For those who experienced – or should one say suffered – its ravages in the 1970s, the impending return of inflation may be a rather unwelcome phenomenon. In late 1973, the world was broadsided by an oil crisis that sent its cost soaring. The members of the Organisation of Arab Petroleum Exporting Countries (OPEC, which at the time controlled over 60% of the world’s oil production) declared an embargo targeted at the West, and specifically at those countries perceived to be supporting Israel during the Yom Kippur War: initially the UK, the US, Canada, Japan and the Netherlands, but later extended to include Portugal, Rhodesia and South Africa. Between October 1973 and the end of the embargo in March 1974, the oil price rose nearly 300%, from US$3 a barrel to almost $12 globally.
In the UK, the effects of the embargo were severe, even for its largest corporations, which began laying off huge numbers of employees, leading to heightened workforce discontent and, ultimately, national strikes. Those of a certain age will have no difficulty recalling the dark days of the miners' strike in 1974 and the Three-Day Week. The OPEC crisis is regarded by many as the point at which the UK finally came to terms with its vulnerability to underlying shifts in the global economy. It was also the first time the country had experienced 'stagflation' – rampant inflation and unemployment at the same time – which would lead, unsurprisingly, to a widespread abandonment of the consensus as to how a successful economy should best be run.
Inflation rocketed … from low single figures to over 24% in 1975, the highest level ever reached in peace time. The oil price rise was, of course, the key contributory factor but, the augmented power of the unions, and their consequent ability to negotiate unprecedented wage rises, served to fuel the spiral. In 1974, New Earnings Survey data showed the average full-time gross weekly wage to be £41.70; by the following year, this had climbed to £54.00 – an increase of 29% in one year.1
Source: ONS CZBI - 2019
Recent decades have been considerably more benign from an inflationary perspective: as the chart above demonstrates, the UK inflation rate has not exceeded 4% since 1991.2 Why the concern therefore? It's surely bizarre to be apprehensive about the return of inflation during the most rapid, and most severe, economic contraction in living memory. Possibly not – after years of disinflationary conditions, the latest UK inflation figures surprised both the Bank of England and investors by coming in higher than expected. The bank had earlier forecast that inflation would fall to nearly zero during the course of the year as a result of the economic impact of the coronavirus pandemic but, conversely, having been stubbornly subdued for some time, it is edging up: currently, the UK Consumer Prices Index including owner occupiers’ housing costs (CPIH) 12-month inflation rate was 0.7% in September 2020, up from 0.5% in August 2020. It remains well below the Bank of England’s 2% target but recent months have left investors wondering whether the factors necessary to bring about the return of inflation are indeed emerging and, if so, their resultant impact on portfolio strategy – not least the ongoing growth vs. value debate.
Whilst no one is suggesting the return of '70s-style double-digit inflation, there is an incipient view that inflationary forces have been widely underestimated by markets. What are the key factors fuelling that view therefore?
- Monetary policy The marked loosening of monetary policy through central bank largesse has hit unprecedented heights. In November, the Bank of England decided to extend the size of its large-scale bond purchase programme by £150 billion in order to stimulate the economy, extending its quantitative easing (including £20 billion of sterling non-financial investment-grade corporate bonds) to a total of £895 billion. The latest money supply growth figures from the US are equally eye-popping: a fifth of all the US dollars in existence were created in 2020. If this degree of intervention proves excessive, inflation may well pick up.
Source: Bank of England purchases of bonds in £ billion
- Consumer spending The arrival of three Covid-19 vaccines has offered the world a roadmap to something resembling normality. The household savings ratio (household savings as a proportion of household disposable income) increased from 9.6% in Q1 2020 to 29.1% in Q2 of 2020 (compared with 6.8% in the same period in 2019). The ratio is more than twice as high as the previous record of 14.4%, set almost three decades ago. Once the virus is contained, the economy could potentially overheat as exuberant consumers, and making up for lost time after months of confinement, go on a spending spree that outpaces the ability of firms to restore and expand capacity, triggering price rises.
- Deglobalisation As national borders across the world tighten – or in some cases close – post-COVID, companies will find themselves having to respond in a deglobalised way. Those which have seen their supply chains substantially disrupted by the pandemic have embarked upon programmes to repatriate or diversify their suppliers, as well as absorbing increasing amounts of inventory in order to address weeks or even months of potential disorder. The globalisation story over recent decades has been disinflationary, but initiatives undertaken to counter the effects of COVID-19 seem likely to exacerbate latent inflationary pressures.
