Updated: May 17, 2022
Renowned economist Milton Friedman wrote: “Inflation is a disease, a dangerous and sometimes fatal disease, a disease that if not checked in time can destroy a society”. While this may have been a reference to hyperinflation, notably that of Weimar Germany, inflation does not have to be ‘hyper’ to cause trouble.
"The last time this happened was from 1317 to 1339"
First, a quick reminder for those not convinced that high inflation is a problem for investment portfolios. The worst of the three notable financial events of the 20th century in the US, in terms of their impact on the real value of balanced funds, was not as many might think the Crash of ’29 but the period from 1973-1974. This period saw a drawdown in the real value of a 50/50 balanced fund of 35.4% compared with just 9.5% for 1929-1931.
The reason? Inflation. In 1929-1931, consumer prices fell by 15.8%, which was generally fantastic for bonds, whose principal and coupons are fixed in nominal terms.
1973-1974 on the other hand saw consumer prices rise by 22.1%, which had the polar opposite effect on real bond returns. In the case of equities, performance was comparable, with real returns registering -53.7% and -48.6% in 1929-1931 and 1973-1974 respectively.
As to whether we should be starting to worry about rising inflation, there are two parts to the question. The first part relates to whether we are reaching the point in the current cycle at which central banks want to nip rising inflation expectations in the bud. The second relates to longer term or structural inflation, which tends to be a function of entirely different forces altogether.
The main driving force behind cyclical inflation is wages, which are largely a function of labour market tightness. Commodity prices, taxes and the exchange rate can also influence consumer prices but it is wages, as the largest component of value added, that have the biggest impact.
Since the end of 2008, wages in real terms have fallen by 2.1% compared with a rise of 23.3% in the previous nine years. In recent months, wage growth has started to outpace consumer price inflation, with real wages as of end June rising by 1.1% on an annualised basis. Were this to continue it is likely that inflation expectations, and thence actual inflation, will rise.
Moreover, there is every reason to think it will continue. The employment rate is now at levels not seen in getting on for 50 years. Furthermore, employers are starting to complain about the effects of Brexit on the availability of EU workers.
The question of longer-term inflation is a trickier one. Both the US and the UK appear to have had four distinct periods since 1900. Roughly speaking, 1900-1920 and 1940-1980 saw rising inflation, while 1920-1940 and 1980 to the present saw falling inflation.
There is an interesting correlation with income inequality. In the US, longer-term inflation exhibited an inverse relationship with the proportion of total income accruing to the top 1% of earners.
It seems logical to me that a shift in income from labour to capital would see a rise in inequality as it is generally the wealthy who are the owners of capital. It also seems logical that the shift would see a decline in the real median wage, which should naturally be disinflationary.
Given that income inequality in many countries has in recent decades risen to very high levels, and that general discontent is now manifesting in a backlash against mainstream politics, it is possible that we have reached an inflection point.
Higher inflation, in either the shorter or the longer term, would of course play havoc with real bond returns. However, note also that in order to achieve the 5.3% real return that long-term Gilts generated from 1998 to 2016, consumer prices would have to halve. The last time this happened was from 1317 to 1339 and related to The Black Death.
Published in What Investment
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.