As the G20 meeting comes to a close in Indonesia, the leaders of the 19 most industrialised economies of the world, and the EU, have been meeting to discuss the most pressing global economic issues. Top of the agenda – until a missile flying over Ukrainian airspace crashed into a Polish village and diverted attention – was inflation.
Inflation is an odd thing. A bit of inflation is a good thing – as it is a signal of economic growth and is actively encouraged. However, a lot of inflation is bad as it signals an overheated economy. At the moment we have ‘bad’ inflation in most of the developed economies of the world. Bad inflation is also termed as ‘hyperinflation’ or ‘runaway inflation’ and in simple terms is too many pounds chasing too few goods.
Bad inflation erodes purchasing power, which means that consumers are unable to buy the same levels of goods or services for the same amount of money that they did in the past. As a result, people have to work more, or get paid more for the work they are currently doing – which in itself is inflationary – or find new sources of capital, or else their standard of living will diminish. This hits people at the bottom of the economic pyramid more than those at the top, as they end up having to make very binary choices between essentials, such as food or heating, not both, as their budgets will not extend to both of them.
Inflation also affects the better-off (and possibly older), who might have savings, as as the value of money decreases, the value of a saver’s pot also shrinks. If the saver needs to make an emergency payment, because of the diminished purchasing power of money, they will have to call on more of their savings than they had budgeted for, which can have implications on their later life.
Costs of production
Businesses are also adversely affected by runaway inflation. Yes, some will do well – like petrol stations, mechanics, oil companies, supermarkets, utilities – but most will be affected. First, primarily for manufacturers, the cost of production increases, as they have to buy components and raw materials at a higher cost. For a while the producer can absorb the costs without passing them on to consumers, but eventually that businesses’ reserves will deplete, and they will have to pass the costs they are paying on to customers. This also adds inflationary pressure, but makes their products less attractive to customers, who are having to budget more carefully, which leads to a loss of sales, revenues, profits and ultimately the ability of the company to pay its employees and bills and force the company out of business.
Second, businesses are a collection of individuals all working together to a common aim. At least that’s the theory. If costs for the individual go up, they will need more money, so will come to their primary source of income – their job – and ask for a better salary, to deal with their cost of living. That business might be under pressure and working to a very fine margin, so increasing costs by increasing wages might tip that business into unprofitability. Increasing wages adds to inflation. However, if that business rejects the demands of its employees, it will have a poorly-motivated workforce, who might look to other opportunities in the economy and leave the company; or in the extreme case collectively withdraw labour leading to strike action. Both will have an affect on the productivity of the business, making them less competitive and ultimately pushing the business into insolvency.
Business of government
At a government level, inflation diminishes the ability of government to do government business. The government, just like consumers and businesses, will have to pay more for its products and services – there are always a lot of lights on in the House of Parliament – but also pay its employees – nurses and doctors, civil servants, police – more because they as individuals are having difficulties making ends meet. As a result, the business of government becomes more expensive. At the same time, as inflation hits the real economy, the government’s take from tax – its primary income – reduces as companies go out of business and employees get laid off, going from income-generators to expense-producers, as more people are forced into benefits.
It’s a moot point as to what causes inflation, but it comes down to two phenomenon – cost-push inflation and demand-pull inflation. Right now we have very Dr.Dolittle-esqe pushmi-pullyu beast affecting inflation. On the cost-push side globally commodity prices have risen exponentially. Prices were already on an upward trajectory following the Covid-19 pandemic, but the War in Ukraine saw global oil and gas prices spike, as Russian hydrocarbons were taken out of the mix, and given Ukraine’s position as a significant producer and exporter of grains, food prices were also significantly affected.
On the demand-pull side, the Covid-19 pandemic artificially subdued the demand for goods and services, which came back with a vengeance when lockdowns were lifted and the raised economy raised its shutters after two years of inactivity. Producers have taken a while to get back into pre-pandemic levels of productivity, and given the historic low interest rates in most of the developed world, there was plenty of cheap cash floating around the economy, with the inevitable result that demand quickly outstripped the economy’s ability to meet supply, which saw an increase in prices.
Perfect storm
So, the perfect inflationary storm. The surprising thing is that the world’s legislators (primarily in the developed bit) were so surprised that this would happen.
At the moment the way we solve the problem of inflation is a bit brutal, like taking a sledgehammer to the task of pinning a post-it note on the fridge. Like driving a tank, the government – or in many developed economies a sub-contacted Central Bank – has two levers that make the vehicle go forward or backwards, as opposed to a steering wheel and set of gears. The steering rig is called monetary policy and the Central Bank seeks to control inflation by regulating economic activity through raising or lowering short-term interest rates.
The theory runs that by affecting short-term interest rates the Central Bank can control monetary supply. Stop: High interest rates, less borrowing as it becomes more expensive, less money sloshing around the economy, reduction in the demand-pull effect. Go: Low interest rates, making borrowing attractive in the hopes businesses will invest and consumers with buy things which leads to economic growth.
Debt servicing
However, the issue comes with people and businesses that already have debt, as they suddenly (at a time when their wages from employment or revenues from sales are worth less in purchasing power) suddenly have to pay more from a diminishing pot of resources to pay the bank for the money they have. Higher interest rates will discourage borrowing, but at the same time with less cash in the economy, businesses and individuals are not able to buy things. Ultimately prices will come down to a level where products and services become more affordable, but in the interim period – which could be quite a while – a lot of companies will be forced to go out of business as people aren’t buying their stuff anymore.
