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Comment: Inflation outlook – ‘bad’ inflation is coming

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Jerry Haworth, Director, 36 South Investment Managers Ltd, examines the outlook for inflation and explains the forces that are driving economies towards a ‘bad’ inflation scenario.


It has recently been reported that the CPI rose sharply to 3.4 per cent in March, up from 3.0 per cent in February.
This rise is a sign of things to come, and we will see significant inflation in the medium term. As such, investors should be growing increasingly worried about the effect of inflation on their portfolios. Wealth creation will be replaced with wealth destruction and investment strategies that have worked for the last thirty years will not work going forward – if investors get their asset allocation wrong their wealth could be decimated.
The starting point for this argument has got to be a fact that most people, and sometimes even pre-eminent economists, don’t understand: inflation can exist even whilst there is excess “capacity” in an economy.
Believing that inflation will not occur whilst there is excess “capacity” in an economy is probably the biggest logic error made today. Whilst extreme, Zimbabwe is an example of nearly 100% excess capacity in the “real” economy and hyper-inflation in the “financial economy”. This is an example of classic stagflation.
In addition, many policy makers are locked in an ‘inflation or deflation’ debate, but it is important to note that both inflation and deflation can exist within an economy. The figures published by the CPI only show net inflation/deflation. However, it is essential that investors understand which parts of the economy are inflating or deflating as it is this that determines whether there is net wealth creation or net wealth destruction in an economy.
As the credit-fuelled boom of the past thirty years unwinds, the assets markets are being subjected to massive de-leveraging forces. If left to do their own thing, these would have resulted in substantial deflation. So, in response, governments have lowered interest rates and increased the money supply, both of which are inflationary. However these measures are not guaranteed to stop deflation, as has been seen in Japan over the last 20 years. It is therefore likely that we will see the worst possible combination of inflation and deflation.
With regard to investment strategies that can be put in place to plan for this, we must first look to the past to understand the future. Low inflation over the part 30 years has masked what really went on. In fact, we had significant financial asset inflation combined with significant real asset deflation. Investments in property, shares, and so on performed well as easy credit fuelled price rises in most asset classes. But, the price of real goods remained stable or went down as a result of productivity gains relating to globalisation and the Internet. This led to our “wealth” growing as financial assets grew faster than real asset prices – we grew rich while doing nothing.    
However, now the opposite is the case – ‘bad’ inflation is coming. Prices of real goods and services are going to go up faster than financial asset prices or property, which will result in wealth destruction. Evidence of this is already available by examining March’s CPI rise which has been the result of widespread upward pressures, the largest coming from housing and household services, transport, food and non-alcoholic drinks, as well as from clothing and footwear.
For investors what is important is the relative rate at which inflation/deflation is happening in the real economy in comparison to the financial economy. Wealth creation happens when our financial assets inflate faster than the real assets we wish to purchase in the future. Wealth destruction happens when real asset prices rise faster than financial asset prices. It is clear that investment strategies that have worked for the last thirty years will no longer yield results, and, moreover, if assets are not re-allocated, wealth could be devastated.
Investors urgently need to re-assess their portfolios to assess if they are prepared for the new reality that is dawning. It is also important that in drawing up new investment strategies, investors diversify the investments they plan to use to beat inflation, rather than focusing on one particular commodity.


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