Just before I get started this morning, some very exciting news. We’ve got Nick Train speaking at the MoneyWeek Wealth Summit this year. If you haven’t already booked your ticket, then now’s the time to nab it.
We’re doing it virtually this year – I’m hoping we can go back to seeing each other in person next year but at the same time, it does make it a lot easier to attend for everyone who doesn’t have London on their doorstep. So book your ticket now!
Right, onto today’s topic (which is one that I’m pretty sure might just come up at the summit too).
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Inflation is “transitory”, or so central banks keep telling us. Yesterday, that narrative was tested to the limit – US inflation hit a 30-year high, and came in far hotter than expected.
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The question now is – just how “transitory” is “transitory”?
Persistent inflation means you need to rethink your asset allocation
US inflation came in at an annual rate of 6.2% in October. That was a 30-year high. More importantly from a market point of view, it was also much higher than expected.
Even if you take the “core” measure of inflation, which excludes the volatile stuff like food and energy, inflation still came in at 4.6% – again, much higher than expected.
The market reaction was interesting. Until now, markets have tended to react to inflationary data by assuming that it will put pressure on the Federal Reserve, America’s central bank, to raise interest rates more rapidly than expected.
However, given the recent “dovish” surprises from central banks (the Bank of England in particular), markets seem to be re-evaluating the willingness of monetary policy makers to act.
The most obvious symptom of this change in mentality was that the gold price rose sharply, having been in the recent habit of taking a pummelling almost regardless of the data.
To be clear, this doesn’t mean that rates won’t rise or that the market thinks central banks will never raise interest rates again. But what it does suggest is that investors are starting to believe that central banks are “behind the curve” on inflation, and that they will struggle to get ahead of it.
As a result, they’re starting to place some value in hedging against a form of inflation which rips higher faster than rates can keep up.
From an investment point of view, what does all of this mean?
No one has a crystal ball, but all of us, to some extent or other, whether we like it or not, have to take a view on the future. That absolutely does not mean that you then bet your entire portfolio on one outcome.
But it’s also important to realise that inflation would represent such a profound shift in the backdrop that almost everyone could do with at least reviewing their asset allocation to make sure that they aren’t inadvertently taking a big bet on “business as usual” either.
This is one reason why the “death of the 60/40 portfolio” keeps coming up as a topic. The 60% equities, 40% bonds allocation is meant to be a diversified portfolio. But some would argue that it’s really just turned into a one-way bet on interest rates continuing to fall and inflation remaining tame (particularly if the equities component is mostly in FAANG stocks, for example).
So what will central banks do now?
OK, so with that in mind, here’s my central theory on “the big picture”. It’s not especially complicated; there are just two main assumptions to it.
The first is that inflation is not transitory. We are now embarking on a period of structurally higher inflation. I have no strong view on how high it goes as yet, but I don’t think that’s very important right now. The shift in direction from falling to rising inflation is significant enough in itself, and a decade of average inflation at 4%, say, would be a pretty big change to what most of us have grown used to.
The second assumption is that central banks, which are ultimately extensions of the government, will not act to crush inflation until the political pain of ignoring inflation is greater than the political pain of risking (or realistically, causing) a recession in order to crush it out of the system.
This is critical to understand. Paul Volcker, the central banker who put interest rates up to 20% in 1981, didn’t do it because he was ideologically a “hard money” man, nor because he enjoyed being hated by people. He did it because Ronald Reagan was standing up and comparing inflation to a mugger and treating it as the biggest threat to the US way of life. And Reagan could only do that because, ultimately, it was the voters’ priority too.
So until politicians feel threatened by rising prices, central banks won’t act. There are signs of that fear arising now and it’ll be particularly keen what with the US facing mid-term elections again in 2022 (it’s a miracle they get anything done with their endless electoral cycle).
However, fear of higher rates and all that this implies – a possible economic slowdown, a jump in government borrowing costs at a time when government debt is high and the desire for more of it is also high – means we’re a long way from Reagan’s “mugger” analogies for now.
The good news for US politicians is that they do have ways of taking the edge off the worst inflationary pressures. The one thing voters (of all nationalities) hate, is rising petrol costs. The US administration has ways to take the edge off this specifically – if Opec won’t pump more oil, America can push the frackers to act.
Despite the “green” talk, I can see Biden’s administration gently – then aggressively – pushing on this particular lever to affect this specific price, well before they start telling Powell (or his possible replacement) to start raising interest rates.
There’s another thing to bear in mind: there is definitely scope for inflationary pressure to take a break. That will almost certainly coincide with the point at which everyone is stressing most about it (which might even be happening now).
Why do I say this? It won’t be as widely reported – simply because it’s not as headline-grabbing – but a lot of the scariest-looking price surges have started to ebb, or have been ebbing for a while.
For example, container shipping costs have fallen sharply. The price of coal has slid sharply as well. Eoin Treacy of FullerTreacyMoney makes the good point that even during the 1970s, inflation came in waves. We’ve got this initial shock where a series of “pipeline” shocks related to supply disruption have pushed through the system.
If inflation is to be persistent, that will be replaced by waves of wage and product inflation, but in the meantime there will be lulls (partly helped by “base effects” flipping around), and those can be pointed to by nervy politicians as evidence that inflation is indeed “transitory”.
In short, my assumption is that central banks will indeed stay behind the curve and that the backdrop will give them just enough leeway to keep claiming that it’s all “transitory” for a while yet.
So as I’ve been saying for a while, position your portfolio for ongoing financial repression. Buy value. Own some gold. And do attend the Wealth Summit, because we’ll be talking about all of this in a lot more detail.
