s publications.
Our analysis began with an old saying: “the cure for high prices is high prices”.
The idea is that if the price of X (a product or commodity) is unacceptably high, then suppliers of X will think creatively to boost the output of X, with the result that the price falls.
One way or another, most of our publications pointed to the same conclusion.
There are attractive investment opportunities when a rise in the price of X does not – or cannot – result in a rapid increase in the supply of X.
In some instances, the opportunities are the shares of companies that produce X.
In other cases, the opportunity is X itself.
Other important and relevant questions include include:
- What is the best approach to investing in stocks in the current environment if you want to stay calm?
- What is one stock that protects against deforestation and inflation?
- Which industries in the UK are set to grow rapidly, regardless of economic conditions?
- What role does crypto play in a balanced portfolio?
- In an era of inflation, is there a metal whose prospects are better even than those of gold?
The one certainty…
Every day, the value of your cash falls. The only question is: by how much?
Think of all the things that you might buy in a typical month.
Those things include groceries and clothing, car repair/maintenance services, gym membership, visits to the hairdresser, public transport, food and drink at a pub or restaurant and dozens of other items.
At any one time, you will always be able to find examples where the price of something is higher than it was a year ago.
Sometimes, the price will have gone up because of a government decision, as announced in the Budget by the Chancellor of the Exchequer.
If that’s the case, you can be sure that the price rise is covered extensively in the mainstream and social media.
However, the bigger picture, and one that is almost never discussed, is rather different.
A new generation grew up with no inflation in the UK
For most of the last 28 years, inflation – the year-on-year rise in prices for a basket of goods and services – has been in the 0-2.0% band that the Monetary Policy Committee (MPC) of the Bank of England targets when it decides what to do.
There have been a few years when inflation has been a little above the target band of between 2.0% and 2.5%.
However, there have only been two years in that time when inflation has exceeded 2.5%.
Those years were 2008 (3.5%) and 2011 (3.9%).
Inflation had also been quite a bit higher in the late 1980s and the early 1990s.
Overall, though, it is fair to say that inflation in the UK has been running at about 2% per year since 1993 – and that’s why we’ve chosen that year as a starting point for this discussion.
It is possible to manage with 2% inflation.
A lot of commentators will tell you that inflation at that level will have a corrosive effect on the purchasing power of the money that sits in your pocket or in your bank account.
On their own, the maths confirm this.
If you reduce the value of £100 by 2% each year for 28 years, you will be left with £57.96.
If you’re like most people, though, you should be able to cope quite easily with 2% inflation year-after-year.
And that’s true even if your income rises by less than 2% annually.
For instance, you may be able to find whatever it is that you are looking to buy at a cheaper price – just by shopping around.
Or you may switch from buying X to buying Y – something that is similar (but not the same) and which offers you better value.
In the meantime, changing technology means that goods and services have got (a lot) better over time.
Taking just one example, think about what your mobile phone is like now relative to the one that you had, say, 10 or 15 years ago.
It is very difficult for the statisticians who devise the baskets of goods and services that go into calculations of inflation to capture all this on an ongoing basis.
They have no idea as to how you – or most people – might be able to find a bargain.
Now do they know how you may be changing your shopping preferences.
And it really won’t be possible for them to capture how much better your new mobile phone is relative to the last one that you owned.
So, what does all this really mean?
Over the last 29 years, the official inflation numbers here in the UK have probably overstated the extent to which the purchasing power of money is falling.
Inflation has generally been around 1.5%.
Now consider someone who was born in 1973, and who was entering the UK workforce as a 20-year-old in 1993.
That person is now a 49-year-old and he/she has basically not experienced inflation at all since starting to earn a wage or salary.
As discussed above, he/she has been able to make adjustments – or benefit from new technology – to cope with 0-2% rises each year in the cost of living.
Of course, the same is true of anyone who is younger, and who has joined the workforce since then.
A prophecy foretold
Now consider someone who is the parent of a person who was born in the UK in 1973.
It is a reasonable bet that the parent was worrying almost as much about the cost of living as about getting to the hospital’s maternity ward in time.
Inflation in 1973 was 9.2%.
And it was about to get a lot worse.
Inflation rose to 16.0% in 1974 and 24.2% in 1975.
The cost of living, measured in this way, grew by 16.56% in 1976, by 15.84% in 1977 and 8.26% in 1978.
In 1979, 1980 and 1981, the corresponding numbers were 13.42%, 17.97% and 11.88%.
1981 was the last year in which inflation in this country was at double-digit levels.
The very big picture is that inflation was basically on a steady downtrend from 1981 to 1983 – since when, as noted, it has been at very low levels.
We don’t have the space in this report to discuss all the other things that were going on in the UK and global economy in the 1970s and the first years of the 1980s.
In many countries, the story was a depressing one.
That story typically involved some or all of: soaring prices for energy; strikes and industrial relations chaos; currency crises; sub-par rates of economic growth; de-industrialisation; and barriers to international trade that are far higher than they are currently.
In fact, for our purposes, there are four things to bear in mind.
First, inflation in the United States peaked at 13.55% in 1980, and was in downtrend until the early 1990s, since when it has basically tracked sideways like inflation in the UK.
