Am I right to worry about higher inflation? Followers of our funds and my writing will know that we have been reducing risk in anticipation of inflation becoming a problem over the next 1-2 years. There is a sound basis for this stance, but it is one we keep under constant review.
"It is possible that the decades ahead could well see structurally higher inflation"
There are two aspects to this question about inflation. First, should one in general worry about high inflation? If yes, should one be worrying about it right now?
As to the former, a Mr Bill Bengen has the answer. Bengen was an MIT-trained aeronautical engineer turned financial planner who in 1994 wrote a paper titled “Determining withdrawal rates using historical data”. His approach was empirical not theoretical, looking at how balanced funds performed during 20 year periods since 1926 given a certain equity/bond proportion and a certain withdrawal rate.
Part of the analysis involved looking at the effect on portfolios of the three major financial events during the period under review, which Bengen called “Little Dipper” (1929-1931), “Big Dipper” (1937-1941), and “Big Bang” (1973-1974). The results of the analysis are shown in Table 1 below.
The Wall Street crash of ‘29 may have been the worst equity market decline of the three, but a 50/50 bond-equity fund only fell 9.5% in real terms from 1929 to 1931. The period that was the worst for balanced funds on an inflation adjusted basis was “Big Bang” (1973-1974). The reason for this was that consumer prices rose by 22.1% during the 1973 to 1974 period, compared with just 10.5% from 1937 to 1941 and deflation of -15.8% from 1929 to 1931.
While deflation can be nasty, the real killer is high inflation. This is obvious in relation to bonds, where principal and coupons are fixed in nominal terms so get impacted by high inflation in real terms (the opposite occurs in a deflationary environment though it is possible default rates will be higher).
With equities, the relationship is indirect. During a recession or otherwise, companies, unlike bonds, are able to adapt to high rates of inflation. They can raise prices, adjust capex, mothball capacity, cut workforces etc.
This is borne out by the performance of equities and bonds during the two prolonged periods of rising inflation in the last 150 years, 1901 to 1920 and 1940 to 1981. During the first of these, annualised real returns from bonds and equities were -4.3% and -0.3% respectively. During the second, they averaged -2.7% and 5.9%. On this basis, it could be argued that bonds are more risky than equities! Furthermore, it is also possible that many have forgotten just how badly bonds can perform given the 70s are now a distant memory.
One way however in which there is a more direct impact of higher inflation on equities is via real interest rates. Monetary policy will naturally be tighter when inflation is high; the higher the inflation the higher the real interest rates required to bring it down. Since equities compete with bonds, rising real interest rates associated with rising inflation will tend to mean higher equity yields. This, of course, means lower equity prices, all else being equal.
In summary, therefore, high inflation is more damaging to portfolios than low or negative inflation.
As to whether we should be worrying today about high inflation, there are again two angles. One pertains to cyclical inflation, the other to longer term or structural inflation.
From a cyclical perspective, wages across the developed world are accelerating and this will likely feed through to higher inflation pressures in the months ahead. Respected economists like Larry Summers have been arguing that the Phillips Curve is now redundant given that, as The Economist noted, “since 2010, as the unemployment rate has fallen steadily from 10% to 4.4%, inflation has hovered between 1% and 2%”.
I wonder however if the relationship is still intact and that what has in fact changed is central banks’ ability to prevent higher wage inflation resulting from tighter labour markets feeding through to inflation. This suggestion is supported by the below chart from US investment strategist Ed Yardeni’s excellent new book, “Predicting the Markets”.
While it maybe correct that there has been some change in recent years in the relationship between unemployment and consumer price inflation, the above chart shows that the relationship between unemployment and wage inflation has if anything got stronger over the last 30 years. It also shows that wage growth hitting 4% triggered the last three recessions in the US, which thus would have been a good leading indicator for the equity bear markets that preceded them. The recessions themselves likely were the result of the tight monetary policy aimed at preventing the rising wage inflation from feeding through to consumer price inflation.
As can be seen in the chart below, the unemployment rate is now lower than it was on the last three occasions wage inflation hit 4%. Also, the only time in the last 55 years that unemployment was lower than it is today, wage inflation was around 6%. I’m not an economist, but my simple brain tells me that on the basis of the above chart wages are likely to continue to accelerate and wage inflation could well hit 4% (currently 2.7%) fairly quickly.
Of course, this analysis pertains only to the US but it is likely that the same relationships apply elsewhere. Furthermore, given global interconnectedness, other countries’ economic cycles are probably somewhat coincident – or at worst lagging – with that of the US.
What about inflation over the longer term?
This is perhaps a trickier question. While it is logical that there is a link during an economic cycle between unemployment and inflation pressure, it is less clear what has caused the longer periods of rising and falling inflation. As mentioned, there have been two prolonged periods of rising inflation over the last 150 years or so, from 1901 to 1920 and from 1940 to 1981. These appear to have coincided with periods of falling income inequality, as indicated by Chart 2 below.
Not only was rising inflation associated with falling inequality, but falling inflation appeared to coincide with rising inequality – the last 40 or so years being a case in point.
There may well be economic theories as to why this is the case, or indeed ones that suggest the opposite holds true. For me, it makes sense that rising inequality is associated with a shift of income from labour to capital. It also makes sense that a shift from labour to capital would mean falling or stagnating real incomes for the majority of workers, which should be and indeed has been disinflationary.
There is growing discontentment among workers across the developed world about stagnating incomes and falling economic mobility. This discontentment – anger even – is manifesting itself in a backlash against the mainstream political establishment, for example in the election of Donald Trump or the vote to leave the EU, among others.
Given that wealth and income inequality in many countries has reached extreme levels, and that a backlash seems to have started, it is possible that the decades ahead could well see structurally higher inflation.
The one thing I haven’t mentioned is QE, which many see as inherently inflationary. I do not ascribe to that view, as I believe QE was the necessary response to interest rates hitting the zero bound, but I suspect my suggestion that the years ahead could see materially higher inflation will make those that do happy!
Published in Investment Letter, August 2018
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.