Scotland on Sunday – Inflation
08 November 2009
I am often asked by clients: what is the single most important factor which will determine how financial markets perform over the next few years? Many people expect me to talk about the economic cycle in China and America, or perhaps political developments in the UK and Europe. My answer is one word: inflation. Let me explain why.
Inflation is so important for investors. At its simplest, we must always consider how the returns which we receive from any investment compare with changes in the price level. It is no use making a 30% profit over five years if inflation has been 40% in that period. More fundamentally, inflation is a key driver of stock markets, corporate bonds and the gilts market; after all it is another word for a company’s pricing power, affecting its cash flow and profitability, while government bond prices must include market expectations of future inflation.
Even more importantly though, inflation levels, and their change from year to year, have a major impact on investor confidence. The 1980s and 1990s were decades of low, and more importantly stable, inflation; moderate business cycles meant investors could price in future profits growth over a longer time horizon. Since the early 2000s, though, we have seen more volatile inflation and a more extreme business cycle. Lower investor confidence is not a surprise.
Against that backdrop, where do we see inflation going in the next few years, and more importantly what are the risks?
Inflation has recently followed a textbook cycle. During the recession, unemployment rose, housing costs fell, and commodity prices plunged. Eventually, the headline RPI turned negative, broadly for the first time since the 1950s. The official CPI measure, which the Bank of England targets, was as low as 1.1% a year in September, close to the level where the Governor has to write another letter.
Where next? The good news is that headline inflation should move back into positive territory during 2010. The bad news is that under the surface disinflationary pressures remain in place, which could have adverse implications for company profits. Hasty fiscal or monetary tightening could be dangerous.
Why should inflation turn positive? There are one off factors, such as VAT rising in January, while oil prices are some 50% higher than their spring lows. Sterling is also important, having fallen about 25% against the other major currencies since 2007; indeed this helps explain why core inflation here has been rather stickier than in many of our neighbours. Headline RPI inflation could reach 3-4% a year by next autumn.
Investors need to look underneath the surface though. There are still major headwinds restraining inflation, especially wages and salaries growing at the slowest rate in over 40 years. History tells us that wages lag for some time after a recession ends, even more so on this occasion. The UK economy has become unbalanced, we need to become more competitive, and while sterling can help, it can only be part of the answer – wage restraint is another.
What about inflation in 2011? That will partly depend on how the UK prospers within the wider global economy. Just as importantly it will depend on some important decisions by the Bank of England and the government. For example, will VAT rise to 17.5% or further to 20%, to help bring the enormous public sector debt burden under control? How and when will the Bank of England exit from quantititative easing? It faces some difficult calculations. There is considerable technical disagreement amongst economists about the degree of spare capacity in the economy, the size of the output gap in the jargon. Similarly there are technical discussions about how QE is working, about the money multiplier mechanism. It is no surprise a vociferous debate had begun between ‘hawkish’ and ‘dovish’ elements in the Bank. In view of these risks, we suggest central banks, in the UK and other countries, will prefer to be cautious and hence interest rates in most major economies will remain lower for longer, only rising slowly from late 2010 into 2011.
Investors are understandably anxious about the inflation outlook, as this is a fundamental driver of bond, credit, equity and property markets. In this article we have concentrated on the UK’s experience, but we warn that inflationary pressures are starting to differ from country to country. This reflects the variable impact of the economic crisis, different problems in the financial sector, how effective are each government’s policy response, as well as currency movements. Across the major economies, deflation fears have eased; however, it will not be possible to say they have disappeared until well into next year. All in all, 2010 will be a vital one for central banks, and the risks of policy error are unfortunately high.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
This article was first published in Scotland on Sunday on 8th November 2009.