- Social pressure Governments generally, and in the UK in particular, will be reluctant to deploy punitive austerity measures as a means of relieving debt – now over £2 trillion in the UK – preferring to allow rising inflation to take the strain of the massive debt in the system.
- Abandonment of targeting Most central banks, including those of the UK and the US, use an inflation target of 2%. In August of last year, the US Federal Reserve announced that it would allow a target inflation rate of more than 2% in order to help ensure maximum employment. Whilst it is still seeking an average 2% inflation rate over time, it is clearly willing to accept higher rates of inflation for a period, where circumstances require it. The European Central Bank may well adopt a similar approach.
- Pricing power of survivors Many businesses will, of course, struggle to survive the pandemic but those which do will find themselves in a strong position – with fewer competitors in the landscape, the opportunities to raise prices are likely to be widespread, adding further fuel to inflationary pressures.
While the concept of rising inflation may seem fanciful for now, there would seem to be little doubt that the benign consensus that it has been permanently defeated will be seriously challenged in the years ahead. Indeed, central banks and governments have largely ceased to be concerned about inflation, and are now rather more intent on stimulating it than controlling it. Should inflation see a return, the previous beneficiaries of a deflationary conditions are likely to fare relatively poorly, whilst assets that were previously struggling to make headway may find themselves in rosier times – hence the enduring growth vs. value debate, given that higher inflation expectations offer a glimmer of hope for long-suffering value-oriented investors.
The performance gap between the two has rarely been larger although, admittedly, the impressive outperformance from ‘growth’ over the last decade has only just begun to extinguish the prior decade’s period of marked underperformance relative to value. Over the 10 years to the end of 2020, the MSCI All Country Value Index has grown at a compound annual rate of 6.85%, and so it's hard to argue that value has 'failed' as a strategy; it's simply that growth has performed so much better, delivering a compound annual rate of 12.44%.3 Any reversal of fortunes for value stocks could have profound implications for fund selection however, precipitating a rotation out of COVID winners in technology into, say, banks, insurers, asset managers and energy. It’s worth bearing in mind that over 25% of the FTSE 100 Index is accounted for by the financials and energy sectors.4
Given that the relationship between inflation and value isn't necessarily self-evident, a brief explanation may prove helpful. Investing in a value business (defined by a low price/earnings multiple of, say, 5x) suggests that you will recoup your investment after five years. In contrast, a growth business is likely to have a higher P/E ratio, say 15x, meaning that investors will recoup their investment over a 15-year period. In an inflationary environment, money today is worth more than money tomorrow and so value, which sees investors recoup their money sooner, is more attractive.
If one were of the view that inflation was set to make a comeback, it would unwind a significant proportion of value’s recent underperformance. Their remains also a question mark as to whether growth stocks can sustain their momentum. Big tech stocks, for example, are both under-taxed and under- regulated, not unlike the position the banks were in prior to the financial crisis, and may be set for a fall. One need look no further than Tesla which has a decidedly controversial valuation, considering it only sells half a million cars compared with Toyota’s 10 million.
A shift in inflation, coupled with a vaccine-led and QE-fuelled recovery from recession, could be just the catalyst markets have been seeking to knock growth off its perch. It may be time to fix the roof whilst the sun is still shining.
1Source: 1974 to 1997 New Earnings Survey, Office for National Statistics
2Source: Consumer Price Index, to December 2020
3Source: MSCI ACWI Value Index (USD) and MSCI ACWI Growth Index (USD)
4Source: FTSE Russell, as at 31.12.20
Inflation - The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.
Consumer price index (CPI) - A measure that examines the price change of a basket of consumer goods and services over time. It is used to estimate ‘inflation’. Headline CPI or inflation is a calculation of total inflation in an economy, and includes items such as food and energy, in which prices tend to be more prone to change (volatile). Core CPI or inflation is a measure of long-run inflation and excludes transitory/volatile items such as food and energy.
Monetary policy - The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money. See also fiscal policy.
Price-to-earnings (P/E) ratio - A popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio.
Quantitative easing (QE) - An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system.