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Inflation: Götterdämmerung or Gangnam Style? PDF Print E-mail
News - Economy
Monday, 19 November 2012 12:44
By Robert Farago, head of asset allocation, Schroders

Who would have predicted that a chubby Korean singer in his mid-thirties would top the UK chart, singing in his own language?

Psy’s Gangnam Style must be the first chart-topper whose success can be so clearly attributed to the power of the internet. The combination of a catchy tune and a distinctive dance routine has seen his video attract over 600,000,000 viewings on YouTube.

You too will need to study Psy performing his horse-riding moves or risk looking out of touch when you hit the dance floor at the office Christmas party.

It also seems inevitable that the ever more aggressive inflationary policies of the major central banks will eventually trigger a bout of inflation. The question investors face in the internet age is: will inflation pervade market psyche as quickly as a Korean pop sensation?

Will holders of US dollars, sterling and yen wake up and discover together that the emperor has no clothes; that all the unconventional measures taken by central banks cannot hide the fact that governments do not have a way to pay back their debt and are following the well worn path of debasing their currencies?

This could trigger chaos as investors empty their bank account and pile into gold and other real assets.

Or will price rises unfold gradually like Wagner’s classic ring cycle of four operas, ebbing and flowing, before climaxing with the six and a half hour epic, Götterdämmerung? History provides examples that can help our understanding.

World War II left a number of countries saddled with record levels of debt relative to the size of their economy.

What happened next depended in large part on which side you were on. Hungary, which was an Axis power, holds the record for the worst ever bout of hyperinflation, which peaked in 1946 with prices doubling at a rate of more than once a day. This marked the end of the Kingdom of Hungary.

Japan avoided hyperinflation but this provided little comfort to bond holders. Japanese inflation soared in 1946 to over 500% before returning to single digits in 1952 with the debt burden substantially reduced in real terms.

US inflation spiked too, reaching 20% in 1947 and 9% in 1951, but never became a widespread concern since memories of the Great Depression meant people continued to fear deflation.

Price rises averaged just 2% over the next twenty years before the oil crisis hit and sent prices soaring in the 1970s.

Debt to GDP in the US was gradually reduced over 35 years through a combination of these two inflation spikes, strong economic growth and financial repression through regulatory constraints, including limits on nominal interest rates.

But in all three examples the end of the war provided a critical juncture that played a significant role in signalling an inflationary outcome.

In contrast, the Israeli inflation era of the 1970s and 80s is perhaps more typical, in that there was no single trigger. Instead price rises gradually infected the economy.

Inflation was below 4% at the start of 1970 but was above 10% by the end of the year.

However, it then stabilised around this level until 1973, when it ramped up to over 20%, exceeded 50% in 1974, and then moved between 20% and 56% until 1979, when it rose again to over 100%.

Even this was not enough to signal the end. A culture of inflation had become embedded in the economy and price indexation was widespread. This allowed the economy to function, even with prices doubling every year.

It was not until 1984 that prices spiralled out of control, sending inflation to its peak of 486%. An economic stabilisation policy was enacted in 1985 and inflation fell to 19% the following year, marking the end of an era.

For now, consumer price indices in Europe and the United States are rising broadly in line with central bank targets, while Japan continues to suffer deflation.

Inflation is expected to ease next year in many countries. High levels of unemployment are keeping a lid on wage pressures. The slow recovery from the economic downturn of 2008-9 means there is spare capacity in the manufacturing sector, putting a lid on goods prices too.

The removal of government subsidies is the most obvious inflationary force for now, with the tripling of university fees in the UK pushing consumer price inflation above expectations in October.

In contrast to broad measures of consumer prices, markets dominated by the super wealthy are seeing new records set on a regular basis. A London home overlooking Hyde Park is currently on the market for £300m.

A Gerhard Richter abstract was sold for U$34m, a new record for a living artist. Gold has also become a favourite market for private clients looking with a distrust of fiat currencies.

The price remains below its 2011 high in dollar terms but has hit new highs in a number of other currencies including Indian rupee, a key market for bullion.

The boom in commodity prices over the last decade means there are plenty of new oil barons and metal moguls hitting the headlines, but the agricultural world is clearly benefitting too.

