Merryn: Hello, and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine and with me today is John Stepek, our executive editor. Morning, John.
John: Morning Merryn, how's it going?
Merryn: Probably the afternoon, by the time everyone gets to hear this, but it's morning now.
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Today, I think we need to talk about inflation, because everybody has talked about nothing but inflation all week. So I think we had better talk about it.
So to introduce the topic, to those of you who have not also been talking about it all week, the latest CPI figure – Consumer Price Index number – for the UK came in at 2.1%. Now, you may look at that and think, well, who cares? That is a very small number. But the Bank of England forecast that it would come in at 1.8%. So this is in percentage terms, at least fairly significantly above what they expected.
And if you look at the other numbers that came out at the same time around prices, again, they are higher than we would like.
So the Retail Price Index, which is the number that we always used to look at back in the old days, it was the retail price index that we talked about when we talked about inflation, we're not allowed to do that anymore. I've almost forgotten why, perhaps it's something to do with the fact that the RPI always comes in higher than the CPI. That's now 3.3%.
Factory gate prices, which are rising quite fast, are 4.6%, do we see those being translated into consumer prices? Interesting question.
And then we have a number that I think is pretty interesting, which is CPI at constant tax rates, if you were to take out the VAT cuts that we've seen recently, and do things on a constant tax basis, what is CPI? And the answer there is 3.8%, which is the highest for 12 years.
So these are beginning to be proper numbers. Now, the Bank of England – indeed all central banks – will tell you about their inflation numbers that they are transient, that this is simply a phase effect, because last year was so weird, there's a lot of confusion in the numbers, you mustn't look at these and think there's any inflation problem coming, it will soon work its way out of the system, this recent burst of inflation, which isn't even very high inflation, will be over. And we'll be back to normal, very low interest rates, very low inflation for the rest of time.
Is that the way it's going to be John?
John: I hope not. Because one of the things we have been trying to get moving along for quite a long time now is inflation. So apart from anything else, if we can't get it going with the money that's been pumped into the stockmarket, and the money that’s being pumped into the economy, and all the other massive factors that are going on, then we are never going to get it going.
Merryn: Hang on, stop right there. Why do we want to get it going?
John: I'm not sure that I want to get it going. But that's what central bankers target has been for ever, since the financial crisis. And why else are they pumping all this money into the economy? Why else would they be pumping all this money in the system, if it's not because of fear of deflation.
And honestly, I just think that the whole transient idea, this idea that it's going to just be a flash in the pan, is based on wishful political thinking on the part of central banks, that they don't have to do anything. Because part of their unspoken plan, if you like, is to run inflation higher than interest rates for a prolonged period of time.
Merryn: But they've been doing that for a long period of time, one of the things I wrote about this week is that we've got used to this idea that interest rates are much lower than inflation.
If you look at your own bank account at the moment, your deposit account, you'll find that you're either being paid zero in interest, or maybe if you're really lucky, you're getting 0.1%. And if you're insanely lucky, maybe you'll be getting 0.4%. But with inflation at 2%, maybe rising to 3%, you're losing real money every day, and you're going to lose ten, 20% over the next five or ten years. Is that OK?
To anybody 20 years ago, that would have seemed absolutely extraordinary, because you always got a couple of percentage points more on your deposit account than inflation to make sure that you didn't lose money by holding cash.
John: Yes, it's astonishing how things have changed in a remarkably short period of time. I still remember whenever Northern Rock went bust and then they were sorted out by the government, and they ended up offering a fixed rate savings account of 7%. I remember you writing about how we should all rush and open one up, and I didn't, like an idiot. But anyway, there we go.
But yes, before, yes, we've already seen about a decade of financial repression if you like, but I guess that inflation hasn't been high enough to erode the debt to the extent that it needs to be eroded. And so now that we've taken on all this extra debt to finance the pandemic shut down, which still isn't over, then the period of depression is going to need to continue for a lot longer.
But now, we also have this problem that we've got a massive supply and demand shock that's happened. And again, I think the key here is whether or not that does turn out to be transitory or not. And from our point of view, it looks as if it's quite clear that it probably won't be.
