The inflation debate

January 2023

Key Points

  • There is passionate debate within the Multi Asset Team on whether inflation will remain high
  • This matters because bond markets are directly affected by inflation; and equities and other asset classes indirectly
  • We always consider inflation resilience when deciding capital allocation to asset classes and when picking individual stocks

All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.

As investors, we value engaging in healthy debate, even when we disagree with one another. It lessens the risk of groupthink and makes for more robust portfolios.

Inflation is an example of where the Multi Asset Team holds opposing views. It is a significant risk to investment returns, and its impact differs by asset class. That makes it especially important for us to take on board different perspectives and test our view thoroughly.

Steven Hay and James Carver are two essential people in that discussion. Hay worked with the Bank of England’s Monetary Policy Committee for seven years. Carver has over 20 years of experience in global macro and asset allocation. They disagree on inflation’s long-term path.

Carver thinks we are seeing a short-term spike in the long-term low inflation trend. In contrast, Hay believes it is a fundamental shift to a higher inflation world. They outline their views below.

The output gap reflects the difference between what an economy can produce (its potential) and what it actually does.

During the Great Financial Crisis (GFC), there was a massive economic hit relative to its potential, and a significant output gap opened. And, while there was substantial fiscal stimulus through the GFC to boost economic growth, it was in keeping with the hit to the economy.

The same cannot be said of the Covid-19 pandemic. Due to the many Covid restrictions, economic potential was hit harder than economic demand, resulting in a minimal output gap. Despite the output gap not lasting for more than a quarter, we saw record stimulus.

UK output gap and fiscal stimulus (1990–2022)

Source: Macrobond. Underlying data from World Bank and OBR.

The Bank of England printed £440bn of extra money, nearly 25 per cent of the gross domestic product (GDP). That money is sloshing around the economy and will push prices higher.

So, my argument is:

  • There has been a significant boost to demand;
  • There is a lot of liquidity; and
  • If supply cannot expand to meet this higher demand, we will get higher inflation.

That is precisely what is happening.

This is not just a UK story. In the US, if you look at how inflation has progressed each year over the last 20 years, the last two years are off the scale.

Plus, I see evidence of a shift in inflationary outlook all around me. If you, like me, are getting work done on your house, you will know that even if you can find a builder, there are big shortages of crucial building materials such as timber, cement and glass.

This is true across the economy, with shortages of the correct type of workers in hospitality, logistics and similar industries. There is clear evidence that demand is outstripping supply.

Some of this will be due to bottlenecks. Still, the current cyclical inflationary dynamic is the strongest I can remember for many years, and it has already lit the fuse on rising inflation expectations.

Carver: Yes, but Steven, you are underestimating the transient nature of this inflation.

Inflation measures the yearly change in prices, so although prices have risen significantly in the past two years, circumstances have changed. The transitory nature of the demand-boosting stimulus and Covid-related supply issues should mean price inflation falls. I already see evidence in the financial markets of what happens next.

Covid restrictions caused peoples’ savings to increase massively. With time on their hands through furlough and restrictions, there was a surge in speculative investment activity.

The most spectacular rise was probably in cryptocurrencies, whose value went from approximately $250bn to about $2.5tn. Elsewhere, Covid-induced bottlenecks and some speculation led to a 500 per cent price rise in lumber/timber futures.

But prices began falling after the final stimulus cheques went out in the US and restrictions eased.

And now, after the Federal Reserve has increased interest rates, Bitcoin and lumber prices are less than 70 per cent of what they were at their highs. I believe this price action will be repeated across many goods in the wider economy.

As the ‘free’ government cash ends, workers will revert to pre-Covid wages and spending patterns, which alongside tighter financial conditions, should normalise demand. Relaxing Covid restrictions will ease bottlenecks so that supply can also respond.

These two forces should cause price anomalies to reset, and next year the inflation scare will disappear.

The next question is whether we get structural inflation. To get a structural rise in inflation, you must have wage inflation. Otherwise, any price increase will reverse as we have limited ability/willingness to use savings to boost our spending above our income. And my view is firmly in the camp that wage inflation is a pipe dream.

Technology and demographics have played an important part in why the average worker’s wages have failed to keep up with inflation.

Technology includes both the increase in automation and the relative fall in the price of equipment relative to labour (the price of computers, for example, has fallen 10 per cent per annum for the last 15 years).

Technology has improved productivity, which theoretically should boost wages. But the effect of technology cutting the cost of capital has led to the reverse. A recent International Monetary Fund (IMF) study estimated that technology alone has accounted for half the fall in labour’s slice of the economic pie.

Automation and technology will be even more harmful to labour markets in the future, given the scale on which it is occurring. According to a McKinsey study technology is one of four global forces that will deliver change 10 times faster and at 300 times the scale of the industrial revolution.

Instead of this leading to new products/services that create jobs (such as the invention of electricity did), it will replace labour, directly increasing unemployment across more sectors and at higher skill levels.

Another factor influencing wage bargaining power is demographics. Commentators often say that demographics are causing a decline in the working-age population, which should boost wages.

But that is because their definition of working age is 18–65. People are healthier and able and willing to work for longer. Governments are also raising the retirement age.

Japan has the worst demographics in the world and should be the canary for any structural rise in wage inflation, but it’s not happening. The labour force as a percentage of the working age population (defined as aged 15–74) has risen to over 73 per cent. Five per cent more of this age group is in the labour force than seven years ago.

No wonder there has been no supply/demand mismatch and no wage growth. And without that wage inflation, there is no ability to generate sustainably higher inflation.

Labour force (aged 15–74) participation rates over time
Source: Macrobond. Underlying data from OECD.