Second, inflation has been at low levels in most developed economies since the early 1990s.
In fact, deflation – or a fall in the general level of prices – has been a problem for the Bank of Japan for much of that period.
Third, many people in the UK genuinely had trouble in making ends meet when inflation was running at double-digit levels.
Finally, and most importantly, inflation has been in downtrend – falling and then staying down – in much of the world economy, including the UK of course.
This means that any prediction that inflation really is going to return, whether to the UK or to the global economy, is a very big call.
Here at Southbank Investment Research, that is precisely the big call that we made in June 2021.
Like many big calls, we were not proven right immediately.
Throughout the second half of 2020, the UK and global economies continued to be profoundly disrupted by the Covid-19 pandemic.
It is now 18 months or so since we made the big call that inflation would rear its ugly head again.
Since then, several things have happened.
Vaccination programmes went reasonable well here in the UK, the United States, much of Europe and in some other countries – meaning that the threat from Covid-19 has been reduced.
Thanks in part to the furlough programme, and in part to flexibility on the part of businesses, mass unemployment has been avoided here in the UK.
The story is similar in other countries as well.
The bottom line is that things in economies are much closer to (a new) normal than they were in the summer of 2020.
And the new normal has been accompanied by… inflation.
This is what we explain below.
In May 2021, one of our publications carried the title “Inflation reaches 1970s levels”.
Several hard numbers had caught our editor’s eye. The consumer price index (CPI) in the United States had risen by 4.2% over the year to April.
Financial market commentators had been expecting an increase of 3.6%.
The higher number was seen as bad news.
Meanwhile, “core inflation” in the United States, which excludes the prices of food and energy, spiked up to 3.0% in the year to April.
Because the prices of food and energy are often volatile, core inflation is often seen as a good indicator of what is really happening to the underlying cost of living.
Make no mistake, though, the prices of food and energy are important.
As our editor put it: “food and energy are the most important inputs to inflation because all economic activity is based on one or both of them. That is unless you are happy to work in the dark without a lunchbreak.”
For our discussion, though, here is what really matters: the month-on-month rise in the core inflation index in April was 0.9% – which was the largest single increase for one month since the 1970s!
So, what drives inflation?
To understand inflation, you need to understand what money is.
Money can be used to buy things – both goods and services.
Money can be used as a store of wealth.
It is also useful as a way of measuring values – such as the worth of a house, or the profits made by a business.
Money can be found in two places: as notes (and coin) in your pocket or available for withdrawal from an ATM and in bank deposits within the entire financial system.
Some of those bank deposits will be owned by the banks themselves, as they place money with each other or with the central bank (i.e. the Bank of England here in the UK).
And the other deposits will be owned by the non-bank public – businesses, institutions and people like you and me.
If the supply of money grows broadly in line with the total production of goods and services – or “stuff in the economy generally” – there should not be much inflation.
Conversely, if the supply of money grows a lot faster than the total production of goods and services, there is a real risk of inflation.
Note how “real risk” does not mean certainty.
In the wake of the global financial crisis of 2008-09, the Bank of England – and a lot of central banks – took steps to ensure that the problems did not turn into a 1930s-style depression.
What the Bank of England and the others did is known as quantitative easing (QE).
This is a fancy way of saying “creating money” or “boosting the money supply”.
QE involves a central bank buying a lot of bonds (and, sometimes, other securities) from banks.
If a central bank buys X amount of bonds, then the assets on its balance sheet go up by that amount.
The corresponding rise of X on the liabilities side of the central bank’s balance sheet is usually called something like “banks’ claims on the central bank”.
Those claims are bank deposits, and they are part of the money supply.
The amount of interest that the central banks have been paying on these deposits have been very low (and, in some cases, negative).
This gives the banks an incentive to take the money that they have deposited with the central bank and to lend it to customers – or, to put it another way, to get the money into the real economy.
However, that generally did not happen; in part because a lot of households and businesses were reluctant to take on new debts.
Put simply, there was a lot of new money created, but it generally stayed on the side-lines – or, more specifically, with the Bank of England and other central banks – rather than moving into the real economy where stuff happens and where goods and services are transacted.
The bottom line is that money is not just growing a lot faster than the real economy.
The new money is getting into the real economy: and that is why inflation has become a certainty, rather than just a risk.
Crunching the numbers
To understand what all this could mean in practice over the coming year, bear in mind the following equation, which one of our editors has discussed in the last year or two.
MV = PY
M stands for money supply, as discussed above.
V stands for velocity of money.
In plain English, that means the speed at which money is spent.
If people fear inflation, they will try to spend the money faster – and V will rise.
That may mean that it may feel that more money is moving around the economy – even if M is not rising.
P stands for the level of prices.
As we have seen, it has not actually moved all that much in the UK since the early 1990s.
Y stands for all the stuff that happens in the economy – all the goods and services that are produced.
So, what does it all mean?
If you increase M (the money supply) or V (the velocity), then one or both of P (the price level) and Y (output of goods and services) must rise correspondingly.
The United States is the only country where statistics are published for the velocity of money.
