ZOMBIES AND UNRELIABLE BOYFRIENDS: WHY WE CAN’T IGNORE INFLATION

With inflation rising to levels not seen for a long time and debate raging about the implications for authorities and investors alike these concepts are all in the headlights right now ...

Gregory Clark 2022-03-23 03:42:45

In the last few years, investors have had to add a raft of new terms to their financial lexicon. We all knew about inflation, but what’s the difference between deflation and disinflation? Stagflation – what’s that? Quantitative easing? Financial repression? With inflation rising to levels not seen for a long time, and debate raging about the implications for authorities and investors alike, these concepts are all in the headlights right now. 

Since the Great Financial Crisis, central banks have been providing support to markets through the provision of cheap money. With lots of money sloshing around the financial system, the prices have risen. Policy rates have been low – and even negative in some cases – providing a boost to borrowers, at the expense of savers: this is financial repression. Arguably, these policies have worked: markets have enjoyed stellar gains, and the global economy rebounded.  

Thanks in no small part to continued globalisation and international trade, we saw disinflation – a reduction in the pace of inflation. For a time, we even flirted with deflation – negative inflation. This could have paralysed the global economy: why buy something now which will be cheaper in a month’s time? Thankfully we avoided that scenario, and the persistent low rate of price growth gave central banks room to keep rates low, not forcing them to raise rates to keep a lid on inflation. 

But the landscape has changed in the past few months. Suddenly – some would say inevitably, given how much liquidity has been pumped into the system – inflation is on the rise. Post-lockdown spending, supply chain disruption, product shortages, oil and gas price rises have all conspired to push inflation back to levels not seen in many years. The question on everyone’s lips is whether these price rises will be temporary or permanent; the answer to this question will determine whether the authorities need to react by raising interest rates or can afford to keep rates low.

Zombie companies 

The term stagflation has been mentioned in recent weeks: high inflation with low or negative growth. This is another difficult scenario for the economy, but thankfully we seem to have avoided this – for now. Central banks will fear the consequences of making a policy error - this is when they make the wrong call on rates. In the current situation if they raise rates to combat inflation, they run the risk of simultaneously stifling economic growth. Higher rates imply higher debt servicing costs, which could push “zombie companies” – those just about managing to survive and meet their obligations at current levels, but with no scope to grow – out of business. And higher rates mean less borrowing, which means less spending. Markets seem to be expressing a view that this might indeed be the case: short rates have risen in expectation of policy rate hikes, but long-dated yields have not (and in some cases have even fallen) in anticipation of lower future growth.

Unreliable boyfriends 

While some central banks have raised rates already – especially in commodity-dominated economies like Norway and Canada - the US Fed, the UK Bank of England (BoE) and the European Central Bank (ECB) have so far all resisted raising rates. Of those three, the ECB have been most vocal about their belief that the current high inflation levels are partly due to transitory factors that will soon die down, and partly due to factors which a rate hike will not solve.  

The UK BoE was widely expected to hike rates at its last policy meeting, but surprised markets by not doing so, leading many commentators to reprise the term “unreliable boyfriend” when referring to current BoE governor Andrew Bailey. This moniker was last used to describe Mark Carney, when he promised one thing but failed to deliver. 

But while current high inflation levels may seem to be the result of factors that are transitory in nature, these factors are stronger, and have now persisted for longer than many commentators initially expected. October’s inflation level in the US was the highest in 30 years. The trouble with this is that these current inflation levels are now being validated, with wages beginning to rise. Sooner or later, expectations of higher inflation become self-fulfilling and what was once a temporary problem becomes a structural issue. 

If we get to that point, then there may be no alternative for the authorities other than to hike rates – with all the risks doing so poses.

So – transitory or structural? Personally, I’m leaning towards transitory, but I think the pressures might persist for a bit longer than people expect. And then when the pressures do subside, I think inflation will settle at a higher level than we’ve become accustomed to. And I see that as a positive result: inflation means a measured level of inflation is good for companies that can regain some pricing power; wages can rise; and inflation will help reduce the real (inflation-adjusted) debt burden faced by many individuals, companies, and countries.  

Good money management is always important, more so with inflationary pressure and with a series of related issues so prevalent in the world. It is the first time in possibly a generation that existing income generating investments, that we have all relied upon are going to fall so very short of our expectations. 

David Clark is Regional Director at CI Associates Wealth Management a company regulated by the Superintencia de Mercado de Valores here in Panama, offices throughout South America and personally licenced in the USA to give financial advice. If you are interested in reviewing your current investment strategies or simply looking for investment opportunities, please contact me on 6377-6675 or by email at david.clark@ci-associates.com.

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