Inflation deep dive – should your portfolio be inflation ready?

As economies recover rapidly from the Covid crisis, inflation has become the latest monster under the bed to rattle financial markets.

Inflation is the rate at which money loses its value, which is another way to say it’s the rate at which prices are rising on average. Thanks to inflation, £1 buys you less in 2021 than it did in 2001.

The Bank of England is responsible for controlling inflation in the UK and it’s done a reasonable job keeping year-on-year inflation close to its 2% target in recent years.

But after the momentous events of the last 18 months, some people are worrying that runaway price rises could now be on the cards.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

Inflation so far

The last we heard from the Bank on inflation was the August Monetary Policy Report. In short, the Bank thought we’d see a small amount of inflation (around 4%) in the near term, but that it would fade quickly, and we’d get back to the 2% target by late 2023.

The report came after a surprisingly high inflation reading of 2.5% in June. Since then inflation has dropped back to 2.0% in July, before rebounding to 3.2% in August. This shows how quickly the situation can change. So it wouldn’t be surprising if the Bank’s view adjusts in the next report in November.

However, the Bank’s unlikely to radically reassess the fundamental drivers of inflation, so its reasons for thinking inflation is likely to be temporary are still worth looking at.

To start with, inflation was unusually low early on in the pandemic. So now prices are recovering, the annual change looks bigger than it really is. The graph below shows the level of the CPI index with a 2% benchmark overlaid in January 2020.

Source: ONS, 15/09/2021

As you can see, averaged over the last 18 months or so, inflation has actually only been running at around 2% a year. Inflation was just unusually low in the early stages of the pandemic and only started rising recently. This is known as a ‘base effect’, and it gives the impression of rapid inflation even though this might be misleading. But, because inflation is measured year-on-year, this base effect can only be temporary.

What’s caused the recent spike?

This is in part because global energy and commodity costs have surged due to increased demand as economies recover from the pandemic. Fuel costs deserve a special mention here. Oil prices fell dramatically in the early stages of the pandemic but have since recovered. And, because so much of modern life is powered by oil, its price has knock on effects throughout the economy.

This meant the temporarily low oil price held down inflation at the beginning of the pandemic, but the price recovery has pushed up on inflation more recently.

In July, transport costs were up 7.7% year-on-year and were the single largest contributor to inflation, mostly due to the cost of fuel.

Gas and electricity prices are currently at record levels, perhaps bearing out the Bank’s forecasts in the near term. However, the longer-term forecasts rely on energy costs stabilising, which remains to be seen.

To add to that, temporary frictions caused by the pandemic, including in the labour market, are causing prices to rise in certain sectors, particularly in hospitality where staff shortages are acute.

In our latest HL podcast, owner of London’s Greenberry Café, Morfudd Richards, told us how one competitor booked a table for lunch and tried to lure waiting staff away by offering them big salaries. Pay rises and financial perks are also being offered to HGV drivers given the shortage in the industry as we’ll discuss in another episode.

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Our shopping habits also reflect how different life has been over the last few months. In general, we’ve spent less on services and more on goods. But demand has also shifted to reflect more homeworking and less socialising. On top of that, the government has spent a lot to combat the virus, which is also likely to have boosted overall demand in the economy.

All of this means demand patterns have changed dramatically at the same time as the pandemic has disrupted supply chains and labour markets around the world. The overall effect has been to push up on prices.

The Bank thinks the price rises caused by changing habits and pandemic related frictions are also likely to be temporary. Lots of our habits will return to normal as we return to offices and nightclubs. Even if life isn’t exactly the same as 2019 in 2023, the economy should have mostly adapted by then.

The illusion of pay growth

The papers have been full of stories about pay growth recently but, unfortunately, the headline figures showing 8.8% pay rises are potentially misleading.

Most of the people who lost their jobs or got furloughed during the pandemic were low earners, while higher paid people could generally keep working from home. So, because average pay no longer includes all the low earners who lost their jobs, it looks like average pay has risen dramatically. But it’s just an illusion.

Also, we have another base effect, which the ONS thinks was the largest distorter in the most recent figures. Pay fell towards the beginning of the pandemic, so the year-on-year increase looks stronger than it is in reality.

Having said that, there are some specific sectors where the frictions in the labour market are leading to higher pay. But most of these are likely to be temporary as people learn new skills and feel more comfortable moving for work again.

The upshot is that actual pay growth is likely to be considerably lower than the headline figure suggests. The ONS estimates that underlying year-on-year pay growth for the three months between April and June this year was between 3.5% and 4.9%. Clearly, there’s a lot of uncertainty in that range, but it’s not wildly out of step with its pre-pandemic trend.

Source: ONS, 27/08/2021

Pay growth matters because a ‘wage-price spiral’ is one of the potential mechanisms that could turn a temporary spurt of inflation into something more permanent.

It works like this: if workers see prices rising, they’ll ask for pay rises to keep up. This could lead businesses to raise prices even further to protect profit margins, which could lead workers to ask for more pay rises, and so on. If we do start seeing sustained underlying pay growth, that could be a sign that inflation will be less temporary than the Bank hopes.

So, what could go wrong?

There are a few reasons to worry inflation might be more persistent than the Bank expects.

Firstly, spending might never return to normal, or could take a lot longer than expected. If supply can’t adjust quickly enough to meet changing demand, upwards price pressure could be persistent. The same is true for global supply chain disruption, which might not get better for some time. This could then spark a wage-price spiral as discussed above.

But perhaps a bigger risk is the argument that the Bank’s overall model is flawed. There’s actually quite a lot of disagreement among economists about what causes inflation. The mainstream view, which the Bank shares, is that inflation is caused by a combination of people’s expectations and the interaction of supply and demand.

But there are other ideas out there. Some economists are concerned about massive budget deficits as governments have spent so much combating the pandemic. Central banks have also been printing massive quantities of money as part of Quantitative Easing (QE) programmes to help control interest rates.

In the past many economists might have expected this to lead to inflation. However, deficits and QE didn’t lead to inflation after the Financial Crisis, which is partly why lots of economists aren’t so worried about this now.

But it’s still possible that our current theories are missing something important.

What should investors do?

As always, the most important thing is to stay diversified. While there’s a risk of sustained inflation in the next few years, there’s also a chance we see the opposite. New strains of the virus could derail the economic recovery and cause prices to fall again. If that happens, you don’t want to have all your eggs in the inflation basket.

However, some investments do tend to do better than others during periods of inflation.

Inflation means cash is getting less valuable. So holding lots of cash isn’t going to do investors too many favours if inflation takes off. By the same token, bonds are just promises to pay cash at some point in the future, so they tend to do poorly during inflationary periods too.

Instead, commodities tend to do well when inflation strikes. Stocks can be more varied, and those with strong pricing power are likely to be better able to pass cost increases on to customers.

Remember, the situation is very fluid right now. While inflation could take off in the next few months, it could also continue to moderate.

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