Understanding inflation as the biggest risk to financial health for older/lower risk investors

By Guy Myles, Chief Investment Officer and Chief Executive, Flying Colours Finance Ltd

2 October 2020

Summary

We now believe inflation is a significant risk to investors and could cause damage to the finances of older and more risk averse investors.

As a result, we are recommending that all lower risk investors review their plans to make sure they are protected against this risk.

 

For the last 40 years we have lived through a low and declining inflation environment and, for many people, this is the only environment that they have known. Declining inflation has had a very large impact on investments helping to drive up stockmarkets and directly leading to higher returns for bond investors.

We believe economies and markets move through cycles over the short term and the very long term. Our analysis has made us concerned that we are nearing the end of a long-term debt cycle and that global borrowing has risen to levels that will prove unsustainable. This long-term cycle is an important factor making us believe there is a risk that low inflation environment that exists at present will reverse.

There are several trends meaning inflation is more of a risk now than it has been for a long time. The economic conflict with China and a likely reduction in globalisation is important but the stretched state of overall economies makes high levels of state spending inevitable and this is likely to be financed by Governments printing more money.

Any increase in inflation is bad news to lenders, who are in investment terms people that have money on deposit at banks or hold bonds. Cash and bonds are large parts of many portfolios especially for lower risk investors and this issue is therefore important. Bonds and cash aren’t likely to be able to keep place with rising inflation meaning the value of your money will fall behind your costs of living.

There are ways to protect your portfolio from this new significant risk and we believe that should be considered by all lower risk investors.

Our suggested actions for investors

  • Reduce growth assets in stockmarket investments in favour of value.  Whilst value stocks tend to be focused in mature industries and Growth stocks in rapidly expanding industries Value stocks can become too cheap and trade at a level below their true worth.
  • Increase inflation linked bonds and decrease government and corporate bond exposure
  • Introduce holdings in gold or gold funds

 

Analysis

From the 1970s we have seen a relentless global decline in inflation. This decline has been very long term and dominates the experience of most active professional investors. It is easy to assume that low inflation is here to stay, and most fund managers seem to believe this, but the underlying situation due to the Covid19 pandemic and central Government actions to support economies has changed this, therefore, we cannot rely on low inflation staying with us.

Inflation in USA from 1960 shown in chart below.

The low inflation we have seen has been driven by a range of factors including new technologies, immigration, inequality and an aging population. The most important of these, however, has been globalisation and the outsourcing of western manufacturing to China. Of these trends inequality and immigration are likely to reverse because of acute political pressure but the issue which matters most is a likely reverse in globalisation.

Globalisation going into reverse

The entry of China into the World Trade Organisation (WTO) in 2001 effectively placed them within the global trading framework and gave them access to most markets. This was done to encourage integration of China into the world economic system in the hope that over time exposure to global democracies would encourage them to become more democratic and similar in outlook.

However, this has been an enormous strategic mistake and none of the benefits have emerged whilst very significant damage has been done. In exchange for cheap goods we have outsourced our manufacturing to China and lost our manufacturing capability. This has been bad for social/political issues with very high wealth disparity inside Western countries and has also made us very exposed to Chinese actions.

It is now apparent that China has no intention of conforming to standards we set and is moving to increase its control over the global system. This realisation in Western governments now means it is almost certain that we will see a retraction of globalisation and a rebuilding of infrastructure for manufacturing in the west. This is a long-term process, and will probably take another 20 years to accomplish, but it could be very inflationary as the money spent to build up manufacturing will flow directly into the real economy and spendable cash balances. Higher wages for working age people is welcome but inflation could be a real problem for lower risk investors.

The underlying trends driving low inflation are reversing

At the same time as we see a retreat from globalisation we have come to an acute crisis in government financing and it is likely government deficits will be high and long term. In this Covid crisis world it is sensible for governments to run deficits because they must avoid a depression and huge unemployment. In the USA the government deficit this year will be almost 17% of GDP and only half of the bonds sold to finance this have gone to investors with the balance bought directly by the central bank. In a country where 50% of people have no savings it is politically impossible for the authorities to remove stimulus in our opinion. Long term deficits financed by monetization, or money printing, are likely and this could be highly inflationary in the long term.