For much of the last 60 years, V has been around 1.8 times in that country. This has recently dropped to around 1.1.
After the global financial crisis in 2007-08, V fell steadily to 1.4 in 2019.
Put another way, the speed at which money was flowing around the US economy dropped by around 22%.
However, the Federal Reserve (also often known simply as the Fed – the US central bank) increased the money supply – shown by M in the equation – through QE to compensate.
The result was low inflation (P) and moderate growth in economic activity (Y).
Then the pandemic struck.
V plunged from around 1.4 to below 1.2.
In other words, it fell by another 14%.
Once again, the Fed had to expand money supply – that is, M – very aggressively to prevent a slump in inflation or a disastrous fall in the level of prices.
In fact, the money supply rose from about $15 trillion to approximately $20 trillion, or by around one third through calendar 2020.
The result was inflation – or P – of about 4.2% (using the data for the year to April 2021) and a fall in economic activity – Y – of around 3.5%.
But, what happens next?
As our editors points out, the Fed is looking for growth in the economy – or Y – of 6.5% in 2021.
If volatility – V – returned to the level it was at prior to the pandemic, it would increase by 27%.
For now, let’s assume that the money supply – M – stays more or less unchanged.
That would mean that the Fed actually stops QE, at least for a while.
To make both sides of the equation balance, inflation – or P – would have to be…
… 19%!
To put that in context, remember that inflation in the United States reached a peak of about 14% in the 1970s.
Of course, these numbers are based on the Fed holding the money supply constant.
If the money supply were allowed to grow by 10% – which is a fairly conservative figure given the rate of expansion over the last year or so – inflation in the United States would be 29%.
As noted above, some measures of inflation in the United States have risen to multi-decade highs.
If inflation looked as though it really were going to soar into double-digits, several things could change.
One is that people and businesses might adjust their behaviour so that economic activity – Y in the equation – falls.
Another is that the Fed might take steps to stop velocity – or V – from rising.
Alternatively, the Fed could try putting QE into reverse – by selling bonds rather than buying them – in order to stop the money supply – M – from rising.
In other words, it is very unlikely that inflation will get into triple digits (meaning that prices would have to rise by at least 6% per month).
It is even less likely that the United States will reach hyperinflation – a situation where prices rise by at least 50% per month.
Hyperinflation is normally the result of political and financial turmoil and, fortunately, it happens very rarely.
In the last 30 years, Zimbabwe,Venezuela and South Sudan are the only countries that have experienced hyperinflation.
What really matters, though, is that the equation and the dynamics apply as much to the UK as they do to the United States.
Who are the winners and losers?
Inflation is an erosion of the purchasing power of money.
Anyone, or any business, that is sitting on cash will be a loser.
Or, more precisely, they will be a loser until they spend the cash, or invest it in something that holds its value in a time of inflation.
Conversely, anyone who has borrowed money at a fixed rate of interest will be a winner.
That is because inflation reduces the real value of the principal sum that has been borrowed.
The inflation will also lower the real burden of interest payments.
This means that the likely winners will be governments.
That includes the US and the UK governments, as well as their counterparts in pretty much all developed (and many developing) countries.
The losers will be most people, insurance companies, banks and pension funds that have invested in bonds issued by governments (and many other bonds, such as mortgage-backed securities (MBS) and high-quality corporate bonds).
Some governments have issued bonds that can provide protection against inflation.
Examples include Treasury inflation-protected securities (TIPS) in the United States and index-linked bonds (“linkers”) here in the UK.
As inflation reappears and rises, both the principal amount to be repaid when the bond matures and the regular interest payments are adjusted upwards to compensate.
However, such bonds are relatively rare.
The vast majority of bonds do not offer protection against inflation and will likely perform poorly as the prices of goods and services rise.
It is possible that investors will demand higher yields on bond investments.
In plain English, that means that some governments (and large corporates) will have to pay higher rates of interest when they borrow from financial markets.
That could give rise to financial problems for those governments.
The governments’ financial problems could cause their countries’ currencies to fall sharply.
Sharp moves in currencies often cause other difficulties – and particularly if the governments have borrowed in a currency that, from their point of view, is foreign.
Seeking protection
What sorts of listed companies provide protection from inflation?
One category includes companies whose stock market capitalisations (i.e. their values, as calculated when you multiply the number of shares on issue by the current share price) are way below where they should be given the companies’ current prospects.
Another category includes companies whose businesses are growing in such a way that their profits are likely to expand rapidly for some years to come.
Often these companies will have pricing power – meaning that they can pass on cost increases to their customers.
However, there is one thing that all the Southbank Investment Research editors are agreed on.
The price of gold always does well at times of sustained inflation.
When the cost of living is rising sharply, gold holds its value.
That’s something that a lot of financial advisers today haven’t had to think about.
Very few of them were working as advisers (if they were working at all) the last time that inflation was a serious problem in the UK.
This is relevant because of the one certainty for the coming year.
That certainty is what Southbank Investment Research foresaw in the middle of 2021.
The certainty will affect all of us here in the UK.
The certainty is that our money will fall in value because of inflation.
Andrew Hutchings,
Managing Editor, Southbank Investment Research