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03 May 2022

The Inflation Genie

We all know that inflation is a hot topic. For some years now we’ve talked about it being our No. 1 emerging global risk. Inflation has however only latterly hit home in the real economy and financial markets. Portfolio Manager WILLIAM FRASER looks at how the inflation genie escaped the bottle.

The risk that inflation poses to long-term savings should not be underestimated — inflation of just 5% per annum will halve your capital in less than 15 years. Investors therefore ignore inflation risk at their peril.

First, some useful context to the current inflationary pressures. In the depths of the global financial crisis of 2008/9, authorities desperately employed massive monetary and fiscal stimulus to save the global economy from outright depression. And it worked. But this plentiful, cheap money resulted in a decade-long ‘everything rally’ in global financial markets — otherwise known as asset inflation.

Financial assets thus enjoyed a goldilocks period of strong economic growth, absurdly low interest rates and record corporate profitability. This was due, in part, to the complete lack of inflationary pressures, which are normal for buoyant economic cycles. Regardless of the myriad reasons used to justify this ‘new normal’, it was our view that the low-inflation anomaly could not persist indefinitely.

When COVID-19 lockdowns shut most economies, monetary and fiscal support to consumers dwarfed that of the global financial crisis. This money was used to buy goods and, later, services as economies re-opened. While consumers went on a shopping spree, factory output slowed due to COVID-19 restrictions. Put simply, demand increased while supply shrank.

Fast forward to today and much of the world is experiencing a synchronised, rising inflation cycle. The major central banks are behind the curve — just as they told us they would be. Inflation expectations have moved up and further market volatility should be expected if the US Federal Reserve and other central banks continue to talk tough.

Governments in developed markets have now started to rein in the free money. Nevertheless, demand for goods and services has stayed strong because labour markets are tight and getting tighter. In short, more people are employed, and they are earning more. As a result, wage inflation has set in for the first time in decades — underpinning a likely sustainable rise in inflationary pressures.

Russia’s invasion of Ukraine is only adding fuel to the inflationary fire. Russia is a major exporter of oil and gas, while both countries account for roughly a third of global wheat production. As a result, energy and food prices have already surged.

So that is how the inflation genie escaped the bottle — and getting it back in will be a challenging task. As we have said all too often in the last ten years, we seem to be in uncharted territory and the rear-view mirror is a dangerous place to be looking.

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