26 February 2018

The Cost of Living Counts

While shares calmed swiftly, it unnerved many investors who were concerned at the trigger for this sudden correction

While shares calmed swiftly, it unnerved many investors who were concerned at the trigger for this sudden correction. Behind the slump in sentiment was some payroll data from the US that suggested wage inflation was rising. The concern that gripped markets was that this might lead to a faster increase in interest rates than had been expected.

Let’s put this into context. Interest rates have been at rock bottom for the best part of a decade, following concerted action by central banks to avoid a sustained recession following the financial crisis of 2008. The monetary easing that was initiated was expected by many to stimulate inflation, but this failed to materialise. The developed world settled into a prolonged period of cheap money with apparently little harmful consequences, if you ignore the fact that corporate and personal debt rose significantly.

But all good things come to an end and gradually central banks have been tightening the reins. This is not before some started to encourage inflation as a way of stimulating economic growth. In Europe this appears to be succeeding, but in Japan, where encouraging higher inflation became part of Prime Minister Abe’s economic policy, growth has slumped to a two year low of an annualised 0.5%.

In the US the Fed has already started to raise interest rates and inflation crept up at the beginning of the year to 2.1% from the 1.9% at which 2017 ended. Indications that wage inflation was on the up encouraged belief that overall inflation was destined to go higher. Ten year government bond yields were already rising, reaching nearly 3% by the middle of February – nearly double those of the UK and some four times the equivalent return in Germany.

As it happens, inflation in the UK has also proved more robust than expected, with January’s Consumer Price Index remaining unchanged at +3%. Most governments consider a little bit of inflation to be a good thing, with 2% a year the target given by the Treasury to the Bank of England. To be a full percentage point above this target will demand some action and the concern is how this might impact upon consumers. Many have taken on debt at very low levels of interest, so higher rates could impact heavily on their spending ability.

Inflation can, though, deliver some benefits. For a start it effectively devalues debt. It can also enhance the value of certain assets, though if allowed to run wild will wreck whole economies. There are many examples of this and Germany’s caution over encouraging inflation to rise has its roots in the post First World War Weimar Republic, during which time the cost of living rose dramatically and created the backdrop to Adolf Hitler’s rise to power.

"Most governments consider a little bit of inflation to be a good thing." 

Here in the UK we have experienced our own period of high inflation, even if the outcome was less dramatic than that which engulfed Germany. In the early 1970s a combination of a sharp rise in the oil price and profligate economic management by the Labour government that replaced that of Edward Heath in 1974 resulted in the cost of living rising to more than 20% and the country needing to be bailed out by the International Monetary Fund. Indeed, inflation remained in double figures for much of the next two decades.

An important issue is what rising inflation might do to equity valuations. Presently, with cash yielding little and bonds still returning modest rates of interest, the dividends generated by companies look attractive. If bond yields rise, as they inevitably will if inflation picks up, then investors will have a true alternative for their money, even if it is one which over time will see the capital value eroded. But in the short term we could see valuation levels fall, particularly if economic prospects are downgraded as a consequence of higher interest rates.

In the longer term, though, inflation can be a friend to equities. Presently we have what is known as a yield gap between equities and government bonds, which means equities yield more than bonds to reflect the added risk. For a long period a reverse yield gap was the norm, with bonds yielding more than equities. This was because the interest they paid was fixed, whereas companies could and often did increase their dividends to shareholders, while the capital value of bonds would not keep up with inflation, while the opportunity for capital appreciation existed with equities. A return to a reverse yield gap would indicate higher inflation is here to stay.

Understanding Finance

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