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When money gets sick

A spectre keeps haunting investors: inflation. It is a spectre that proves to be as elusive to grasp as its fallout is hard to contain following a breakout. In simple terms, inflation is what happens when money gets sick and devalues. Along those lines, hyperinflation happens when money dies. As the driving forces of past inflation have never been alike, there is no panacea for protecting financial wealth against debasement.




Key takeaways:

  • Inflation is an elusive concept, it is hard to apply over time, and it is in many ways also quite an individual matter.
  • Tools for measuring inflation, such as the consumer price index, are quite crude and a one-size-fits-all option.
  • There is no consensus on the causes of inflation, with economists offering a range of different explanations (e.g. in terms of cost-push/ demand-pull inflation and monetarism).
  • The journey to higher – and therefore more normal – inflation rates and bond yields may be a rewarding one. While some of the policies facilitating the normalisation of inflation may sow the seeds for a new 1970s’ type of turmoil, this may be years, if not well over a decade, away. Before that happens, investors should try and enjoy the ride.

The best solution so far has been to ensure that one is invested in a broad mix of real assets and their derivatives, such as equities. Since the early 1980s, however, and contrary to common sense, disinflation and deflation – rather than inflation – have become investors’ worst nightmare. The measures for resolving the deflation crisis may sow the seeds for the next crisis, which may, nevertheless, only hit us by the 2030s. Before then, the slow return to more normal (i.e. less compressed) inflation rates may prove to be more of a joyride than the road to hell feared by investors.

Why are economists and policymakers so obsessed with inflation? The simple answer is: because it transfers wealth and power – from old to young, from rich to poor, from creditors to debtors and so on.

Christian Gattiker, Head of Research

Inflation? What inflation? 
Political Economy 101 at the University of Berne. The professor asks: “What is the most pressing issue in the economy these days?” We have no clue, so we guess: “Unemployment, perhaps?” “No. The collapse of the Soviet Union?” “Hmm. The housing market?” “You are getting closer,” the professor replies. Then he solemnly declares: “The answer is inflation.” And he was right, at least until the housing bubble burst a year later and the economy tanked along with it. Since then, Switzerland has never again had to worry about inflation, and the phenomenon has been absent from the statistics for more than 30 years. And yet the fear that inflation might return continues to resurface. In this respect, inflation is like war, as people often worry about armed conflicts breaking out again on the European continent even after an unprecedented period of peace. We shall later see that there has been a link between the two in the past.

Why does inflation matter? Because it redistributes wealth
Why are economists and policymakers so obsessed with inflation? The simple answer is because it transfers wealth and power. Inflation is a transfer of wealth from old to young, from rich to poor, from consumers to producers, from creditors to debtors, from the private sector to the public sector, from developed countries to developing countries, and so on. These are rather controversial claims and ones we seldom hear made in public.

“Whoa, not so fast”, you might say. “Why should these transfers happen at all?” Well, consider the case of creditor and debtor. Suppose that you lend me USD 100, and I agree to pay you back USD 105 at the end of the year. Let us also assume that in the meantime inflation strikes and prices go up by, say, 10%. Accordingly, all my collateral goes up 10%: the value of my home, the value of the gold I own, the working hours I sell to my employer, and so on. In fact, everything goes up in value except for what I owe you, since we agreed that I would pay you USD 105 at the end of the year. However, in real terms (i.e. taking into account the 10% rise in inflation) the USD 105 I have agreed to pay back to you are now only worth USD 94.50, and the difference is effectively the wealth transfer from you, the creditor, to me, the debtor. The only way for you to protect the value of your loan to me is to increase the interest payment by a sizeable amount. Incidentally, this is the reason why rates already jump in anticipation of inflation: investors are trying to protect their creditor status. The other transfers mentioned above are variations of the theme just outlined.

It is for all these reasons that inflation matters so much to economists and policymakers. In fact, it should matter to all of us, for whether prices rise, fall, or remain stable, they have a crucial effect on the economy and society overall. This may also be the main reason why the mandate of almost all central banks is to keep prices steady. In doing so, they ensure peace between the economic actors in society. I will shortly explore the significance of inflation for investors and their wealth, but let me first try to elucidate the phenomenon itself, which is anything but straightforward.

So what is inflation?
Let me give you a real-life example. My eldest son is a long-time follower of the London-based Arsenal Football Club (AFC). Suppose that I give him GBP 50 this year to buy the 2020/2021 official shirt and that I will give him GBP 60 next year (merchandise- savvy as the ‘Gunners’ are, they release a new shirt every year). My son will feel richer walking into the sports shop next year, expecting to have an extra GBP 10 to spend on other AFC valuables, only to learn that the wicked sports marketing people have raised the price by the exact same amount to a new total of GBP 60. So the budget is just enough to buy another AFC shirt, period.

