Market Insights

11 July 2022 | Simon King

Thoughts on 2022: Money’s Too Tight (to Mention)

There are many topics we could discuss surrounding the current period of malaise. We discuss many of them in “The Halfway Point”, our investment review of the first half of 2022, and as such we decided to focus on the subject which we believe is currently the most important; inflation.

We first started commenting on it back in our investment outlook for March 2021. We were relatively early, but since then the subject has received a great deal of column inches as it has surpassed even our gloomy predictions. Given the extreme cost-of-living crisis it has created, we thought it would be useful for our clients if we reiterated our original thoughts and views, update them for recent events and express them in layman’s terms. As Simply Red reminded us in 1985, “Money’s Too Tight (to Mention)

The starting point for this discussion has to be an actual definition of inflation, of which there are many. The standard economic definition is “a persistent increase in prices”. Another is “the decrease in purchasing power over time”. We would also throw in the famous quote from Milton Friedman “inflation is taxation without legislation”. Already in this limited selection we have highlighted the confusion that can be created when discussing the subject. The simultaneous use of increase and decrease, the concept of losing money by stealth, all confuse even sophisticated investors. This leads to many closing their eyes and hoping it goes away. The fact that a large part of the adult populations in developed economies have never witnessed or had to deal with elevated price rises over a long period, further adds to confusion.

We have frequently commented in previous pieces that it is essential to remember that inflation is a rate of change and not an absolute number like interest rates. Our concern is that many people assume that once it reverts to more normal levels then the problem is over. What they are now realising, is they are actually considerably poorer than they were at the start of the process and their only hope of maintaining standards of living is wage increases. Often this will require changing jobs and, although there is evidence that employers are starting to reward incumbents, this will only benefit private sector employees and leave vast swathes of the workforce in a seriously disadvantaged position.

Inflation has been demonised for at least the last 50 years. Ronald Reagan came up with the infamous quote “inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman”. This has suited the rhetoric of both governments and central banks who have been able to pat themselves on the back as they have consistently “controlled” inflation. The fact is that it can be very useful to individuals who have assets. The prime example of this, particularly in the UK, is the housing market where anyone who has owned property with a mortgage attached has benefited from the debt deflation that consistent rises in property prices has produced. Most people will recognise this as the equity in their house.

We noticed a change in the rhetoric in the UK approximately two years ago. Suddenly politicians were espousing the supposed virtues of inflation. They had cottoned on to, or had been whispered to, the only way for the UK government to alleviate its long-term debt position was to basically deflate the debt in the same manner as the housing market described above. Unfortunately, they chose to not hear or ignore the second part of that process ie that inflation had to be at a consistent level and that it should be less than GDP growth, the exact conditions they had witnessed for the previous 10 years. We have long highlighted our concerns of letting the inflation genie out of the bottle and unfortunately that has now occurred. Now both the Bank of England and the government are in firefighting mode with very few tools in their armoury. This is a situation mirrored in the majority of developed economies where central banks are simply behind the curve.

The other political benefit that inflation brings to a certain element of the electorate, is that a generally rising tide keeps most asset prices at elevated levels and generally produces a feel-good factor. It also brings the real versus nominal equation into the debate ie levels of growth have to be adjusted to allow for inflation. This is often confusing for less sophisticated consumers. Both government and financial commentators have managed to confuse the subject further by introducing into the debate whether the current levels of inflation are persistent or temporary. We maintain our view that this is irrelevant, as is the constant microanalysis of the constituents of inflation and the regular attempts to explain it away as a series of one offs. The fact is that it is here, and it hurts. This is particularly true for the lower echelons of society where real rates of inflation are much higher due to the composition of their costs. Not only is this deeply iniquitous but also raises the real prospect of social unrest. This will initially be manifested by an increase in labour disputes and strikes but could easily lead to social unrest as already witnessed in countries such as Sri Lanka where inflation has hit stratospheric levels.