Hay: James is right that there has been a lot of downward pressure on wages from enormous structural forces such as globalisation, automation and demographics. The question is, what happens from here?

The impact of globalisation has been crucial. First, in opening up the UK economy to cheaper imports from Japan, Korea, Taiwan and China. Second, in enabling the outsourcing of services to the likes of India and the Philippines.

But I believe the impact of globalisation has peaked. After many years of global trade becoming a larger GDP share, it has stalled and potentially gone into reverse.

Why? Probably the biggest reason is the integration of countries such as China and the former Soviet Bloc into the global trading system. It was a one-off change that happened over the last four decades.

It’s also the case that the political landscape has become less conducive to shifting production overseas. The persistent tension between the west and China will make CEOs think twice about relocating production there.

Another more recent trend that will become more important is the pressure from the pandemic and climate change to keep supply chains short and source locally.

What this means is that local labour market conditions will matter more. If there’s a shortage of workers, rather than outsource to an emerging market or bring in immigrant labour, the only option may be to pay domestic workers more. And that is how we get wage inflation.

What about demographics? The facts are these:

  • The share of the population that is working age in advanced economies has been shrinking for a while.
  • That hasn’t mattered because the working-age population in emerging economies has been growing.
  • Through globalisation, we have effectively integrated them into the global economy.

However, that’s the past. Birth rates are falling everywhere, and the global working-age share of the population is now shrinking. At some point, we will start to see the shrinking of the working-age population, leading to higher wages as workers become scarcer.

So, of the three significant structural factors that have brought inflation down in recent times:

1. Globalisation has stalled or is maybe even in decline.
2. Automation is still there as an important force, but I’m less optimistic it will continue to hold the same sway.
3. Demographics have gone into reverse.

Carver: Okay, so we are in a perfect storm for inflation. But there’s little risk it will be allowed to affect inflation expectations and become a longer-term problem because central banks will (and have) responded by raising interest rates.

Central bank commentary highlights that the negative effect of letting inflation out of the bag, and ending decades of low and stable inflation, far outweighs the benefits.

We also can’t forget that central banks in the developed world have clear inflation targets. There is little scope for them to follow a different tack and allow inflation to break structurally higher. Remember, the Bank of England must write a letter to the government every month if inflation exceeds just 3 per cent.

That is why despite multi-decade high inflation, global supply restrictions, the highest level of monetary and fiscal stimulus since the second world war and a war in Ukraine, US inflation expectations are just 2.5 per cent.

There is no inflation breakout at the height of the inflation storm, mainly because of actions by the US central bank. It began indicating a winding down of its quantitative easing (QE) programme at the same inflation level at which tapering QE was discussed in 2013. And it has since enacted the faster monetary tightening since the 1970s.

Hay: James argues that high inflation forces central banks to tighten policy to bring it back down. Sure, they have started to tighten, but as we move forward, they will be contending with the tricky situation of too high inflation and weak growth. That is a position that central bankers have not been in since the 1980s, which means it is not easy to keep tightening.

One key element in the equation that has changed is that governments have shown themselves willing to throw fiscal discipline out the window as we have faced the pandemic.

Climate change is also likely to pressure governments to spend on infrastructure that will help us combat the impact of a warmer planet.

These existential threats demand government action and justify fiscal spending on a large scale.

If inflation is higher, the central banks would be placed in the unenviable position of raising interest rates and stopping buying government debt through QE programmes. While they may be willing to do some of this, are they ready to derail government programmes?

UK government debt levels now are such that, according to the UK’s Office for Budget Responsibility, raising interest rates 1 per cent adds £21bn to the UK government’s interest bill. That’s a lot of hospitals or grants for hydrogen boilers.

So, in conclusion, I think James’ confidence in central banks is misplaced as they will find it hard to do as much tightening as required to get inflation back down to target.

Carver: Clearly, the future path of inflation is highly contentious, but a good way to understand it from an investment perspective is to set milestones highlighting on which inflation path we are heading. Our key milestones are:

1. Inflation keeps surprising on the upside

And has been until very recently. We keep track of this through a combination of inflation expectations, surprise indices and the actual run rate.

2. Sustained upward wage pressure

Yes, there has been pressure, but far from extreme levels. This is a biggie because it indicates that labour has bargaining power. And if wages are rising with or above inflation, a potential wage-inflation price spiral can start allowing inflation to perpetuate. That bargaining power can be evidenced by the number of people switching jobs, rising vacancy rates and, of course, the recent run rate of wage inflation.

3. Central bank narratives/actions

Most central banks have raised rates aggressively in response to high inflation. If central banks don’t respond, inflation expectations will rise. The longer expectations stay high, the more entrenched they become, leading to a much more extended period of higher inflation.

Hay: In the Multi Asset Income Team we continue to be mindful of the inflation outlook when deciding how to position our funds. I’m thankful that we have nine asset classes to choose from.

We had been adding to real assets, such as infrastructure and property, where the cash flows are often directly or indirectly linked to inflation. Equities also offer protection against inflation. We also added to gold miners which we thought offered some diversity and would do well in an inflationary scenario.

The most affected areas are government bonds and high-grade corporate bonds, nominal assets where you are not compensated for higher inflation. We almost completely sold out of these asset classes before inflation rose and only recently began increasing exposure following the massive yield rise. This also chimes with what the Multi Asset Team has done in the latter half of 2022– increasing exposure to fixed income assets, where their long-term return expectations have increased noticeably and relative to real assets.

But as you would expect from Baillie Gifford, we focus on investing in the right companies.

When we discuss individual investment cases within each asset class, we make sure that we have considered how the company would do in an inflationary scenario: does it have pricing power? So, it’s not only asset allocation but in stock selection too that we are considering how to protect the portfolio against higher inflation.

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