“Inflation is taxation without legislation”

Milton Freidman

The view of economists and investors of inflation is split. There is the camp that believes it will continue to rise and be sustained for the immediate future and beyond; and those who believe tightening of money through interest rate hikes by central banks, a recession and other factors mitigate against a continued rise.

Inflation in the US, as measured by the CPI index, is currently 10%: a 40-year high. The CPI index is flawed as it does not contain income tax, investments or credit. We should not forget that any data on inflation is a lagging indicator. It does NOT predict what inflation may be at any point in the future. As all us who do the shopping and fill our cars know, actually inflation as measured by the decline in purchasing power of our currency is higher in some sectors of the economy than the CPI or a cost-of-living index will indicate. The inflation in commodity prices, caused by a supply crisis following the invasion of Ukraine, has fallen from the peak, especially in the case of agriculture and copper – a good proxy for economic growth. The overall commodity index is down 20% from its recent peak. Oil has around 80 dollars built into the price through supply disruption. However, any increase in supply should lower prices eating into the 80-dollar premium, bringing oil down towards 100 USD a barrel or lower.

Inflation can only be measured retrospectively. However, the effect on prices now in some sectors is real. The question to be answered is, “What is the probability that this will continue to rise and for how long?”

Excessive debt and deficits, falling demographics and consumer demand, rising repayment on loans due to increased interest rate, the effect of technology post Covid and a strong US dollar are all disinflationary pressures. On a balance of probabilities, the risk of a recessionary bear market in equities is greater than the risk of increasing sustained inflation.

It’s important to look at what is causing retail price inflation. This inflation cannot be compared to the 1970s when the US dollar was weak; now we are experiencing a strong US dollar. We have also experienced 13 years of free money being pumped into the financial system, resulting in inflated stock prices without creating consumer demand.

By a historic measurement, the inflation of today is unusual and is primarily the result of a series of global supply shocks as economies were shut down during the war on Covid. Globalisation and the geopolitical landscape changed in 2016 with President Trump calling out China and global trade deals; and then the invasion of Ukraine forced nations to rethink their energy production and supply lines. China, with a zero Covid policy recently, has locked down four million people in Beijing alone. This has an effect on global demand but the bigger problem has been global supply.

The Fed have just hiked interest rates 0.75%. This brings the interest rate to over 2% and they may go further; we think that much of this has already been discounted by the bond market reflected by the sharp decline in price.

History shows us that inflation is notoriously difficult to control in an economy and any measures taken to reduce, such as increasing interest rates making borrowing more expensive, take time. We believe that inflation will be brought back down as consumer demand falls and supply increases. Covid stimulus checks are now in the rear-view mirror and domestic credit has been falling over the last months. Wages are stalling and, although many businesses are hiring, the opportunities are not well-paid skilled jobs.

However, this will take time to come through in the economy. Looking back from 2023, we could see that we are in fact experiencing peak inflation now in the US, Europe and the UK; or it could rumble on into 2023. We will not know until it is behind us.

The bond market is telling us, through the 5-year TIPS breakeven figure, that the expected average inflation rate for the next five years is 2.65%. This is a considerable spread over the current CPI figure of 10% in the US.

We are still at a dangerous time in the stock market for allocating capital, as we are experiencing vicious bear market rallies. Market history shows us that the equity market will not reach a bottom until the treasury market begins to rally. In the short term, it is foolish to try and give any idea of price movement. We simply do not know.

An investor’s view of the immediate future is predicated on the experience of their immediate past. Investors should resist the urge to sell into a declining market or buy into a bear market rally. Patience will reward the long-term investor. Impulsive speculative behaviour is the enemy of successfully growing capital over time in the stock market.

Jeremy Blatch TEP
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