The consumer price index (CPI) rose to 0.7% in October, reflecting a slight increase in the cost of living in the UK based on the price of food, clothing, etc. While this rate of inflation is well below the Bank of England’s target, there is some concern that inflation could rise rapidly over the coming years due to an increase in the money supply in response to COVID-19. Let’s take a look at what that means for investors.

Those readers that remember the 1970s will recall that inflation wreaked havoc on the UK economy (admittedly, as a member of Generation Z, I do not). Some readers may also remember its erosive effect on their savings in real terms and, understandably, fear history repeating. In truth, a period of high inflation would work wonders on the Treasury’s £2 trillion debt pile. However, as an investor responsible for clients’ wealth, I prioritise their concerns.

Since globalisation took hold in the 1980s, inflation has been under control. This is partly because the supply of cheap labour has expanded enormously while technological innovation has led to a fall in the cost of production, both resulting in weak inflationary pressures and lower interest rates.

Central banks have injected trillions into financial markets through quantitative easing to stimulate growth in the economy. In 2020 alone, the Bank of England’s balance sheet has expanded by £2.2 trillion in response to the pandemic, building on its existing £1 trillion built up in the aftermath of the financial crisis. However, experts have shown that the increase in money supply has been accompanied by a corresponding increase in demand for savings. Commercial banks have been reluctant to lend and a persistent economic output gap has existed since. The result has simply been an appreciation in the price of financial assets at the expense of real economic growth and inflation.

So, what is different about the situation this time around? Firstly, from a supply perspective, globalisation is in reverse. Populations are ageing, dependency ratios are increasing, labour forces are shrinking, and the cost of production is rising as corporations reconfigure onshore supply chains. Fascinatingly, the wage of an average US worker relative to a Chinese counterpart has fallen from 35 times in 2000 to 5 times in 2018. With no other economy able to replicate that of China from the 1980s, this shift will give workers in developed nation’s increased wage bargaining power.

Secondly, there have been changes on the demand side. With monetary policy exhausted, fiscal policy (government intervention) will play a greater role in directing our economy over the coming decades. Unlike quantitative easing (which has inadequately stimulated consumption and investment by individuals and businesses) fiscal policy is more effective at reaching the wider economy through increased government expenditure on the likes of education, healthcare, transport and infrastructure, boosting incomes and demand across the wealth spectrum. Tax increases are likely to foot some of the bill, although direct central bank financing (Modern Monetary Theory) is being heavily touted across political lines.

Finally, given we have experienced relatively benign inflation for some time and have managed to accumulate levels of debt not seen since the Second World War, the Federal Reserve has switched its policy to ‘’Average Inflation Targeting’’, thereby allowing future inflation to persist above 2% as defined over a set period. In other words, they will be reluctant to increase interest rates to curtail above average inflation, especially given the threat of higher debt servicing costs.

High inflation threatens to erode the real value of our client’s portfolios, therefore, achieving positive real returns (after inflation) is imperative.

Across our portfolios, we ensure our investments are diverse in nature, holding those equities which are likely to benefit from an inflationary environment, as well as an increasing proportion of index-linked bonds, gold and infrastructure assets, the latter of which typically derive their earnings on an indexed basis. Furthermore, we provide specialist capital preservation strategies for clients where appropriate.

Should you have any concerns about you or your client’s specific situation, we would always welcome a conversation.

ⁱ  https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/october2020

ⁱⁱ https://www.ons.gov.uk/economy/governmentpublicsectorandtaxes/publicsectorfinance/bulletins/publicsectorfinances/july2020#:~:text=2.,the%20same%20point%20last%20year

ⁱⁱⁱ https://www.bankofengland.co.uk/monetary-policy/quantitative-easing

iv https://www.palgrave.com/gp/book/9783030426569

https://www.ft.com/content/dea66630-d054-401a-ad1c-65ebd0d10b38