Governments are likely to have very high deficits for a while and have little room for manoeuvre. This will involve central bank direct financing. This can be highly inflationary.

At the same time as this is developing, we are coping with total debt in most countries at all-time highs. I will cover debt and the implications in another research note but it is important when considering inflation.

Debt is a great source of growth when it is rising but eventually the problems from excess debt will roll over and will lead to long-term low growth or even cause a crisis. Predicting the timing for this is difficult and trends can continue for much longer than you imagine. We are not certain the cycle will end now but when it does it will cause a major investment problem and it is foolish to assume it won’t change.

Once it becomes necessary to reduce total debt there are only three ways this can happen:

  1. You can default (likely to cause significant economic problems and unrest – unattractive);
  2. You can suffer very low growth for a long time and work your way out (virtuous but unlikely to be accepted in a democracy); or
  3. You can use inflation or currency devaluation (this is what normally happens because it is the least painful).

 

The decision for what to do once debt pressure rises has not been made yet, and the point of debt crisis hasn’t been reached, but it is foolish to assume that things will stay as they are. Our analysis is that there is a significant risk that debt will become an issue and the solution chosen to manage it is likely to involve inflation increasing.

Manging total debt will become an issue at some point and this could be soon. At that time, the most likely solutions will include inflation to reduce the problem.

There is an excellent historic parallel to what we are experiencing today and it gives us some insight into what could happen next. The 1930s look very similar to the 2010-20 – we had very high debt, the central bank first reduced interest rates to zero, they then implemented quantitative easing and bought government bonds to try and stimulate the economy. Then, as now, these measure only had a limited effect.  Quantitative easing is a monetary policy whereby a central bank buys government bonds or other financial assets in order to inject money into the economy to expand economic activity. This is an unconventional form of monetary policy, however, it is usually used when inflation is very low or negative, and standard expansionary monetary policy has become ineffective.

In the 1940s further measures where introduced which finally alleviated the debt problem but caused a major transfer of wealth within the economy and investors.

The new measures introduced included very large new spending from government and deficits combined with significant inflation. The effect was a very rapid reduction in total debt as a percentage of GDP.

For investors one final action from the central bank was very significant. To get the economy to benefit from inflation reducing the debt burden without forcing an economic crisis, the central bank forced interest rates and the bond market to have low yields throughout the decade.

High inflation and low interest rates, whilst good for the economy overall, was disastrous for investors in bonds and savings accounts at banks.

The 1940s are an excellent model for what might happen today. There was a successful exit from debt crisis and a rebalancing of the economy but bond investors and savers lost a large amount of their wealth. We are very conscious of this and see it as the largest risk to investors today.

Actions

If you are concerned about inflation risk but still require lower risk portfolios there are options you can use to neutralise the risk.

Within the bond holdings in your portfolio it is attractive to substitute traditional government bonds with inflation linked bonds. These bonds automatically increase in price as inflation rises and given the low inflation expectation in markets today they are attractive.

Gold also has an excellent track record for protecting real wealth in times of high inflation and artificially low interest rates. Gold is the timeless alternative currency and has 2000 years of track record for this purpose. In an environment of accelerating deficits and higher inflation the prospects for gold are good and we expect it to provide risk reduction in any portfolio.

Lastly there are also things you can do within your stockmarket investments. Recently some areas of the stockmarket have risen very strongly and left other areas behind. In particular US mega cap technology and what is known as ‘growth’ companies globally have risen to dangerous levels. Against this the old and boring companies that make up ‘value’ globally have been left behind. Any rise in inflation will likely cause a rebalancing within the market either as a fall in the price of ‘growth or a rise in ‘value’.