Snakes and ladders

When you ask someone what is their biggest fear you usually get a similar list of answers … be it flying, clowns (the film IT will haunt me for life), heights, speed etc the list could go on but usually what they have in common are that they are things that can be avoided in everyday life.

Rather sadly for me my biggest fear is inflation, or to be more precise hyperinflation. Inflation is I feel the single most scariest prospect for our future. It affects all levels of society and all ages but some more than others and very difficult to avoid.

Inflation is loosely defined as rising prices, and is core to the the agenda of most central bankers around the world. Some are trying to contain it, some are trying to maintain it and some are trying to stimulate it. Inflation when contained is a great signal of a buoyant yet stable economy. The main mandate for the ECB is to target an inflation rate of 2% a year. This means they would dearly love to see prices rise each year by 2% thereby indicating a growing yet stable economy i.e. away from boom and bust.

Inflation is the sum of demand in an economy be that real or synthetic. during the most recent period of growth that I can point to namely 2000-2008 inflation could be witnessed as rampant in many areas namely housing.

For investors in certain asset classes inflation can be like kryptonite also. The international bond markets are very sensitive to inflation as if you buy a bond you are lending money to someone be they a government or a corporate and in return you will receive a rate of interest usually on a semi annual basis and this is your income. If that rate of interest is say 2% and inflation is also 2%, well why did you bother? The income or return received is nullified by its loss in purchasing power.

Currently for the most part of it we are in a low inflation environment and interest rates around the world are at all time lows also which means the return on most investment rated government bonds which make up a significant portion of what most of your pensions are invested in are providing very little in the way of a return. A ten year German govt bond will pay you currently about 1.3-1.4% interest rate whereas inflation in the eurozone area is approx 1.9%. So immediately if things stay the way they are you are -approx 60bps  on your investment. You are basically paying the German government to mind you money for a duration as you are too afraid to invest it elsewhere. I’m sure you have all heard the expression ” fear and greed is what drives markets” if you take a look across the curve (duration) in most government bonds then it would not take a genius to figure out we are still strongly in fear mode.

So if inflation is currently low then why am I worried ? Inflation and the economy in general is low at the moment but in my view it is not gong to take much to tip the water in the other direction. Central bankers around the world have been furiously pumping money into the system over the last few years in an effort to stimulate their economies. Great!! free money you may think but it all comes at a cost. When you turn on the printing presses and print up money and inject it into the system you are doing two things. One is devaluing the value of the existing money or decreasing its purchasing power as there is more money now chasing the same amount of products as we are not seeing a corresponding increase in GDP.  The second is increasing synthetic or artificial demand for commodities.

Where you are seeing the inflation currently is in the commodity space. Commodities are a natural place for cheap easy money to end up. For one there are 7 billion and counting people in the world who are hell bent on consuming as much as possible. Also most commodities are priced in dollars, when the US govt prints money it devalues the dollar therefore the price of the commodities priced in it go up. Commodity inflation has increased dramatically over the last four years since quantitative easing programmes have gone into overdrive.

Where I see the biggest risk is actually a grey lining on a silver cloud. I think that next year we will see a pick up in the economy across the world. The US will put a plan into place to address their fiscal cliff issues and much as the Eurozone like to amble along at their own pace they do look like they are at least half way there to solving some problems.

This unlocks investors from fear mode and sends them into greedy mode, for most it has been a sparse few years in terms of returns, and many have had it parked in debt instruments. If GDP starts to pick up then equities and commodities will start to move North very aggressively as a large rotation in asset classes will occur. Unfortunately debt instruments will not be able to keep up with the pace as interest rates would have to be increased dramatically from a current level of below 1% just to even attempt to keep pace with equities who not only provide an opportunity for capital growth but also income from dividends.

All that money sloshing around the system looking for a home will lead to a natural bid up in prices across the board. Inflation will be rampant and unless wage growth can keep pace which it certainly wont for the large majority of people then there will be a serious social situation to deal with.  History has shown that when inflation is rampant and wage growth is not keeping up social unrest is never far around the corner. Many blame the Arab spring and tensions in the middle east this and last year on the effects of inflation, not a coincidence most of these countries economies are inextricably linked to oil – a commodity.

Inflation is crushing to the soul, its fair to say that most people work harder and longer hours than at any point in history. People work hard to increase their standard of living, if all their efforts are been thrown back in their face as whenever they step up a notch so do prices and overall cost of living. Like snakes and ladders. It crushes the spirit and eventually they will give up. Possibly that is how we ended up with such a bloated social system in the first place?

Attached is a graph of the consumer price index in the UK over a period of 20 years. The trend is for higher prices, compare it to the rather bumpier graph on unemployment rates and it looks even more worrying. Prices seem to give no consideration to levels of unemployment. So even with a drop in unemployment which is a good thing obviously will it be completely negated by a inversely related increase in prices again?







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