We are frequently asked our views on where the rapid increase in prices has come from. We would make a number of points. In terms of the long-term drivers the major cause is the fact that the vast majority of the population expects and demands a better standard of living year-on-year. To achieve this the world must become increasingly efficient over time. Put simply, the fact is the current demand for goods and services exceeds supply. In terms of the expectations of the developed world this has been further exacerbated by the fact the developing world has grown more quickly, has become more productive and now expects to be able to purchase and consume its fair share of the pie.

Against this backdrop of rising demand and supply failing to keep up we have added two huge rounds of Quantitative Easing (“QE”). We should not forget the vast increase in liquidity around the financial crisis of 2008 was never reversed. Governments and central banks chose to constantly defer the decision, convincing themselves they had found a magic formula of effectively printing money but avoiding the inflationary impact of this policy. Instead of telling people that a cut in living standards was required to correct the overconsumption of the previous two decades, they hoped to gradually deflate their way out of the problem. This could never have worked and was completely derailed with the advent of Covid-19. The ensuing further round of QE has merely doubled up the problem and left markets awash with liquidity. It has always been a question of when, not if, inflation would rear its ugly head.

To compound the situation, most governments then chose to overextend fiscal giveaways, most notably in the USA, and this added further fuel to the fire. This factor has been exacerbated by the unusually close ties between government and central banks in virtually every major economy. This trend of singing from the same hymn book has eradicated the usual healthy natural tension between the two. The final factor has obviously been the invasion of Ukraine which has further damaged supply chains and systems which were only just starting to recover from the ravages of Covid-19. It is unusual for inflationary pressures to come from the demand and supply side simultaneously and makes it much more difficult for economies to react.

It is extremely difficult to predict accurately what levels inflation will reach in the coming months. We do however regard it as more predictable than certainly most central banks appear to think. We believe it will remain at elevated levels for the remainder of 2022 and then start to recede. In our view the monthly numbers are not as relevant as the total erosion in purchasing power once it recedes. The most important statistic is at what level it will settle at. In recent weeks, central bankers have started to fret about whether it will become engrained. Until markets have some clarity of this, it is extremely difficult for them to make realistic assumptions on both interest rates and the level of global economic growth. This is why in our view markets are confused as to what they should be cheering for and why we are witnessing exceptionally high levels of volatility in many asset classes, but particularly government bonds.

In the absence of an honest debate between government and the electorate to explain the fact there will be a permanent reset in living standards, the only way to avoid persistently high levels of inflation is to prevent a wage spiral. Governments and central banks appreciate this challenge but have so far addressed it in a rather timid fashion. This cannot continue, but a tougher stance risks a proliferation of the industrial disputes and social unrest we discussed earlier. There has also been much discussion as to whether the only other option would be to engineer a recession. The main reason for this harks back to the early 1980s which was the last time inflation of this nature was witnessed, and where a series of aggressive interest rate hikes induced a major economic reversal. At present central banks queue up to assure us this will not be necessary, but that rhetoric is likely to change in the coming months. We expect the conversation to change as to how the impact of recession can be reduced, rather insisting it can be avoided.

We are not necessarily concerned about whether any economy enters a technical recession. In our view there is a very real possibility that such a recession could be short lived and reasonably shallow. Indeed we have some sympathy for the theory that outright unemployment might not rise as much as some fear but there will be many people in employment with poor wages and, hence living standards. This is not a situation that financial markets have ever really had to deal with.

In terms of what can actually be done to combat inflation, we take a somewhat different view to many other commentators. We have been amazed to the extent to which interest rates have become regarded as the only tool that central banks have to deploy. As we have commented on earlier in this piece, we regard QE as the main culprit in the situation we currently find ourselves. As such it is clear to us that the reverse of this process ie Quantitative Tightening (“QT”) should be the main plank of policy. In simple terms we need to get on with it. We have witnessed a state of near paralysis since 2009, with much of the reasoning for this inaction centering around unintended consequences and how markets may react. We did not worry about these on the way in with QE and we should not worry about them on the way out with QT. There will be unforeseen problems given the distortions in most asset classes that excess liquidity has created, but interest rates and specific responses can then be used to fine tune the situation.

