Has The Inflation Dragon Broken Free Again? – Our Q2 Update

Has The Inflation Dragon Broken Free Again? - Our Q2 Update

Author Timothy Dingemans • 12th May 22

In my last piece, I pointed out that the investment outlook is profoundly changing. I had expected this to lead to a tougher period for asset prices as part of normalising financial conditions that required Central Banks to raise rates. I did not expect that Central Bankers would be rushing to prove that they were the toughest in the group. Official predictions of rate hikes to come moved dramatically from earlier official forecasts. In short, the World Bank meeting in April turned into a Central Banker “Ironman” competition, with each Banker determined to show how ready they were to react to inflation and raise rates.

What does this new era mean? The cost-of-living crisis is of huge political importance in the UK and globally rising as a dominant issue. Firstly, inflation is seen as Tolkien’s Smaug. We have had a period where it has been below official targets (around 2% for many Central Banks). As has been recently demonstrated, it can ratchet up very fast to dangerous levels (approximately 10% in several developed market economies). The danger is that once inflation reaches these levels, it then drives up wage demands, and we get a spiralling effect. Here, the initial causes of inflation, excess demand versus supply, are taken over by higher wage demands, driving up manufacturing costs, which further drives inflation, leading to even higher wage demands. Precisely this effect exaggerated the horrors of the 1970s inflation and, at times, stagflation in the UK. You had high inflation coupled with low growth – the most toxic mix for financial assets.

To slow the demand, Central Bankers are raising rates to lower demand. They were already artificially too low to act as a stimulant against the financial crisis in 2007-2008 and COVID. However, the problem is that as the demand falls, it fast leads to reduced company profits, leading to an economic slowdown and even recession.

Central Bankers are aware of this risk, and indeed the US central bank released the following statement, in its latest semi-annual Financial Stability Report, on Monday. “Further adverse surprises in inflation and interest rates, particularly if accompanied by a decline in economic activity, could negatively affect the financial system.”

If you look at the chart below, there is indeed a correlation between inflation going up (blue line), interest rates going up (red line) and recessions (shaded grey area).

The chart shows US Inflation and FED Funds, with the grey area being recessions

Source:- St Louis Fed, Aventur

So here is the crux of the problem faced by investors. Central bankers need to ensure inflation is kept under control. As a result, they need to raise rates with the risks mentioned above to growth and general standard of living costs. Currently, there are additional complications for Central Bankers. Firstly, the War in Ukraine is driving up fuel and food prices. Secondly, Governments have little room to expand their balance sheets (borrow) to support their economies, as they are already bloated due to quantitative easing. They have a very narrow path between doing too little and seeing inflation spiral or doing too much and seeing the economy and personal living standards crumble.

This is a terrible time for most financial assets. Bonds suffer from increasing yields as this lowers prices. Equities fall as lower growth reduces returns/prices. Property, especially residential, which has seen steep gains (driven by cheap borrowings), tends to see reduced returns as higher mortgage rates reduce demand. It is also a bad time for holding cash as inflation erodes cash’s value. Additional bonds, equities and residential properties are by many measures still historically expensive and certainly are not cheap or value offerings.

Is there any hope? Is there a large dart to slay the dragon that does not take us all with it? There is the risk of a hard landing and a prolonged recession. There is also hope. Firstly, Central Bankers are very aware of the tightrope they are walking along. Rates will rise, but Ironman competition aside, they will be responsible in the process of raising rates. Secondly, maths, provided we don’t slip into a wage demand spiral, it is hard for inflation to stay at 10%. Remember is the change in the price, not the level. So, prices can remain high (indeed they might), but inflation comes down if they don’t go up, especially as lag effects fall away. If prices stay high, it does not, of course, help the cost of living crisis. However, it does start to give governments more room to manoeuvre again.

In conclusion, we are indeed being buffeted by storms on many sides. Unwinding QE, exaggerated asset prices, inflation, and the War in Ukraine. This is a time when losing the least money, either nominally or in inflation adjusted terms on assets, will be the best result. This can best be achieved by diversification and active management of your investments. At Aventur, we work with leading technologies to help our clients in these challenging times.

Want to know more? Get in touch with this blog’s author, Timothy Dingemans, or fill out our contact form today.