You can see that commodity prices have taken a hit this week. But for a start, I think you have to think about how far they shot up in the last year or so – things don't move in a straight line.
But copper has virtually gone up every single week since March. People are worrying, though, that it's rolling over, but it's like, have you seen how far this thing has come? Lumber fell in half, but it's gone up about ten fold, it has been like bitcoin in the last six months.
So everyone's suddenly talking about how the commodity bull market is over and it's like wait a minute guys, it's more like saying crypto has collapsed because it's gone down by 10% in a day. That's not how asset classes work anymore these days.
The more important thing is employment. We are moving into a time where a lot of this structural stuff that was supporting this inflation – and the things that people keep talking about, like technology, globalisation – they're reversing. Globalisation stopped a long time ago, actually, when you look at the statistics. It decayed during the period of Trump and also due to Brexit, but those are symptoms rather than causes.
And now that we've got a global pandemic, we're going to be lucky to be able to fly anywhere in the world for the vast majority of us before next year.
Merryn: Don't be so depressing! I'm going on holiday at half term.
John: Yes, well, that is great, but you've seen how much these tests cost, you're talking about, £300 to £500 per person by the time you're done flying. Now, some might be able to get out of the country to visit relatives, but I'm not taking the whole family with me, for an extra grand of cost, and that's assuming we don't end up in total quarantine.
Merryn: You've found an excuse to leave the kids at home when you go on holiday!
I agree with you on this labour thing. It's really interesting, because we've seen wages begin to go up quite fast in the UK; we've seen it happen in the US as well.
And, by the way, inflation numbers in the US are much higher than ours already – they're running at 5%. And they're loading this vast new fiscal stimulus on top of that rate. So I think we can expect fast inflation in the US before we see it here.
But lots of people are looking at these wage rises and going do “you know what, this is just a bit of a reshuffle”. This is people coming out of the pandemic and moving sector; some sectors are soaring, some sectors aren't doing so well. We need to persuade people to move from working in coffee shops to working in warehouses, etc. And you have to pay a premium to get people to retrain. So it's a one-off reshuffle. And that reshuffle will end quite soon.
And at the same time, the very high unemployment benefits – well, very high relatively speaking – being paid in the US over the last year are going to come to an end. And in the UK, we're going to finally get two million people who are on furlough off furlough, and they will re-enter, hopefully, a lot of them will keep their jobs, but I think we can all be pretty sure that most of them will be re entering the labour market.
And then all these temporary confusions will disappear, things will go back to normal, we'll go back to grotesquely under-paying people to do the work that they do rather than seeing wage rises come on through.
So you've got this whole short term effect and I buy a lot of that, that's probably possible. But on the other hand, there are all sorts of things happening around the world that mean that, as you say, globalisation is slightly going backwards and certainly labour mobility is going backwards.
And there has been a shift in demographics globally. We're not getting younger anymore. We're getting older. Birth rates are falling everywhere. The demographic tide has turned in most European countries, it's definitely turned in China. We can no longer rely on cheap young labour around the world. We have to get on with managing with the labour that we have, and that's going to make a fairly significant long term difference.
It's interesting, lots of people think that the shift in demographics is deflationary. But I suspect they're in for a nasty shock when they find out that it could just as easily be inflationary.
John: I've never understood this. The myth that getting old is necessarily deflationary probably comes from people thinking about the generation before the boomers and remembering how thrifty they were. But they were thrifty because they grew up in a period where you needed to be thrifty. That particular generation in America grew up in the depression and the generation here grew up during the World War, so they were used to being thrifty. The boomers aren't. And that's not a bad thing, it's a good thing. Whenever you've retired, if you've got money, you want to spend it. So I certainly don't think that ageing is necessarily deflationary.
I think the other point is the politics to all of this. If you sit down and read any paper, now... I was looking at an article in I think it was Bloomberg or the New York Times the other day that was looking at Amazon, and how it performed during the pandemic, and the pressure that was put on it.
Amazon must be one of the most heavily scrutinised employers in the world right now. And the reality is that, yes, I don't think most of us would be desperate for a warehousing job in Amazon if we had other options. But it's not that badly paid by the standards of those sorts of jobs. The conditions are not the worst that you've ever seen in the history of employment relations.