In the longer term we have to address the problem of a lack of productivity improvement. For too long the debate has been obscured by arguing that we do not measure productivity correctly and we have kidded ourselves that we have become more productive over time. We do have to find better ways to measure progress, but ultimately governments, whose primary aim is to establish frameworks, have to find ways to better incentivise investment and innovation. It does not need to be a precise science but both companies and individuals have to be encouraged to be less risk averse. The main thrust of this is likely to be centred around taxation incentives, but should also include in our view a return to targeted industrial strategies which have tended to become a dirty word in the modern economy.

Our main responsibility to clients is obviously to construct portfolios which are appropriate for all types of economic conditions. We hope that the majority of our investments will produce healthy returns on a long-term basis. We do recognise that we are able to finesse portfolios in order to protect against the ravages of inflation. This is not as easy a process as some may suggest. Very few assets offer real inflation protection and many of those that suggest they do are often overcomplex, expensive and riskier than they claim. There are areas that offer some element of diversification and are not necessarily correlated to the wider market eg both hard and soft commodities and certain parts of the property market. We still believe that if we can identify equities with strong growth profiles then the market will reward them with relatively high ratings, since growth is likely to be rare and precious in the short term. We also expect companies with exceptionally strong franchises and pricing power, and the ability to manage cash flows and working capital in more difficult economic conditions, to continue to prosper.

Overall we have to accept the fact that inflation is real and probably here to stay. It will undoubtedly reduce growth and keep interest rates higher than has been the recent norm. It will take time for central banks, governments and financial markets to adapt to a new norm and as such we can expect most markets to remain volatile for the remainder of 2022. But everyone will adjust and as inflation reduces, supply side issues are resolved, and financial markets receive the clarity they always crave - then things will start to move forward again

There are many topics we could discuss surrounding the current period of malaise. We discuss many of them in “The Halfway Point”, our investment review of the first half of 2022, and as such we decided to focus on the subject which we believe is currently the most important; inflation. We first started commenting on it back in our investment outlook for March 2021. We were relatively early, but since then the subject has received a great deal of column inches as it has surpassed even our gloomy predictions. Given the extreme cost-of-living crisis it has created, we thought it would be useful for our clients if we reiterated our original thoughts and views, update them for recent events and express them in layman’s terms. As Simply Red reminded us in 1985, “Money’s Too Tight (to Mention)

The starting point for this discussion has to be an actual definition of inflation, of which there are many. The standard economic definition is “a persistent increase in prices”. Another is “the decrease in purchasing power over time”. We would also throw in the famous quote from Milton Friedman “inflation is taxation without legislation”. Already in this limited selection we have highlighted the confusion that can be created when discussing the subject. The simultaneous use of increase and decrease, the concept of losing money by stealth, all confuse even sophisticated investors. This leads to many closing their eyes and hoping it goes away. The fact that a large part of the adult populations in developed economies have never witnessed or had to deal with elevated price rises over a long period, further adds to confusion.

We have frequently commented in previous pieces that it is essential to remember that inflation is a rate of change and not an absolute number like interest rates. Our concern is that many people assume that once it reverts to more normal levels then the problem is over. What they are now realising, is they are actually considerably poorer than they were at the start of the process and their only hope of maintaining standards of living is wage increases. Often this will require changing jobs and, although there is evidence that employers are starting to reward incumbents, this will only benefit private sector employees and leave vast swathes of the workforce in a seriously disadvantaged position.

