Strategic Insights | Covid and the Spectre of Inflation

Strategic Insights | Covid and the Spectre of Inflation

Published September 20, 2020
If the experts are to be believed, we are only just getting started with Covid and it will be many months or even years before we have a clear idea of the damage it has done to the world economy. There is currently very little in the way of agreement over what the economics of a post-Covid world will look like. But one thing most analysts agree on is that at some point, both inflation and interest rates will start to rise again.
Inflation is essentially a general rise in price level relative to available goods. It’s the rate at which what we pay for goods and services increases, and is one of the most frequently-referenced indicators of financial well-being – it determines how far the money in our pocket goes and affects everything from the price of bus tickets and how much it costs to go to the cinema… to property prices and mortgages.

Most economists distinguish between three broad categories inflation:

Demand-pull inflation is caused by increases in demand due to increased spending. This encourages economic growth – excess demand and favourable market conditions will stimulate investment and expansion. Recently, for example, we have seen sudden surges in demand for flights from Spain, France and Switzerland to the UK as people have raced to return home before the introduction of quarantine measures, causing airfares to skyrocket.
Cost-push inflation is caused by a drop in supply following a natural disaster or increased prices of inputs. A sudden decrease in the supply of oil, for example, will push oil prices up, resulting in cost-push inflation. Manufacturers and service providers for whom oil is a component in their overall costs could then pass this on to consumers in the form of increased prices. In recent weeks, costs in all of the products and services that we buy – everything from haircuts to the meals we enjoyed in August as part of Rishi Sunak’s “Eat out to Help out” endeavour – have gone up. This has pushed prices up.
Built-in inflation is often linked to the price / wage spiral: unionised workers want their wages to keep pace with prices (staying just above the rate of inflation), and so companies try to pass on their higher labour costs to their consumers in the form of higher prices.
Most countries’ central banks have an inflation target of somewhere between 2% and 2.5%. Such a rate provides some incentive for consumers to purchase products sooner rather than later, and companies find it easier to raise people’s salaries, boosting economic growth.
Inflation is one of the factors that the Bank of England looks at when setting the base interest rate: cutting interest rates lowers the cost of borrowing and so encourages spending. It also has a direct impact on people’s incomes and their purchasing power. Although the inflation figures for July show a bigger than expected rise to 1%, we are still below the Bank of England’s target rate.

Who benefits from inflation?

Inflation is only an average rate, and only certain products are used to calculate it. This means that the way in which it affects your finances will depend on your individual circumstances.
If you have a fixed-rate mortgage, you’ll benefit from inflation – it will effectively reduce your debt. Governments can also benefit: if we had a higher rate of inflation right now, for example, it would erode our national debt (which currently stands at £2 trillion, exceeding the size of the economy for the first time in more than 50 years).

Who gets hurt by inflation?

However, for people on fixed incomes, creditors, consumers and savers – including those planning for their retirement – inflation negatively impacts how far their money will go in the future. Rising prices might mean that businesses need to negotiate the wages of workers so they can keep up with increases in the cost of living. And if inflation is higher than expected and companies and governments are uncertain about future costs and demand, they may postpone investments and infrastructure projects.
We definitely want to avoid the kind of hyperinflation that has been seen in countries like Zimbabwe and more recently in Venezuela (where the annual rate is currently 15,000%). But a little bit of inflation – around the 2% target set by the Bank of England – is beneficial to the economy.
In recent years, central banks have been finding it difficult to get inflation back up to a respectable level. The global financial crisis, the Eurozone crisis, Brexit and now Covid-19 have all taken their toll. Furthermore, the world is phasing out its dependency on fossil fuels as it transitions over to cleaner energies, so there are no inflationary pressures from inputs like oil. Another inflation killer – alongside automation and robotics – is the Internet. It has revolutionised the way in which consumers consume: buying online means they no longer have to pay top dollar, which pushes prices down.
Right now, the only certainty is uncertainty. And it’s definitely sensible to be in the “better safe than sorry” camp. So let’s look at some of the ways people can protect their savings against any post-Covid spikes in inflation.
A good rule of thumb has always been to allocate your savings across a number of different assets. A sensible spread across equities, bonds, property, cash and some alternatives – such as commercial property and infrastructure – is a sound starting point. People also usually buy in some element of inflation protection, such as index-linked bonds. These are bonds which have their coupon payments adjusted for inflation by linking the payments to some inflation indicator, such as the Consumer Price Index or the Retail Price Index. Such interest-bearing investments will typically pay you a real yield, plus accrued inflation, effectively hedging you against inflation. The yield, payment and principal amount are all calculated in real terms, not nominal numbers. The problem is, since everybody is expecting inflation to start rising again at some point, these “linkers” have become very expensive.
So at IQ, we have taken a different approach. The equities that we target are the titans of today’s economy – companies that are growing significantly faster than inflation ever could in the UK – the Apples, the Microsofts and the Nestlés of the world. The money they make can be allocated through rising dividends and cash distributions to their shareholders, providing an element of inflation protection.
We have also been buying global infrastructure. After ten difficult years, we can be pretty certain that Boris Johnson and whoever the next incumbent of the White House is are going to commit to spending money on roads, bridges and the numerous other infrastructure projects that ended up being put on ice in the wake of the global financial crisis. And since we are no longer getting our dividends through bonds, it makes sense to focus on infrastructure: in addition to paying healthy dividends for clients, the sorts of companies that we buy are not correlated to equity markets. Infrastructure therefore provides a measure of inflation protection in addition to some income.
But what if robotics, the Internet and the transition over to a non-fossil fuel-based economy really do spell the end for inflation and it doesn’t rear its head again in our lifetimes? What if we never return to our offices and we stop driving our cars, buying clothes and picking up takeaway coffees for good?
Recent data offers no clear indication: with record unemployment and recession, there could just as easily be a long period of deflation in the offing. Fortunately, we firmly believe that our approach at IQ is a good long-term investment strategy in general, as well as being a hedge against inflation.