Do we need to worry about inflation, the thief in the night?

What is inflation?

It’s the change in the price of a basket of goods and services over time.

Our clients have typically been awarded a settlement to meet their anticipated lifetime needs. If the cost of these needs rises unexpectedly and appropriate actions are not taken with their funds, they may find themselves with a shortfall. 

We’ve lived through four decades of well controlled inflation but the implications of the last 12 months’ monetary and fiscal policies, designed to keep the global economy afloat, should not be underestimated. Inflation headlines are taking up more space in the trade press. The debate over whether we’ll see a fleeting spike in inflation versus a more lasting trend is fast becoming the most important economic question of 2021.

Runaway inflation would be a high–impact event, causing central banks to tighten monetary policy sooner than expected, driving bond yields higher and equity valuations potentially lower, especially those of the ‘growth’ stocks (companies expected to grow their earnings at relatively higher rates for a relatively longer period than the median company). We think this is also a low–probability event, though we are mindful of the risks. Global investors are most concerned about US inflation and the Federal Reserve’s (Fed’s) reaction, given the bellwether effects of US interest rates.

What might cause inflation to increase?

Energy – prices were abnormally low in March and April 2020 due to COVID-19, but their sharply increasing contribution to inflation (usually expressed as an annual rate of change) is likely to fade quickly. It’s clear we’re in for a big spike, however huge increases in energy inflation have not translated into large spikes in core inflation over the last 40 years.

Shipping – although typically volatile, shipping costs haven’t affected core inflation significantly in the past and our analysis shows the correlation with goods inflation is statistically non–existent. During economic recoveries, it’s normal for shipping costs to rise sharply but these costs are unlikely to add more than a few tenths to inflation over the next few months.

Expectations – these are still well–anchored. Over the last decade, too little inflation has given policymakers headaches and they actively want to see inflation expectations move above their recent average. Of course, they do not want to see inflation expectations rocket, but that’s not where we are today.

Bigger issues – in theory, inflation results from an imbalance between the demand for goods and services and their supply, and for now, there’s ample spare production capacity. Even though global GDP is likely to surpass the pre–COVID level by the end of 2021, it will probably take a few years before it surpasses the pre–COVID trend. A greater role for the digital economy means greater disinflationary pressures, and a lagging recovery in employment is also likely to suppress inflation. 2020 wasn’t a so–called balance sheet recession, like 2008’s, and we don’t expect an associated profound period of debt reduction from households and businesses — that’s why we’re not forecasting worryingly low levels of inflation.

What are the risks?

There are four main risks to our sanguine view on inflation:  

1. Behavioural change — households and businesses save less than ever because they now assume the government will bail them out
2. Greater damage to the supply–side of the economy than anticipated
3. Unanticipated fiscal stimulus
4. Frontloaded rises in the US minimum wage to $15 an hour

A rising rate of inflation is not necessarily a bad thing for equity markets nor are rising bond yields. Both tend to be indicative of expanding economies and rising earnings. We’ve found equity markets tend to do well until inflation rises above 3.5%. Rising short–term interest rates are a different matter, they’re the scourge that can flay the backs of equity investors. Central bankers tightening rates too far are much scarier than the ’bond vigilantes’ pressuring up long–term government yields.

Why does it matter?

For a client who has received an award of damages, inflation can have a ‘double whammy’ effect. It can decrease the real value of the award and increase the cost of annual needs, such as care.  The chart below illustrates the eroding effects of inflation on a pot of £2million. With no inflation, the real value of the client’s funds lasts for their anticipated lifetime, whereas inflation at 10% would see the award depleted within 11 years.  

You can read a more detailed version of our article in Rathbones’ Investment Update: Brace for an inflation spike, but we don’t see it lasting.

For further information view Rathbones’ specialist personal injury and Court of Protection services.