What could increased inflation mean for investors?
Here we’re chatting to Relationship Partner, Jonathan Elsigood, about inflation.
There’s been a lot of media speculation about rising inflation and what this could be mean for investors.
Jonathan unpacks the detail and explains why there’s no need to panic…
So, why does everyone seem to think inflation is going to go up Jonathan?
It’s mainly to do with how the western countries have responded to COVID. A big learning point from the 2008 financial crisis was that central banks in the US, UK and Europe didn’t pump enough liquidity (cash) into their respective economies which slowed down the recovery.
This time around, wealthy countries have pumped money into the system as quickly as possible and on a much larger scale than we’ve ever seen before.
This in turn creates something called the velocity of money:
– As we come out of lockdown people start to spend the money that’s been pumped into the economy
– At the same time products and services are in short supply
– So, there’s a lot of money chasing not a lot of product
People are willing to pay more for products that are in high demand causing inflation to go up and up and up.
We keep hearing about interest rates alongside all of this, what’s that got to do with it?
Historically speaking, governments and central banks have combatted higher inflation by putting interest rates up.
But if you’ve got governments creating money by taking on more debt – alongside an increase in borrowing by companies and individuals too – that means paying the interest cost on all this debt could rise as well. The net result then creates an economic slow down or worse, the next recession. So, you end up going back to a boom and bust cycle; something which we thought we’d left behind.
What does this mean for investors?
Don’t forget – all crystal balls are cloudy!
Markets have a way of predicting what they think the likely inflation rate will be in the future.
Essentially, it’s the difference between the yield on a conventional government bond and the yield on an inflation linked bond.
This figure is the markets ‘best guess’ at inflation and even with the prediction of a strong economic bounce back in 2021 and 2022, and lots more spending, the market’s best guess for inflation is still only predicting it to rise to around the 3% level.
Over the last ten years markets have priced in inflation at around 2.5%-3%! So, we’re not talking a 1970’s double digit increase here.
Markets are more relaxed than what the press is trying to have us believe. And Japan has had a very easy monetary policy for many years and hardly any inflation at all. Nothing is a given certainty.
Could increased inflation be good for investors?
Actually yes, a bit of inflation working its way through the system means prices increase, companies make greater profits and so equities should go up!
Governments will also welcome it so they can inflate away some of their debt rather than having to raise taxes or cut spending.
What markets and investors don’t like is when inflation becomes rampant, and governments have to ramp up interest rates quickly to counteract it.
Hypothetically what would happen if inflation rates became rampant?
Trying to steer the economy through a boom and bust cycle is like trying to put the brakes on a super tanker – before you stop you have to apply the brakes years ahead!
If this was the case the government would apply the brakes by increasing the cost of borrowing – people would then be spending more on debts and mortgages than products and services.
We’re a long way away from this kind of action.
How do we combat a potential rise in inflation at CPW?
We always use short dated bonds – so even if the price of bonds is impacted by an increase in interest rates, they also keep maturing and being reinvested at the next highest yield, so you’re gradually going up the yield curve.
The other thing is that we’ve always held a third of our bond exposure in index linked government bonds as a direct hedge against inflation.
So we’ve got this backstop if inflation does become rampant.
If you have any questions about inflation or interest rates just get in touch with myself or a member of the team – we’re happy to help.
Past performance can’t guarantee what investments will do in the future. The value of a portfolio can go down as well as up, so there’s a chance you’d get back less than you put in.