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Inflation and markets


Inflation – what is it?

If economists argue over a precise definition of inflation, they argue even more about the cause of it. But for the sake of this blog, inflation is best described as when an economy experiences a sustained period of rising prices in goods and services. This in turn pushes up the overall cost of living, which is a problem for those on fixed incomes, and those who are unable to squeeze out higher wages from their employers.

How inflation affects markets

It’s been several years since investors have had any serious worries about Western inflation. Inflation - or rather the terrifying effects of hyperinflation - is generally a subject for the history books, invariably referencing the German Weimar Republic of the 1920s. Even more recent outbreaks such as those this century across Argentina, Venezuela and Zimbabwe have failed to touch the majority of us. But high inflation, especially when it spirals into hyperinflation, has terrible consequences for a country. If it were to afflict a major economy like the US, then given globalisation and our current high levels of interconnectedness, other countries could suffer the consequences. Deflation - defined as a fall in prices for goods and services - also has its downsides, including increasing the real value of debt which in turn reduces the spending power of firms, potentially leading to job losses. Most policymakers aim to strike a balance, keeping inflation targets at around 2%.

Could inflation return?

The coronavirus pandemic is a deflationary shock. But the responses from both central banks and politicians could eventually see a sharp uptick in inflation. Perhaps that’s no bad thing, particularly if it helps to reduce the horrendous debt burden that many governments, corporations and individuals are suffering under. But once inflation takes hold, it can be very difficult to stop. The worry is that central banks, in particular the US Federal Reserve, will prove reluctant to raise rates as inflation picks up. Bear in mind the pressure that President Trump has already brought to bear on the Fed’s Chair Jerome Powell. On top of this government spending is rising dramatically. In response to the economic collapse due to the coronavirus pandemic and subsequent lockdown, the gloves are off. Initially this fresh spending will merely offset the effects of the lockdown. But once started, it could prove impossible to end. After all, which politician is going to stand up in the next year or two and say we’ve got to stop spending money on health, education or social welfare? Add in building programmes, using money borrowed at extraordinarily low interest rates, and we could soon have inflationary lift-off. If inflation picks up, and if interest rates remain low, then government bonds will lose their appeal. This could undermine investor confidence in years to come.

Measures of inflation

Economists, and therefore investors and traders, tend to focus on a few standardised indices to help gauge inflation. All the world’s major economies produce some variation of a Consumer Price Index, or CPI. This tends to be the most popular measure of inflation although there are others, such as the UK Retail Price Index (RPI), and the US Personal Consumer and Expenditure (PCE) index. The CPI tracks the prices of a basket of goods and services. These are weighted using a specific methodology to produce an index which shows up any changes, whether up or down, on both a month-on-month, and year-on-year basis. But some analysts and economists are wary of placing too much emphasis on CPI data, arguing that it can fail to pick up inflation in certain areas, such as home purchases.

Certainly, all major inflation measures for the US, Euro zone and UK are remarkably tame currently. This is understandable due to the effects of the recent lockdown. But over the last few years, most inflation measures have failed to hit central bankers’ 2.0% target, despite near-zero interest rates and quantitative easing programmes.

Inflation and the markets

Historically, the concerns of investors and traders regarding inflation may be seen through the movements of certain markets. This can sometimes be a better guide than relying on official measures. Precious metals and other commodities often become increasingly popular. Property prices also are susceptible to stay strong when inflationary concerns grow. But it can be a mixed picture for equities. Companies that have the ability to pass along higher prices can survive and even thrive, but others don’t. Recently, we saw stock markets perform well in countries that have had episodes of high inflation or hyperinflation, even if, ultimately, they couldn’t fully keep up. The mining sector often does well during inflationary times. People tend to lose confidence in their currency and look to get rid of it by purchasing hard assets. Inflation is also an effective way to get rid of debt, as the money you owe shrinks in value as time passes. That’s why inflation is bad news for people on a fixed income, as the money they receive can’t keep up with rising prices.

 

Conclusion

There were some commentators who expected inflation to escalate following the coordinated monetary stimulus following the Great Financial Crisis. That didn’t happen. All the major economic inflation measures stayed relatively low and rarely pushed above the 2% target rate. The 2008 onwards stimulus and bond buying did not have the intended effect of trickling down into the wider economy, instead staying primarily within the financial system, evident in the record highs hit in global equity and real estate markets. But it is interesting that gold and silver did rally sharply in the years following the crisis. Given this, it’s fair to assume that markets move on investor expectations and sentiment and it is likely that investors won’t wait for traditional inflation measures like the CPI to pick up before worrying about inflation.

This time around we’re seeing governments increase their spending plans in order to save their respective economies ravaged by the response to the coronavirus pandemic. This should see money flow directly into the economy, rather than being held up by financial intermediaries but bear in mind it has to fill a big deflationary hole first. Once it has done that, if politicians can’t bring themselves to snap the wallet shut, inflation could skyrocket.


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