A good example in the real economy is what is happening in the property market in the UK right now as it becomes harder for new buyers to borrow money, which is leading to a fall in the demand and prices for houses. But at the same time people servicing mortgage debt now have to pay more from their diminishing resources to service that debt, which may force some to sell their assets, the biggest being their home, but actually find they will get less for their assets than what they owe in debt.
The other tool in a government’s toolbox to deal with inflation is fiscal policy. Again, it is a brutal and crude tool, a bit like using a pneumatic drill to put up a set of shelves. The government will try to fight inflation by raising taxes and cutting spending, thereby putting a damper on economic activity. In the UK we will find out how that works out tomorrow, the last ‘fiscal event’ wasn’t very successful. However., the sledgehammer-cum-pneumatic-drill approach to fixing inflation needs to be handled delicately and subtly, because going too far, even a little, can push an economy into deflation, which has its own set of very negative consequences.
Deflation
Customers buy less, so producers are forced to charge less, but that means businesses have to cut costs and lay off workers and the economy shrinks, as opposed to growth. It wasn’t that many weeks ago when the then Prime Minister and Chancellor of the Exchequer were selling the line of ‘Growth, Growth, Growth’, how quickly things turn around. And if the workmen at the face of the financial economy keep hammering and keep drilling (which given the dialogue coming from the seats of power is quite likely) deflation can quickly turn into recession, and recession can quickly turn into depression. The last time this happened in the twentieth century, the world did not cover itself with glory in the following decades.
Cheaper stuff is great, but if you are out of a job, don’t have any money and can’t afford to keep the lights on, even cheap stuff is going to be too expensive.
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Higher interest rates
So at least in the medium-term, we had better buckle ourselves into a period of higher interest rates, which leads nicely onto bond funds. Inflation is going to batter investment portfolios across the board as it chips away at savings and returns. A portfolio has to keep up with inflation to increase real purchasing power, but in a cycle of runaway inflation that target is ever upwardly moving. If you manage to for example, make a 4% return on your portfolio, but inflation is 6%, your actual return is -2% once adjusted for inflation.
Equities are just companies, and as explained most companies are going to be affected by external policies that they can’t do much about. If interest rates rise, borrowing becomes pricey, so any debt that needs servicing becomes much more expensive and borrowing to invest gets taken off the table, which can affect productivity, growth and shareholder returns. Also, with customers forced to make choices, some companies will see their revenues affected, which again affects shareholder returns.
However, the sledgehammer effect on interest rates begins to play into asset allocation. Commodities and inflation-linked bonds love inflation. Bonds have had a tough time over the last year, but in itself creates opportunity. It’s not just the Bank of England that has been raising interest rates; rates have been on an upward trajectory across the board in all markets. This has seen a fall in prices and an increase in yields – or interest repayments. Investors holding bonds will have seen a fall in their value and as interest rates rise, further falls could be in making.
But yields – namely what an investor earns from holding bonds – have been rising. A 10-year gilt (a UK government bond) was earning about 1% at the start of this year. At the end of 3Q22, that same bond was paying 4.1%. This pattern is repeated across most developed economies and has been a tangible change.
Yields
The pattern is the same with corporate bonds. At the end of 2021, for example the S&P Global Developed Corporate Bond index was paying a yield of 1.8%. fast forward to the end of September this year and the same index was yielding 5.2%. In the discussion above, households will have to look at increasing the amount of money incoming, either through higher wages (good luck with that) or from other sources of capital, and right now the yields that can be gained as income from bonds are too good to ignore. The opportunity to buy this asset class relatively cheaply, but have increased income (in equities this is derived from dividends) is worth considering. However, you have to build into that calculation the fact that the purchasing power of money is much less in an inflationary cycle, so the cash-money you might get from higher yields, might still buy you less in the real world. That said, the men with the sledgehammers seem to have taken centre stage, so it’s likely interest rates might continue to rise and the price for bonds may continue to fall, so timing is key.
US Treasuries
If you don’t want to make that call, investing in a bond fund might be a better option. One such fund is the Vanguard Total Bond Market ETF [LON:0LMD]. The fund’s investment objective is to seek to track the performance of a broad, market-weighted bond index. This fund tracks the investment performance of the Bloomberg US Aggregate Float Adjusted Index, an unmanaged benchmark representing the broad, investment-grade US bond market.
It invests in taxable investment-grade corporate, US Treasury, mortgage-backed, and asset-backed securities with short, intermediate, and long maturities in excess of one year, resulting in a portfolio of intermediate duration.
The USD268bn fund is passively managed and tracks its benchmark index using a sampling technique to closely match key benchmark characteristics: duration, cash flow, quality, and callability. Optimized sampling is designed to avoid the expense and impracticality of fully replicating the index.
The US is the biggest global bond market, and this fund will provides broad exposure to the taxable investment-grade US dollar-denominated bond market, excluding inflation-protected and tax-exempt bonds, offering relatively high potential for investment income.
It has offered a yield-to-maturity of 4.9%, against 5% for the benchmark with an average maturity of 8.8 years, against 8.4 years for the benchmark and is heavily weighted towards US Treasury bonds, with an allocation of 45.8% to Treasuries and 25.2% to corporate bonds.
It has a current price (16th November) of USD71.76 and has offered a -15.4% one-year return. Vanguard has ongoing costs for individual funds of 0.06% to 0.78% and fund transaction costs of 0.01% to 0.89%.
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