Inflation has been demonised for at least the last 50 years. Ronald Reagan came up with the infamous quote “inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman”. This has suited the rhetoric of both governments and central banks who have been able to pat themselves on the back as they have consistently “controlled” inflation. The fact is that it can be very useful to individuals who have assets. The prime example of this, particularly in the UK, is the housing market where anyone who has owned property with a mortgage attached has benefited from the debt deflation that consistent rises in property prices has produced. Most people will recognise this as the equity in their house.

We noticed a change in the rhetoric in the UK approximately two years ago. Suddenly politicians were espousing the supposed virtues of inflation. They had cottoned on to, or had been whispered to, the only way for the UK government to alleviate its long-term debt position was to basically deflate the debt in the same manner as the housing market described above. Unfortunately, they chose to not hear or ignore the second part of that process ie that inflation had to be at a consistent level and that it should be less than GDP growth, the exact conditions they had witnessed for the previous 10 years. We have long highlighted our concerns of letting the inflation genie out of the bottle and unfortunately that has now occurred. Now both the Bank of England and the government are in firefighting mode with very few tools in their armoury. This is a situation mirrored in the majority of developed economies where central banks are simply behind the curve.

The other political benefit that inflation brings to a certain element of the electorate, is that a generally rising tide keeps most asset prices at elevated levels and generally produces a feel-good factor. It also brings the real versus nominal equation into the debate ie levels of growth have to be adjusted to allow for inflation. This is often confusing for less sophisticated consumers. Both government and financial commentators have managed to confuse the subject further by introducing into the debate whether the current levels of inflation are persistent or temporary. We maintain our view that this is irrelevant, as is the constant microanalysis of the constituents of inflation and the regular attempts to explain it away as a series of one offs. The fact is that it is here, and it hurts. This is particularly true for the lower echelons of society where real rates of inflation are much higher due to the composition of their costs. Not only is this deeply iniquitous but also raises the real prospect of social unrest. This will initially be manifested by an increase in labour disputes and strikes but could easily lead to social unrest as already witnessed in countries such as Sri Lanka where inflation has hit stratospheric levels.

We are frequently asked our views on where the rapid increase in prices has come from. We would make a number of points. In terms of the long-term drivers the major cause is the fact that the vast majority of the population expects and demands a better standard of living year-on-year. To achieve this the world must become increasingly efficient over time. Put simply, the fact is the current demand for goods and services exceeds supply. In terms of the expectations of the developed world this has been further exacerbated by the fact the developing world has grown more quickly, has become more productive and now expects to be able to purchase and consume its fair share of the pie.

Against this backdrop of rising demand and supply failing to keep up we have added two huge rounds of Quantitative Easing (“QE”). We should not forget the vast increase in liquidity around the financial crisis of 2008 was never reversed. Governments and central banks chose to constantly defer the decision, convincing themselves they had found a magic formula of effectively printing money but avoiding the inflationary impact of this policy. Instead of telling people that a cut in living standards was required to correct the overconsumption of the previous two decades, they hoped to gradually deflate their way out of the problem. This could never have worked and was completely derailed with the advent of Covid-19. The ensuing further round of QE has merely doubled up the problem and left markets awash with liquidity. It has always been a question of when, not if, inflation would rear its ugly head.

To compound the situation, most governments then chose to overextend fiscal giveaways, most notably in the USA, and this added further fuel to the fire. This factor has been exacerbated by the unusually close ties between government and central banks in virtually every major economy. This trend of singing from the same hymn book has eradicated the usual healthy natural tension between the two. The final factor has obviously been the invasion of Ukraine which has further damaged supply chains and systems which were only just starting to recover from the ravages of Covid-19. It is unusual for inflationary pressures to come from the demand and supply side simultaneously and makes it much more difficult for economies to react.

It is extremely difficult to predict accurately what levels inflation will reach in the coming months. We do however regard it as more predictable than certainly most central banks appear to think. We believe it will remain at elevated levels for the remainder of 2022 and then start to recede. In our view the monthly numbers are not as relevant as the total erosion in purchasing power once it recedes. The most important statistic is at what level it will settle at. In recent weeks, central bankers have started to fret about whether it will become engrained. Until markets have some clarity of this, it is extremely difficult for them to make realistic assumptions on both interest rates and the level of global economic growth. This is why in our view markets are confused as to what they should be cheering for and why we are witnessing exceptionally high levels of volatility in many asset classes, but particularly government bonds.

