News, Reflections and Ideas

Introduction – In this fortnight’s feature we look at the cost of living crisis, and more specifically the elements and psychology of inflation. Everywhere we look we see prices going up at quite a rate (British understatement at its best) and it has now become a dominant news item, a key feature in voter surveys and is almost as popular in conversation as the crazy world of UK house prices (a topic for a future blog).

News – Is this the 1970s just with different clothes?

Inflation is a spectre that now floats around the news and conversations – it is making its presence felt in a number of ways: an inability by some to afford the basics of food and heating, companies having to pay through the nose for inputs when they can resource, etc.

However, inflation does not impact equally, it depends on what you buy. The inflation indices are based on a basket of goods that is seen as being representative of an average consumer – of course, there are lots of us who are far from being average consumers. Let us take the elderly (and here there is also a distribution) who, on average, spend a great deal of their income on heating and eating. In the current crisis, they are being particularly, badly affected because a core part of the current inflation is to do with energy prices and basic foodstuffs (themselves affected by energy costs and feed costs). Similarly, not all sectors have been hit equally, with transport costs rising significantly, while communication prices have barely moved. In a similar vein, it is the intermediate goods (products sold as inputs to other companies – such as electrical and electronic components) that have seen the largest price rises as the companies up the value chain have tried to both satisfy current demand and build up stock levels as a means of improving the security of delivery.

Perhaps, not surprisingly, a lot of the central banks have been arguing that the current inflation crisis is transitory because it is largely to do with a supply shock caused by Covid (disruption to supply chains) and the war in Ukraine (impact on energy costs, etc.). The mounting evidence suggests this view is mistaken for two reasons. First, the supply shocks are lasting far longer than anyone expected. The war in Ukraine may well continue for quite some time and Covid is still causing supply problems as China locks down its major cities. Second, and more importantly, inflation is bedding itself down into the expectations of individuals and feeding through to wage demands. And here we have the horrible situation of a wage-price spiral that takes some hefty and painful government action to reverse. There are clear signs we are now in this phase and we could end up with stagflation where the actions to gain wage increases dampen supply/productivity/output whilst increasing prices.

The above does not affect individuals nor companies equally, and the responses of both should determine how investors respond to the challenges. Before we look at individual sectors, we should consider whether equities, in general, do well in inflationary periods? From a theoretical perspective, the arguments are mixed – depending on the ability to protect margins through a pass-through of higher prices. From an empirical viewpoint, the evidence is less equivocal, with equities performing poorly in periods of high and rising inflation. In the period from 1973 to 2021 equity returns have lagged inflation and been, in general, negative in the periods of high and rising inflation. However, this does not mean that all sectors performed poorly. Energy stocks have generally done well for obvious reasons and real estate assets have also done well. However, when looking at these sectors, the volatility should be borne in mind – especially, the energy sector. There is a similar argument with precious metals which are often seen as a safe bet during periods of inflation – gold and precious metal prices are extremely volatile.

To us, the current situation has lots of the hallmarks of the 70s inflation regime, the one big difference being the lower strength of the unions currently – however, we should not fool ourselves, with vacancies equalling unemployment for the first time in recorded history in the UK, workers have a lot of individual bargaining power and this is being reflected in substantial wage offers in the private sector, whether the public sector will be able to follow suit remains to be seen.

So, it does feel like the 1970s, just with different clothes.

Reflections – Living with Difficult Expectations.

Inflation is the outcome of effective demand outstripping supply. We have already discussed supply issues and here we will focus on effective demand.

Effective demand is the needs and wants of individuals potentially turned into demand via purchasing power. For inflation to be the outcome of effective demand exceeding supply, both parts of effective demand have to be in operation – effective (the purchasing power) and demand (the needs and wants).

A lot of the literature on inflation looks at how the printing of money (via various means) increases the purchasing power of consumers until inflation bites and reduces it. And the solutions are then focused on reducing the money supply and/or increasing interest rates (these encourage saving and/or discourage borrowing).

Another way the effective part can be increased is for individuals to reduce their idle balances (savings) and turn them into consumption. One part of the psychology of inflation is if individuals believe it is more than transitory, then it will pay them to satisfy their demands earlier because the cost of doing so will be less. And if this is done across the piece then the inflation expectations become self-fulfilling – the brake on such expectation fuelled inflation is the size of the idle balances (assuming no further increase in the money supply).

This is all well and good but it leaves one piece of the jigsaw not being discussed – the basic wants and needs of individuals. These are taken as a given (as in so much of economic theory) and there is no discussion of the view of the individual as a consumer rather than as a producer, etc. In essence, the money supply could be increased and could go into idle balances if the individuals tried to understand themselves as producers and custodians of the planet. This moves us into the whole discussion of the planet and our roles, but this is a discussion for another time.

What is being touched on here is that inflation is more than just a consequence of money, etc. – it is a consequence of the way modern capitalist economies are structured and their participants are encouraged to see themselves primarily as consumers. If individuals see it as their right to consume, then the consequences of money supply, debt, etc. will periodically feed through to inflation when supply (productivity) cannot keep pace.

There are many elements of the primacy of the consumer in modern economies and just a few are the dislocation of a direct connection between production and consumption, the ongoing battle of the rights of the worker versus capitalists, the growth of the state to provide for the wants and needs unable to be met by the private sector. Essentially, we have ended up with a situation where the needs of the individual are seen as all powerful and it is up to the system of enterprise and government to be able to deliver on them. No need/want should be ever forgone. We are seeing this at the moment when individuals have to be protected by the government from the cost of living crisis. In many ways this is right and proper, as part of the crisis has been caused by the actions of the State in dealing with Covid.

The upshot of all of the above is that we will have periodic bouts of inflation when effective demand (and all of its elements) moves out of kilter with supply (and productivity). One message investors can take from this, is never underestimate the power of the state on the economy and its constituent parts as it tries to satisfy the electorate – again, this influence will not be equal, depending on the relative power of the different voting blocs at any one point in time.

Ideas –

How to protect your investment from inflation? Interestingly, if you are a stock investor you have already done so. Historically stock investment has been seen as a means for hedging the inflation relative to fixed income (bond) investment. Let’s look at how the stock investment performed around different inflation regimes in the UK from 1969 to 2022.