Merryn: You’re making it sound great! Let’s all apply
John: Ha! This is a massively successful company, which is coming under major, major scrutiny for its working practices, and it already put through a rise in the minimum wage.
Everyone's falling over themselves to be seen as more ESG than thou – all of that sort of stuff is going to put pressure on wages to go up. And the people that we're electing at the moment are all in the camp of either spending more, or helping the workers and all that sort of stuff.
And believe me – I know that you agree with me – I don't think there's anything wrong with this. Labour has lost out to capital for the best part of 40 odd years now. That needed to change at some point. But that's the point: it’s changing. This is not transitory; this is a turning point. I think the turning point came a while ago, but...
Merryn: ...it's only now showing up. And it’s confused by Covid. People get confused about the cause and effect all over the place.
But going back to this thing about old people or demographics. I do think there's something weirdly ageist about this idea that all old people are now going to sit in chairs with their feet up and stare at the telly all day spending no money except for a TV licence.
I'm getting old, and we're already getting into a household – Sandy, my husband, and I – were getting brochures for weird reading lights, and mobility chairs, and all this kind of stuff, and this is ridiculous! I'm 50, for God's sake! I don't need this stuff, and I'm really hoping not to need it for some time to come.
So this idea that, we hit 50, we hit 60, we hit 65, we hit 70 and suddenly, we aren't spending anymore, it's absolute nonsense.
As you say, this is what they're looking at a totally different generation, a generation that were brought up to be parsimonious, do not spend, save as much as they could, for obvious reasons. And this new generation is not like that. Not like that.
I look at the older people around me, and I am not seeing them acting in a conventional “old people” way, when it comes to their spending, that's for sure.
So I do think that there does need to be a cultural shift mentally among the analysts who look at this thing. And maybe they should move around a more modern type of 65, 70, 75, 80 year-old and they might change some of their forecasts.
John: Yes, definitely. I don't know how the idea has persisted for so long. Yes, we're all getting older as well, but also they forget how well off a lot of pensioners are now. And we've ended up with this triple lock as well, which, again, is not something that I feel strongly about either way.
The reason that was originally imposed was because we had this view of pensioners as being horribly deprived old people. And this was – I can't even remember who introduced it – it was the 2000s. This was the idea that the state pension would always go up by inflation or wages, or whatever rate was higher. And now it’s costing us an absolute fortune and everything.
Every bank in the world wants to get rid of it, but the point is it was introduced for a reason. It's really interesting to look at the way that the generational wars that outsiders were predicting maybe ten years ago, are actually now in full flow, really happening.
So, again, that boils down to politics, all of these things are, ultimately, political phenomena. And I think that one thing we got used to in the late 90s and early 2000s, was not really having to think about politics at all, because everybody agreed – that whole New Labour era over here, where everyone was cuddly, and everyone could tolerate everything else, because there wasn't actually much room for manoeuvre.
And the Overton window, that's all been blown wide open again. Because various people did lose out during those years, and now it’s time for that group to take his revenge. So yes, it is fascinating stuff.
Merryn: OK, so you and I agree, which is nice, that inflation is not transitory. I think we might expect that, OK, so it goes up to maybe 3%-plus-a-bit this year, and it may well then tail off as the base effects come out.
But nonetheless, we're at a generational turning point that will lead inflation significantly higher over the next decade, we need to get used to thinking about inflation being 4% or 5%, etc.
It's interesting, we'll come back to this another time, because I'd really like to talk more about the idea that 2% is the correct rate of inflation. That's been around for so long time.
I like to read the back copies of financial magazines. I was flicking through one of my favourite sets of back copies – of The Statist – and there is an article in 1966 written by a Malcolm Crawford, who I don't know. The headline is “Inflation: good for growth”.
He goes through all the pros and cons of it and he concludes that, for relatively advanced countries, rates of inflation in terms of cost of living indices of about 2% annually may be optimum for encouraging growth and output. It's based on a paper written by a Mr Graham Dorrance for the IMF. And so that's where it came from, or where it appears that it came from.
