Updated: May 19, 2022
Inflation is to investment strategy what location is to property: everything. Inflation drives many things that influence financial markets, not least of them monetary policy. Understand the forces that will shape inflation over the next five years and you should have a reasonably good picture of whether real returns from equities, bonds and commodities will be good, average or poor. Simple? Yes. Easy? Not necessarily.
"Predicting monthly readings will remain a mug’s game"
A look at the past helps to illustrate the point. Real returns in the west from bonds and equities were poor from the mid-1960s to the early 1980s during the period of rising inflation. Similarly, during the 1980s and 1990s as inflation fell, returns from equities and bonds were good. The bursting of the technology bubble and the global financial crisis followed periods when inflation had risen well above central bank targets. In response, monetary policy was tightened, causing inflation to fall below central bank targets, an environment in which equity markets performed poorly.
Conversely, bonds continued to perform well throughout the 2000s. Although they might not have liked the spikes in inflation in 1999-2000 and 2007-08, they loved the subsequent collapse in inflationary pressures. Bond performance was enhanced by falling real interest rates – the yield on 10-year TIPS (Treasury Inflation-protected securities) fell from more than 4 per cent at the end of 1999 to close to -1 per cent in 2012. These falling real rates reflected the gradual build-up of deflationary pressures associated with moderating growth over the period, despite headline inflation that for most of the time sat at comfortable levels.
What about gold? Well, gold performed well in the 1970s when goods and services inflation was rampant, and again from 2008-12 when monetary inflation was raging. It could also be argued that its good performance from 2002-08 was related to the aforementioned forces that were driving down real interest rates.
Then there is the poor performance of Japanese equities for much of the past 25 years and, more recently, the underperformance of emerging markets due, respectively, to too little and too much inflation. Finally, the past five years have been ones in which, at least in the US, there has been too little consumer demand for inflation to rise and too much central bank support for it to fall. Sure enough, US equities have been on a tear.
The logical question is whether it is possible to predict inflation over the medium term. In the past few years many, including myself at one point, believed wrongly that central banks’ inflation of the monetary base would lead to inflation in the broader economy. Might inflation be like a typical financial asset price: hard to predict? I don’t think so.
Predicting monthly readings will remain a mug’s game, but longer term it should be possible to discern the build-up of inflationary or deflationary pressures, many of which eventually manifest themselves in the broader economy. Academic research over the decades suggests financial markets are predictable.
Currently, the sheer amount of debt, whether on central bank or private sector balance sheets, presents a headwind to growth. With so much debt, economies cannot tolerate a big rise in interest rates. A negative feedback loop exists such that higher rates quickly damp demand, causing rates to fall back. The doubling in bond yields last year and subsequent fall is a good example of this.
In addition to excessive leverage, the absence of a new game-changing technological innovation such as the steam engine or the silicon chip may also explain why the world is currently more prone to low growth and low inflation. Even Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, a renowned hawk, was moved recently to say that “inflation is low and not a problem.”
Academic research carried out over the decades suggests financial markets are predictable, particularly at business cycle extremes when thundering herds of investors take bond or equity valuations to absurd levels. These business cycle extremes can be gauged by thinking about one thing: inflation. This may seem overly simplistic, but then a simple approach is often a more effective one.
Published in the Financial Times
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.