Ross Garrard, Stockbroker at Ravenscroft, looks at the impact of inflation
Investing involves putting money aside today for what is usually an uncertain future return over an uncertain time horizon. When both uncertainty and time are involved, invariably there will be potential risks arising, both known and unknown.
Financial markets are seemingly fraught with risk and will always tend to be preoccupied with a few in particular.
Brexit, China, the global financial crisis, Covid-19 and the Ukraine-Russia war are just a few of the more recent concerns.
While such events are undoubtedly frightening at the time, and can cause high market volatility and wealth destruction, nothing destroys wealth greater in the long term than the markets’ current principal fear – inflation.
Potential impacts
This might not seem the case when inflation is benign, as it has been in the UK and US for the past few decades.
One need only look at countries that have experienced hyperinflation to witness the devastation it can cause, most notably in Germany’s Weimar Republic before World War II (allowing Hitler’s ascension), Zimbabwe in the early 2000s and more recently in Venezuela.
In each case, the population’s savings were lost, sometimes, almost overnight, due to the destruction of their purchasing power.
This is why the independent central banks of the world, such as the Bank of England and the US Federal Reserve, have a mandate to control inflation, in both cases at a target of 2% per annum.
But even benign inflation destroys wealth over time. Until 2022, UK inflation has averaged around this 2% target for the past 30 years, so had you just sat on cash and not invested it, its value in real terms today would be around half – a 50% wealth destruction over 30 years.
However, if the current high rate of inflation were to persist over the longer term, this wealth destruction would be much more severe. A 10% inflation rate would lead to the value of your wealth halving in just seven years.
It is hardly surprising, then, that at this pace of real earnings decline, trade unions and public services are opting for the picket line.
Some inflation is welcomed. Indeed, during recent decades, central banks have been much more concerned with avoiding a deflationary debt spiral, such as has been experienced by Japan for more than 20 years.
In his regular updates, Ravenscroft Chief Investment Officer Kevin Boscher has highlighted many long-term, secular disinflationary trends, such as ageing demographics, globalisation and technological advancement, not to mention population decline.
The latter has been a particular problem for Japan and is now being experienced by rapidly developing nations such as China.
Deflation represents a potentially bigger problem for heavily indebted countries such as Japan, as debt is fixed in nominal terms, while assets and their income fluctuate but would typically lose value in such a scenario.
As such, central banks will err on the side of inflation in order to encourage economic growth and reduce the real debt burden of elevated national debt.
It involves a careful balancing act but, after recent crises, it seems central banks have steered too far into inflationary monetary policies to avoid both economic decline and deflation.
Following the Covid-19 shock, the Fed alone pumped some $4trn of additional dollars into the system via a mechanism called quantitative easing, which artificially lowers bond yields and so borrowing costs.
Given that the base of investable assets does not change much from year to year, the effect of this has been to cause asset price bubbles in bonds, cryptocurrencies, equities and property.
When combined with major fiscal stimulus – governments ran large deficits in the aftermath of Covid-19, together with a commodity price shock caused by Russia’s invasion of Ukraine – a 40-year cycle of generally low inflation and progressively lower interest rates has ended.
Changing of the guard
The impact on financial markets has been profound and in 2022 we witnessed the painful unwinding of these asset bubbles as interest rates increased and liquidity was pulled from the system.
The return of inflation has major implications on how we invest going forward but, from a wealth management perspective, there are some positives.
Most importantly, the return one can now get for a given level of risk is higher.
For example, one can get a higher return on cash today than would have been achieved from government bonds and many corporate bonds a year ago, while some high-yield bonds now offer an almost equity-like return.
We consider cash and bonds to be increasingly investable but should be mindful that they usually provide a nominal return, which, if less than inflation, could still result in a negative annual real yield.
Equities and property on the other hand are so-called real assets, for which prices and returns may grow with inflation.
Certain equities are particularly correlated with inflation, most notably energy, financials, food retail and raw materials. These sectors are heavily represented in the UK index and help account for the FTSE 100’s significant outperformance in 2022.
However, being ‘old economy’ stocks, they remain unfashionable, under-owned and undervalued relative to both their own history and the broader market.
This is reflected by UK equities falling to just a 4% share of the MSCI World Equity Index, compared with a longer term average of 8%.
By contrast, in 2021 US equities peaked at 70% of the MSCI World, a huge concentration for one country.
Interestingly, the last time UK equities meaningfully outperformed their high-flying US counterparts was in similar inflationary times in the 1970s and 1980s (for ‘nifty fifty’ read ‘FAANGS’).
In recent months, we have witnessed a resurgence of not just the UK but other unpopular major stock markets, such as China and Japan. Perhaps inflation will herald a changing of the guard for equity market leadership.
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Ross Garrard is a Stockbroker at Ravenscroft.
• Visit www.ravenscroftgroup.com