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The opportunity in inflation

22nd March, 2022

Published in The Sunday Times on March 20th 2022

There’s so much chatter about inflation, that writing about it makes me feel like I’m forcing kids to eat their vegetables. The cost-of-living crisis adds to the long list of calamities our media outlets are feasting upon. So at the risk of prompting narcolepsy, I’d urge you to read on as there may be a few things in here you haven’t thought about.

The consensus opinion is moving towards the expectation that inflation will settle back later this year, but at a higher level than what we’ve become used to in the last generation. The psychological tinder of confidence in quiescent inflation is drying. Do we need to prepare for a fire?

Financial markets as yet are not fretting – as futures markets seem to indicate a willingness on the part of investors to believe that Central banks have the situation under control (as judged by the 5year, 5year Forward Inflation Expectation rate curve which currently is forecasting average inflation below 3% for the five years from 2027-2031).  

Too early to be definitive

In truth, it’s too early to say definitively whether we are in a new inflationary regime where inflation remains much higher than Central Banks target, or one where the overshoot is temporary. Sifting through the data and asking the right questions are necessary but not nearly sufficient for predicting the future course of inflation. 

Our base case is that inflation will moderate later this year and will settle back possibly at higher than pre-pandemic levels. But we don’t expect inflation to spiral out of control. The calculus behind that last statement is changing daily as the war in Ukraine unfolds. 

We hope for a benign scenario where inflation returns to modest levels but should plan with humility, recognising that the future is inherently unknowable.  

Money is purchasing power

At its most basic level, inflation is like a tax. It depletes our spending power. Unlike a tax, its impact is not as explicit. We don’t get reports from the bank quoting our balance in real (after inflation) value terms i.e. what it is worth today versus a year ago. Everything is quoted in nominal price terms. 

This is not a helpful way to conceive of money. In the long run, the only rational definition of money is purchasing power. Money is a means to an end, and that end is its ability to fund our spending habits. If our money is being eroded by 5% inflation a year, we will lose roughly 40% of our spending power every decade. We should therefore make investment decisions in consideration of this risk. 

Many investors have never experienced inflation like we have seen in the last few months, so it may be a good time to revisit what that means for investing. 

Equities over the long term have provided strong real returns (after inflation). If your metric for how much risk you take on is maintaining purchasing power, then the stock market (alongside property and other real assets) has proven to be an important generator (and protector of) real wealth. 

How do stock markets provide a hedge against inflation?

The data suggest that stocks, in general, do well when inflation is between 1% and 4% (based on US equity style/cap indexes). Many companies have pricing power, i.e. can pass along costs to buyers in the form of higher prices and thereby protect their margins. Not all companies do, however. So inflationary regimes may favour some market segments more than others. But in aggregate, stock markets have historically provided strong after-inflation returns, at least part of which stems from company earnings being linked to inflation through pricing power.

Aversion to risk is innate, so inflation should be a concern

The impulse to protect what we have is instinctive to us all. Aversion to risk is innate, passed down from our hunter-gatherer forbears. Our ancestor that assumed that all rustling bushes concealed lions, lived long enough to pass that trait on. His more blasé counterpart exited the gene pool.  Hence we are predisposed to over-weight the negative. Even when presented with a favourable proposition, we will generally avoid it if there is the potential for significant downside. 

So what’s this got to do with inflation? If my living costs double and my capital and interest thereon remain the same, I have effectively lost half my money. This should trigger alarm bells for the risk-averse, but we tend not to think about inflation risk in the same way as we do about the risk of capital loss associated with stock market volatility. 

My thesis on this is that we are concerned about the risks of doing something (making an investment decision), but not concerned about the risks of doing nothing (decisions we don’t make i.e. defaulting to leaving money in cash). This decision-making flaw has the potential for greater wealth destruction than the stock market does. 

There’s a cost to investing and there’s a cost if you don’t. Take control and make a decision and you’ll have a better chance of minimising it.

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