And so this is the beginning of the idea that inflation encourages economic growth, and somehow inflation is necessary for economic growth, and that somehow bagging up from that the “correct” rate of inflation to aim for is 2%. And here we are all this time later, still targeting 2%. That's what the central bank does, based on I think, Mr. Graham Dorrance's paper.
John: That is really interesting. I didn't realise that. Because the origin story that I tell was the New Zealand central bank that first adopted the 2% rate and the rest of them basically learned from that. In 1989, what was happening was that the New Zealand economy was getting battered by inflation. And I could be wrong, but I think it was them that said that the central bank should target inflation. And then they had to sit there and say, “well, what rate are we going t oset it at?” And presumably one of them had read this paper and ended up on the 2%. Because it seemed about right.
Merryn: This view is consistent with the study of price increases, unit cost increases in growth among ten Western European countries, published last week by the UN Economic Commission for Europe in its annual survey. This points out that the lowest rate of inflation during 1961 -64 had been experienced by the United Kingdom, which also had the lowest growth and output, while cost and prices had risen fastest in Italy, France, the Netherlands and Finland, countries which have also enjoyed amongst the highest rates of growth.
John: Hold on, this was based on three years of data?
Merryn: Are you suggesting that long term economic policy should be based on anything else?
John: Isn't it amazing how this stuff becomes – literally in terms of economics – this is like gravity, like 2% inflation is the right thing. It's like terminal velocity is a fact that should not be argued with. And somebody pulled it out from three years’ worth of data in the early 60s. And then it's migrated to us via the Kiwi central bank, which is just fascinating.
Merryn: And it's so interesting, because if we're right, and this is the origin of the whole thing, as far as it goes here is Mr Dorrance inclined to the view that for relatively advanced countries a rate of inflation of about 2%, blah, blah, blah, he inclined to the view. So Mr. Dorrance wrote a paper based on three years of data that left him “inclining” to the view. And now here we are basing absolutely everything on a view that Mr. Dorrance only inclined to.
John: Oh, man. Obviously, economists make psychologists look rigorous.
Merryn: I know. Anyway, moving on. We'll come back to it.
Merryn: I might even pull my finger out and write a column about it. Other journalists listening to this podcast: this is my creation myth, my column!
If we assume that inflation is going to be greater than 2%, recognising the 2% is absolutely ideal – because Mr. Dorrance was inclined towards it – recognising that, but let's say it goes a little ahead and maybe 3%, maybe 4%, etc, then we get into the business of saying “Well, OK, how does one invest?”
Now, one of the first things to say here, and this something I'm not sure we talk about enough though we have talked about it quite a lot in the past, is that in an inflationary environment, it is perfectly acceptable to hold cash. You'll read article after article after article telling you you need to get out of cash so as to protect your long term purchasing power, but cash is one of the few things that has full optionality.
So if we say that in an inflationary environment, there's a very high risk to, say, the equity market, a risk of a correction or even a crash in the equity market, do you want to hold everything in equities and take the risk of losing 40%? Or would you like to hold quite a lot in cash, and lose maybe 2%, 3% a year in real terms, and have that cash sitting there when the market collapses so you can use this optionality to buy in at a better price?
So I just want to make that clear. Before we start talking about what you might or might not invest in in an inflationary environment, there is absolutely nothing wrong with saying cash is, in a slightly entangled way, a reasonable hedge against inflation, if you're an investor. Is that fair?
John: Yes, definitely. Cash in the past has done surprisingly well, in inflationary environments anyway. But that's normally because interest rates start to catch up. The tricky thing is, depending on what you expect and how extensive the repression is, you definitely need to hold it to take advantage of situations that may arise. And you should always have some cash anyway.
As far as everything else goes it's tricky, because we haven't actually ever been here before. We haven't had bond yields this low. And certainly even the last time they lost an awful lot in real terms. This time, if inflation does take off, I'm guessing that they could lose money, both in real terms and in nominal terms. Equities – I guess there you're talking about the value stuff, the stuff that is throwing out cash now, rather than some point in the future.
Merryn: Cash now is definitely better than cash in the future in an inflationary environment. And that's seen as the big driver behind this shift from growth to value over time.