October saw Marchup Midge become the world’s most expensive sheepdog, the eighteen month year old fetching £8,400 at an auction in Skipton, North Yorkshire.

Successful debt reduction

The International Monetary Fund studied the history of debt reduction episodes across different times and countries in its latest quarterly. Loose monetary policy was a consistent theme of successful episodes and it is safe to assume that central bank interest rates will remain low for the foreseeable future.

Structural reform was also a key ingredient. This is a concern since, as highlighted above, the split US administration is not expected to make any substantial progress towards a sustainable solution over the next two years while the euro area is in the midst of an existential crisis.

Economic growth is another ingredient in reducing debt to GDP, yet the outlook is challenging for at least four reasons.

First, growth is typically slower in the decade after a financial crisis.

Second, the developed world will not be able to follow the traditional route of devaluation to boost export growth since you cannot have all countries devaluing against each other.

Third, while debt levels have reached post-war levels, the economy is not faced with the post-war need for reconstruction.

Fourth, aging populations will also make rapid economic expansion more unlikely.

The IMF argues that the risks of inflation are lower since central banks have adopted inflation targeting. However, the US Federal Reserve also targets unemployment and its recent missives have made it clear that restoring jobs will take priority.

In addition, quantitative easing adds controlling asset prices to the list of central bank policy aims. Controlling consumer prices, asset prices and unemployment levels will prove to be an impossible trilemma.

We expect that keeping prices low will fall to the bottom of the priority list, not least because a dose of unexpected inflation would be handy for the heavily indebted government.

This analysis leads to a somewhat unsatisfactory conclusion. It seems clear that inflation will pick up at some point. However, it is not clear (a) by how much, (b) when it will happen, or even (c) if we will suffer another bout of deflationary fears first.

This latter risk would increase dramatically if China suffered a hard landing, since they have been the prime driver of commodity prices over recent years.

In terms of government policy, we expect any rise in bond yields to be met by an increase in financial repression, with regulations introduced to force banks, pension funds and insurers to hold more government paper.

Capital controls cannot be ruled out and this was a notable area of discussion at the recent Jackson Hole gathering of central bankers.

Still, it is dangerous to assume that all this means any rise in bond yields will be orderly. The financial system is inherently unstable and authorities will not be able to control all prices.

Could we be exaggerating the threat? It has been said that having a little inflation is like being a little pregnant. Once it arrives, there will be no denying it.

However, the post-war experience in the US tells us that even high levels of inflation do not necessarily stoke inflationary fears. Still, back then investors were worried about a repeat of the great depression while the population today is more attuned to fears of rising prices.

And there is another dimension. Like pregnancy, inflation can come as a surprise or prove to be a false alarm. Lance Bombardier Lynette Pearce was fighting the Taliban in Afghanistan when she complained of stomach pains before medical staff at Camp Bastion informed her she was having a baby.

In contrast, back in 1557 Queen Mary I’s swelling belly led the nation to anticipate a new heir to the throne. But this proved to be a false alarm. Instead, it turns out that she was suffering from uterine cancer and died soon after.

The parallel for investors is that the lack of inflationary pressures to date should not be seen as a sign of health. The underlying problem that leads us to fear inflation is excessive government borrowing and this is set to grow as the population ages.

It is only when governments introduce dramatic welfare state reforms that the situation will improve. We continue to fear that it will take a crisis in the form of rising bond yields before governments are forced into action.

So what should investors do?

In conclusion, the risks of inflation are clear. This does not mean that 2013 will be the year in which bond markets riot. But we are confident that portfolios should include protection against rising prices.

The impact on asset prices if inflation returns is much clearer. It will be disastrous for holders of cash and bonds, who are not even compensated for current levels of price increases.

For equity investors, inflation puts downward pressure on valuations, with 4% historically proving to be an important threshold.

A global pickup in inflation would hit emerging markets first since many are already suffering high levels of price rises already.

The traditional beneficiaries of higher inflation within equity markets are energy companies and miners of both precious and industrial metals.

The Japanese market would also benefit since that economy has been held back by two decades of price declines and domestic investors would be forced to flee from excessively high bond weightings in their investment portfolios.

And for once we are hoping that it is the fat lady doing the singing and not the chubby Korean.

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