Economists label my son’s happy feelings before entering the shop as the ‘money illusion’. He feels richer because he carries more money around, but in reality, he can only afford the very same goods. This is what many consumers, particularly high-end  consumers in recent years, have seen happen to their purchasing power. Whether it be an AFC shirt or a Picasso painting, prices may rise in line with what they can afford or, alas, go beyond it. If I give my son the same GBP 50 next year, he will have to cover the extra GBP 10 by digging deep into his hard-earned pocket money. That is what economists call a ‘loss in purchasing power’ (of 20% in my son’s case).

Economists try to capture these effects by putting together a consumer basket that mirrors the average spending patterns of consumers. They then measure the prices a year later to estimate the loss or gain of purchasing power overall. Much more could be said about the concept of inflation, of course. Let us simply acknowledge that inflation is quite an elusive phenomenon and one that has some serious shortcomings, especially when it comes to trying to measure it.

Where does inflation come from?
While the concept of inflation may be somewhat opaque, inflation spikes are quickly felt. Let us dwell for a moment on long-term inflation rates. There is quite an illustrative data series available for the UK that goes back many years – back to AD 1265, to be precise. The chart below plots this data series and reveals quite different patterns. First, the further back in time one goes, the bigger the swings. Second, inflation spikes seem to be linked either to natural catastrophes (such as famines) or human-made ones (such as wars). Third, the past 100 years stand out as being relatively stable in terms of inflation (although nobody who has lived during this time period would probably agree with this).

Economists try to explain the causes of inflation, including those seen in the UK, using different concepts. Some appeal to the distinction between ‘cost-push’ and ‘demand-pull’ inflation. Famines can be seen as leading to cost-push inflation, while wars can be seen as causing demand-pull inflation. And then there are also other economists who propose completely different ways of explaining the cause of inflation. So this is the same old déjà vu all over again that we experience in the ‘dismal science’ of economics: two economists, three opinions.

The imperfect world – protecting against inflation with a balanced mix of real assets
Investors may now conclude that while inflation may be out there, its causes and impact are highly uncertain. As is often the case, future outcomes are radically uncertain. So before applying strategies that have worked in the past, thereby courting the danger of preparing for kinds of inflation that are  obsolete, investors would do better to acknowledge that they cannot possibly know much about what kind of inflation will happen and how. Neither life nor wealth will feel much safer after this admission, but the individual investor may nevertheless feel better having surrendered control. In a second step, one could still look at past experiences, if nothing else but to see the agnostic stance confirmed. Barton Biggs offers the relevant evidence in his brilliant book ‘‘Wealth, War & Wisdom’. Biggs’ recommendation in the face of concerns about inflation is to hold a well-balanced mix of real assets and some of their derivatives, such as equities. But in that case, why not go straight to gold or real estate to insulate one’s wealth against debasement? Because history shows that there has never been a panacea for inflation.

A word on equities
You see that history repeating itself is a daring assumption. Yet some readers may be quite surprised to see equities described as an (imperfect) hedge against inflation. Equities may be claims on underlying real assets in companies, but of course they are also financial assets in their own right, and financial assets tend to devalue during inflationary periods. Up to a point, this holds true for equities too. However, as can be seen in the chart below, empirical evidence suggests that equities do protect wealth after an initial phase of repricing, as the correlation with inflation rates is negative at first but then turns positive after some years. Eventually, therefore, the equity market adapts and tends to benefit from inflation. This may also be due to the fact that an increase in inflation punishes the heavyweights of an equity index that previously benefited from falling inflation, while the lightweights in the index benefit but do not drive the index’s overall performance. Equities’ ability to protect against inflation in the long term provides a good counterbalance to commodities and gold, whose correlation to inflation rates is positive early on but eventually wanes. While this may only be weak statistical evidence, it underpins the general finding that equities are by no means losers during inflationary episodes.

So where next? Sweet reflation
After raising all the ‘ifs’ and ‘whens’ of radical uncertainty, you will probably have little faith in forecasts. And rightly so. There is just one thing that strikes me when looking at long-term charts. At the time of writing (April 2021), bond yields in the US are still near their all-time lows, i.e. below 2%. Compared to the double-digit bond yields of the 1970s’ inflation bonanza, this looks like deflation rather than inflation. If you look at the long-term cycles, as shown in chart 3, you see that inflation tends not to break out overnight. The current situation looks more like the 1950s than the 1970s, and there was a long way to go between those two decades. As a matter of fact, the period between the early 1950s and the mid-1960s, when rates moved up due to the better growth prospects of post-war societies, was one of the most rewarding eras in history for financial assets. Stocks posted bumper years, while bonds suffered only moderately in real terms and delivered positive nominal returns.

So to end this essay on a positive note, the journey to higher – and therefore more normal – inflation rates and bond yields may be a rewarding one. While some of the policies facilitating the normalisation of inflation may sow the seeds for a new 1970s’ type of turmoil, this may be years, if not well over a decade, away. Before that happens, investors should try and enjoy the ride.

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