Pick a letter. So far we have been told the recovery will be V-shaped (Andy Haldane of the Bank of England). Or U-shaped. Others aver it will be a W. Howard Davies (former Chair of the FSA and current chair of NatWest) favours Q… we will go round in circles before we finally escape.
All of this focuses on economic activity, measured by GDP, a measure described by its inventor (Kuznets) as flawed, and yet which has somehow become ubiquitous. The financial pages of the broadsheets have focused on GDP and levels of government borrowing. We have never read the adjective “unprecedented” so many times in so few days.
But what of the real enemy? In our view, the big economic fear must surely be the other two horsemen of the financial apocalypse… unemployment and inflation. Why have we heard so little about the latter?
If you look beyond the broadsheets, some worries about inflation can be detected. It seems to split into two camps, with very little middle ground.
The “not bothered” camp
Those who are convinced inflation will not be a problem point to a number of factors. They point out that the velocity of money – the measure of how often £1 changes hands during a given period of time – is at an all-time low. High velocity of money tends to go hand-in-glove with high inflation. If inflation is rampant, then you will want to spend what you earn. And fast, before it devalues.
At these historic low levels of volatility, inflation is not even a remote prospect, so the argument goes.
Another argument in the not bothered camp is that, with so many people hit hard in their pockets by Covid-19, demand will be suppressed for a long time to come and, without consumer demand, inflation cannot gain pace.
Thus we can all relax and focus on stimulus measures to our heart’s content. Besides, these people say, we had 10 years of QE and it didn’t cause any inflation. Japan explicitly used QE to create inflation and totally failed. So the current “unprecedented” levels of stimulus are completely fine and dandy. (That is, until the next generation realises that it will be in hoc for ever and ever.)
The “well scared” camp
Those who are worried are very worried indeed. They make a number of counter arguments.
Firstly, this is not just more QE. This is government-backed loans to businesses via the high street banks. QE did nothing because it went from one massive institution, the Bank of England, to a set of other massive institutions – the commercial banks and pension funds – and there it stopped. Buying ginormous amounts of government paper didn’t mean any cash leaked into the high street. It may have been intended that the freshly liquid banks would lend their new cash piles to local businesses but that never happened and they couldn’t be forced to do so, even with the threat of negative interest rates. All that QE cash stayed well away from the high street and well away from consumers’ pockets.
Government-backed loans are a totally different wheeze. That stimulus is absolutely going to find its way into circulation. And once a government has opened this particular Pandora’s Box, will it ever have the discipline to close it again? A government-backed loan is not a debt on the government balance sheet – it’s only a contingent debt and it shows up as basically zero. For a weak-disciplined government, this truly is the magic money tree. Tell the banks to issue another £50bn of government-backed loans and yet no dead weight appears on your balance sheet; your debt to GDP ratios don’t even flicker.
The well-scared believe that massively increased cash on the high-street means only one thing: inflation will inevitably be the consequence.
As for the not bothered who point to suppressed consumer demand, the well-scared community will gently remind them that as recently as the 1970s and 80s we had massive unemployment (low demand) PLUS high inflation. They are not mutually exclusive.
But, staying with demand, another inflationary factor is there are plenty of consumers who now have significantly increased savings and will look for outlets for that.
Furthermore, you probably noticed already, but business just got much more inefficient. Social distancing in dockyards, banks, trains, up and down the length of the supply chain. That has to result in inefficiency and higher prices. And don’t even mention Brexit.
Or China. For a long time, China has been fanning the whole globe with cooling doses of deflation. A trade war with China means that particular fan gets turned down.
Problems with inflation
- It takes strong resolve to beat inflation down when it gets hold. And yet, we already hear whispers in the papers of politicians saying a bit of inflation would be no bad thing, it would reduce nominal debt and boy does this government want anything that will help chip away at the debt mountain it has created. Where is Paul Volcker (the Fed chair who tamed inflation in the 70s) when you need him? To beat inflation back, central banks are usually expected to raise interest rates. Yet the Fed’s current chair, Jerome Powell, has recently said that it is not even thinking about thinking about raising rates at this time.
- With long queues at food banks already, make no mistake, any inflation will hurt. A lot.
- But any material interest rate rise, or more likely, an aggressive cycle of them, would do huge damage to business and mortgage holders…
- …and also rip through your investment strategy
And what about my investment strategy?
If you are tending to the view that inflation and consequential interest-rate rises are inevitable now, and that it’s simply a matter of when, then you may want to look again at your portfolio.
In an environment of bond yields going up once inflationary expectations take root, things that will do well will probably be gold, some equities and some inflation-linked products. Things that will suffer will include government fixed-interest paper. Gilts will come off the rolling boil they have been on for years. LDI will also fall, but in a magnified way.
We are NOT here to call the market. That’s the job of investment managers and their in-house economics teams. However, we are here to suggest it’s high time for trustee boards to debate how they want to play their hand. Here are a few core strategies:
- Conventional bond and growth portfolios
- As above with de-risking triggers
- Cashflow-driven investment
- tPR’s favourite… Gilts plus 0.5%
Strategies 1 and 2, using conventional funds only, are nice and simple but, as we have said, fixed-interest paper will do badly if inflation takes off, or if markets think inflation will take off. Consider perhaps shifting from fixed to index-linked stocks. But how far you want to go may depend on your liability profile.
Next up, LDI is a fancy arrangement to get you some of the benefits of a matched strategy while facilitating a higher growth bet than would have been possible under either 1 or 2. It is very much akin to insurance against decreasing yields. Inflation would do a lot of damage to a nominal LDI fund; falls in bond market valuations would be magnified by precisely the leveraging which is beneficial when yields drop.
Moving us to Strategy 4. Perhaps an idea whose time has really arrived. There are various definitions of CDI. It means matching your expected cashflows: for some people it means matching them until the last payment is made; for others it is more a case of matching the next, say, 10 years of cashflows and using any remaining assets to chase a growth strategy. As long as your liabilities are consistently valued, perhaps inflationary fears are to some extent allayed.
But the consistent valuation of liabilities is impossible in the Regulator’s new Fast Track world. Although even this year it is still claiming it is “not a ‘gilts-plus’ regulator” (!!!) it is determined to force most schemes into chasing G+0.5. The best we can say about that is that although your assets would be hammered under an inflationary scenario, perhaps your liabilities will fall further.
There will be some interesting conversations around investment strategy during the coming months and years. We have become very used to a low-interest, low-inflation environment. Now feels like the ideal time to start discussing what happens when the next step-change happens.