In the absence of an honest debate between government and the electorate to explain the fact there will be a permanent reset in living standards, the only way to avoid persistently high levels of inflation is to prevent a wage spiral. Governments and central banks appreciate this challenge but have so far addressed it in a rather timid fashion. This cannot continue, but a tougher stance risks a proliferation of the industrial disputes and social unrest we discussed earlier. There has also been much discussion as to whether the only other option would be to engineer a recession. The main reason for this harks back to the early 1980s which was the last time inflation of this nature was witnessed, and where a series of aggressive interest rate hikes induced a major economic reversal. At present central banks queue up to assure us this will not be necessary, but that rhetoric is likely to change in the coming months. We expect the conversation to change as to how the impact of recession can be reduced, rather insisting it can be avoided.

We are not necessarily concerned about whether any economy enters a technical recession. In our view there is a very real possibility that such a recession could be short lived and reasonably shallow. Indeed we have some sympathy for the theory that outright unemployment might not rise as much as some fear but there will be many people in employment with poor wages and, hence living standards. This is not a situation that financial markets have ever really had to deal with.

In terms of what can actually be done to combat inflation, we take a somewhat different view to many other commentators. We have been amazed to the extent to which interest rates have become regarded as the only tool that central banks have to deploy. As we have commented on earlier in this piece, we regard QE as the main culprit in the situation we currently find ourselves. As such it is clear to us that the reverse of this process ie Quantitative Tightening (“QT”) should be the main plank of policy. In simple terms we need to get on with it. We have witnessed a state of near paralysis since 2009, with much of the reasoning for this inaction centering around unintended consequences and how markets may react. We did not worry about these on the way in with QE and we should not worry about them on the way out with QT. There will be unforeseen problems given the distortions in most asset classes that excess liquidity has created, but interest rates and specific responses can then be used to fine tune the situation.

In the longer term we have to address the problem of a lack of productivity improvement. For too long the debate has been obscured by arguing that we do not measure productivity correctly and we have kidded ourselves that we have become more productive over time. We do have to find better ways to measure progress, but ultimately governments, whose primary aim is to establish frameworks, have to find ways to better incentivise investment and innovation. It does not need to be a precise science but both companies and individuals have to be encouraged to be less risk averse. The main thrust of this is likely to be centred around taxation incentives, but should also include in our view a return to targeted industrial strategies which have tended to become a dirty word in the modern economy.

Our main responsibility to clients is obviously to construct portfolios which are appropriate for all types of economic conditions. We hope that the majority of our investments will produce healthy returns on a long-term basis. We do recognise that we are able to finesse portfolios in order to protect against the ravages of inflation. This is not as easy a process as some may suggest. Very few assets offer real inflation protection and many of those that suggest they do are often overcomplex, expensive and riskier than they claim. There are areas that offer some element of diversification and are not necessarily correlated to the wider market eg both hard and soft commodities and certain parts of the property market. We still believe that if we can identify equities with strong growth profiles then the market will reward them with relatively high ratings, since growth is likely to be rare and precious in the short term. We also expect companies with exceptionally strong franchises and pricing power, and the ability to manage cash flows and working capital in more difficult economic conditions, to continue to prosper.

Overall we have to accept the fact that inflation is real and probably here to stay. It will undoubtedly reduce growth and keep interest rates higher than has been the recent norm. It will take time for central banks, governments and financial markets to adapt to a new norm and as such we can expect most markets to remain volatile for the remainder of 2022. But everyone will adjust and as inflation reduces, supply side issues are resolved, and financial markets receive the clarity they always crave - then things will start to move forward again

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