Will the pandemic cause a surge in inflation?
A return to the double-digit price growth of the 1970s could happen fast and hurt investors in the process
Do you remember inflation? You will if you can recall the 1970s, when the oil shock, massive government deficits and spiralling wage demands drove price growth into double digits, and not just in developing countries.
In 1975, UK inflation hit an incredible 24 per cent, while in the US it topped out at 13.3 per cent in 1979, forcing the US Federal Reserve to increase interest rates to a record 20 per cent in a bid to rein in prices.
Those numbers seem unthinkable at a time when central bankers have been struggling to hit inflation targets of 2 per cent a year, despite near-zero interest rates and huge fiscal and monetary stimulus.
Inflation could make a comeback, though, and faster than you think. Governments might even welcome its return, at first. Are they right to do so, and what would that mean for your investments?
As the Covid-19 pandemic hammers the global economy, deflation is the more obvious threat today. The US economy is forecast to fall a record 34 per cent in the second quarter, according to Goldman Sachs, while the unprecedented oil price crash sent futures towards minus $37 per barrel last month.
That could swiftly reverse as governments and central banks combat the pandemic with the world's biggest ever stimulus package, one that dwarfs their efforts after the 2008 financial crisis.
Central banks are likely to tolerate or even aim for above-target inflation, partly to compensate for years of missing targets, partly to help inflate away sovereign debt.
Mark Richards, Jupiter
The Fed’s balance sheet soared from $4.16 trillion (Dh15.28tn) in February to a record $6.72tn by May 6, a rise of 60 per cent. By the end of the year, it could top $10tn. Other countries are following its lead and when those trillions hit the global economy, inflation could catch fire.
Moukarram Atassi, head of investment management at the National Bank of Fujairah, says globalisation, labour outsourcing, technology advances, China joining the World Trade Organisation, high public debt levels and the ageing population have kept inflation in check for decades.
We are now at a turning point for globalisation, as Covid-19 and trade tensions between the US and China change attitudes to supply chains. Instead of sending production offshore to cut costs, many businesses will bring it back home, a process known as ‘reshoring’.
“These trends are likely to drive up prices and trigger inflation, and we may now be at the beginning of a turnaround,” Mr Atassi says.
Mark Richards, multi-asset strategist at fund manager Jupiter, says monetary easing after the financial crisis did not trigger inflation, but this time may be different. “Central banks are likely to tolerate or even aim for above-target inflation, partly to compensate for years of missing targets, partly to help inflate away sovereign debt,” he says.
In true 1970s style, we might even see another oil shock, if the low prices hit supply by killing off US shale, while demand soars once the lockdown reverses.
Today, US crude trades at around $25 a barrel. Egyptian billionaire Naguib Sawiris predicts it could hit $100 in just 18 months.
If the cost of petrol, food, clothes, holidays and borrowing starts to increase, consumers will suffer, especially if their wages do not keep up.
Many who have taken advantage of rock bottom interest rates will struggle to service their debt if interest rates hit 5 per cent, 10 per cent or even 15 per cent.
Last week, Nouriel Roubini, professor of economics at New York University, took inflation warnings a step further, arguing that accelerated deglobalisation and renewed protectionism “make stagflation all but inevitable”.
Stagflation is what happens when a stagnating economy simultaneously suffers inflation, and is the worst of both worlds. There is a reason Mr Roubini is known as “Dr Doom”, but he prefers to think of himself as “Dr Realistic”.
Some say the inflation threat has been overdone. Jahangir Aka, managing director for the Middle East & Africa at fund manager Neuberger Berman, says it is hard to see amid falling gross domestic product, oversupply of commodities, and collapsing consumer confidence. “A decade of stimulus failed to generate inflation. More of the same is unlikely to achieve a different result,” he says.
Paul Donovan, chief economist at UBS, says central banks are not attempting to stimulate the economy, but save it. “This is about making sure things do not get worse," he says. "It is not about creating inflation, but preventing more disinflation.”
Central bankers are trying to keep the banking system and bond markets functioning, and match liquidity demand with supply. “None of this is stimulus. It is damage limitation,” adds Mr Donovan.
Dr Ryan Lemand, senior executive officer of ADS Investment Solutions, says the recovery will take a "very, very long time”, as it will destroy demand. “Consumers will be put off buying that new car," he says. "Companies will be reluctant to hire. I do not see inflation in these circumstances.”
Instead of preventing job losses and company foreclosures, today's stimulus will flood into the stock market, Mr Lemand says: “The Fed is even buying exchange traded funds, which is a direct injection into share prices.”
That largely explains the dramatic rebound in share prices since the lows of late March. Investors piled into shares in anticipation of stimulus-driven gains, even as the economic news got worse.
So where should you invest if we do get inflation? Mr Atassi says rising inflation tends to work well generally for tangible assets such as real estate, energy, precious metals, industrial metals and commodities.
Stock markets can perform well, but some companies are better placed to survive inflation than others. “Those with strong pricing power fare best, typically those operating in materials, commodities and energy. Utilities and telecom companies do well. Financials, consumer staples and the healthcare sector also tend to benefit, as they can pass on costs to customers,” Mr Atassi adds.
Other businesses will struggle, for example car makers, as buyers are priced out of the market.
Over time, inflation reduces the real value of money and Mr Richards says this is good news for gold, a traditional inflation hedge.
Inflation-linked bonds are also attractive, as the interest they pay will rise in line with prices. By contrast, bonds paying a fixed rate of interest will fall out of favour, as its real value shrinks.
Clem Chambers, founder of stocks and shares website Advfn.com, says cryptocurrency Bitcoin is another likely beneficiary. “Bitcoin loves trade wars, threats of military action and any other event that causes people to seek a safe haven, including inflation," he says. "If inflation reigns going forward, its price will go off the dial. I’m currently amassing Bitcoin.”
Property can do well, as prices rise in line with inflation, as do rental incomes.
Arran Summerhill, director at Holo Mortgage Consultants, says this is good news for existing mortgage borrowers. “As property prices rise, mortgage loan-to-values should decrease in real terms, putting owners in a good position if they sell,” he says.
However, this is bad news for potential buyers, who will need larger deposits and may have to pay higher mortgage rates, Mr Summerhill adds.
Inflation creates winners as well as losers. That makes it dangerous, because many could welcome it at first. But if it gets out of control, everybody suffers.
People are nostalgic for the 1970s because of flares and Abba. Nobody wants to see a reprise of inflation, or worse, stagflation.
Updated: May 10, 2020 02:34 PM