Inflation - the dog that could still bark

As inflation plus investors we are focused on outperforming inflation, plus an annual percentage, net of our costs.  Consequently, we think a lot about inflation and as we consider 2018, one of the largest risks we see on the horizon is the threat from inflation.  To our surprise, many investors still seem relaxed about this issue considering that in the UK, the annual rate of inflation as measured by the Retail Prices Index (RPI) reached 3.9% over the year to Dec 2017.  The big question is whether this “imported” inflation from the depreciation of Sterling (which makes imported goods more expensive) will be a temporary phenomenon or become more of a longer-term issue.

We are more concerned by inflation today simply because the world is so ill-prepared for it. Inflation peaked in 1975 when RPI ran at over 26%pa and since then it has fallen reaching its recent low of -1.6%pa in June 2009.  Over that time, a generation of investors have become used to benign inflation coupled with the expectation that an ageing population will make inflation a thing of the past. We believe they could be under appreciating a significant risk to their wealth.

The timing and catalyst for changes in the costs of goods and services are notoriously difficult to predict but this doesn't mean that we shouldn't be considering the risk.  We not only fret about the impact of the current rate of inflation, should it not fall back as expected, but also note the gradual increase of indicators that point to a further uptick in inflation.

For decades now, Japan has been the poster child for both an ageing population and low inflation (even negative inflation) but for the first time in a long time there are signs that this is changing. Whilst anecdotal stories must be taken with a pinch of salt, there has been significant news flow in Japan about the increasing prices of many familiar goods and services which is only newsworthy because they have been stuck at the same price for literally decades. One of the problems with measuring inflation is that the root causes of inflation are often well underway before their impact is noted in official measures.  Therefore, softer indicators such as newspaper headlines can be useful early warnings. 

The primary reason to expect inflation in Japan is due to its labour market where unemployment has now fallen to 2.7% and consequently there are now 3 jobs available for every 2 job seekers.  One can’t help thinking that this is an environment where employees should be able to secure a pay rise and wage inflation is one of critical components for actual inflation.

The developed world has also followed Japan’s playbook with ageing populations, high savings rates and low inflation.  However, there is a point when this reverses and accumulated savings start to get consumed and if the ability to “import” workers becomes constrained then we could see similar labour market shortages as we run out of younger workers to service the needs of their retired brethren.  Whilst we are not necessarily at the point where this becomes inflationary, we believe the downward pressure on prices is waning and the green shoots of inflation can be seen.  The market though, seems to have either not noticed, doesn’t care or disagrees with us.

We are less concerned about inflation than the market’s reaction should it appear. It will not be news to anyone that government bond yields across the developed world are extremely low and one of the reasons for this is a belief that inflation is not coming back. If inflation returns, it will quickly undermine current bond yields and we could see bond prices falling and yields (and the cost of new debt) rising. These losses would not be confined to bonds because the extremely low interest rates have encouraged lending and forced money into higher return assets.  This flow of money has underpinned the lofty valuations for many asset classes from tech companies, property, classic cars, art and even bitcoin.  Our fear is that we could see a sharp adjustment and a significant decrease in asset prices.  This could leave central banks with a dilemma as higher inflation will encourage them to increase interest rates, but falling asset prices will do the opposite.

We see this as a real threat to investment portfolios in 2018 and one we are moving to protect against.

 

Phil Bagshaw CFA
Senior Portfolio Specialist 

 


This document may include forward-looking statements that are based upon our current opinions, expectations and projections. Investment markets and conditions can change rapidly, and as such the views and interpretations expressed should not be taken as statements of fact, nor should they be relied upon when making investment decisions. We undertake no obligation to update or revise any forward-looking statements and actual results could differ materially from those anticipated by any forward-looking statements.

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Luke Carrington