John: Yes. energy looks good to me, partly because of the whole ESG thing, putting a lot of pressure on new supply.
Merryn: Yes, we wrote about that, didn't we? The other day, I think I wrote a blog about that saying, if you're not allowed new supply, and if we do need oil long term, which by the way we do, then you might as well be invested in something that is going to remain reasonably high demand, but where supply is crunched.
Now, one of the things that I was looking at the other day – and this is an out there investment – but back in June 2013, I think I wrote about the JPMorgan Russian Investment Trust, suggesting it as a reasonable investment, because well, actually, almost for no reason other than it was ridiculously cheap.
And what we said at the time is this is basically discounting your return to communism. And while there's a lot of bad stuff likely to happen in Russia, that's probably not going to be it. So at the time, the index was on a p/e of just under six times, I think, and you could get a good yield on it as well. And we looked at that and we were like, “Well, you know what, it's cheap, lots of bad stuff could happen, but really, all of that is discounted”.
Now, it hasn't been the greatest investment in the world since 2012, but it hasn't been awful either – the share price is up around 70%, so you haven't lost any money. Well, everything else might have done better, cash hasn't done better, put it that way. It's done better than cash, how about that?
John: Is that 70%, with or without dividends? Because the yield was very high.
Merryn: True, that is without dividends. Anyway. So I went back and looked at it again the other day, because obviously the very, very high energy part of investing in the Russian market. And you know what, it's still cheap. So the rest of market is a bit more expensive than it was, it's on nearly ten times this year's earnings, but next year, only 7.7, in the great scheme of the markets at the moment it's practically free. And the dividend yield is 4.7%.
So it's still, I guess, one of the cheapest equity markets in the world, and that dividend yield has to stay reasonably high, because there's a government mandate that makes companies which the state owns a stake in, payout 50% of their net profits in dividends. I can't give you a list of the companies that are subject to that, but it'll be quite long. So I just thought that was quite interesting.
I still hold the trust from 2013. And I'm going to keep it, I might even top it up a little because it's got all those things about it that are quite interesting at the moment. It's cheap. It's got that energy element, and the dividend element: cash now not cash later. So that was something I thought was quite interesting this week, but obviously that is not an investment recommendation. It is information.
John: Oh, it's probably because the Russian economy does do better when the oil price goes up as well. So I haven’t looked at the rouble recently, but you would probably expect that to go up as well. As you know, I’m not a fan of Russia, but…
Merryn: ...I know, we've had this argument….
John: ...but that’s just from an ethical point of view.
Merryn: I know there are ethical issues here. But if you want cheap, you want energy – there's cheap energy for you.
John: Exactly. And it's not up to us to dictate other people's ethical choices.
Merryn: Absolutely not, if you want ethical energy, there are a huge number of grotesquely overpriced, renewable things you can buy.
John: You can squander your money on, we're not judging.
Merryn: Not judging. OK, getting close to judging, so I think we're going to have to call an end to this. Any other suggestions for people looking at the inflation numbers and going, “Oh, God, here we go again”?
John: obviously, gold is one, but just expect it to meander about until the market actually believes that inflation is going to keep going higher, and that the Fed is not going to suddenly raise interest rates to prevent it. And it's not. But it's just going to take a wee while to convince people that and I think it's really interesting, and i'll say this very quickly, it's fascinating how jittery the market is, because on Wednesday, the Fed took a step closer to thinking about thinking about thinking about talking about when it might consider putting interest rates up again, and that sent all the stockmarkets down, and then sent the dollar skyrocketing.
And it’s one of the reasons that the commodities have had a tougher week. So this shows you how much is predicated on the actions of one central bank, which is a bit of an indictment of the whole idea of free markets and all the rest. But again, that's a topic for another podcast.
Merryn: I'm getting a long list of other podcasts.
John: Yes, we might even have to... there's podcast debt, we might have to deliver on it at some point
Merryn: We're going to have to stop getting guests on our list!
Right, we have to stop there. John, thank you. Really nice to talk to you. Thank you everybody for listening.
Please do go to moneyweek.com. If you'd like to hear more from us, you can sign up there for our daily email often written by John, Money Morning. Absolutely brilliant. Don't miss it.
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