By Stanislav Grozev, Portfolio Manager
Inflation is one of the most important concepts in the world of investments.
In a world of seemingly endless money printing, while we have all witnessed inflation in the value of financial assets in recent years, we have hardly seen any inflation in the ‘real’ economy.
With respect to the UK, there are currently two very different schools of thought; some believe that inflation is unavoidable, while others don’t see meaningful inflation levels anytime soon.
Since the pension benefits within schemes such as the LGPS are linked directly to inflation, having a view on its likely movement is important for ensuring investment portfolios are positioned correctly to generate the returns needed to pay those benefits.
The case for higher inflation can be supported by both supply side and demand side arguments.
Supply-side & China
Those who argue that future inflation will be modest often cite China and its dominance as a low-cost producer of goods as a key factor in future low inflation levels.
While China currently dominates production of certain supplies, the future may well look different, with diversification away from China due to deglobalisation dynamics and a more geographically spread portfolio of suppliers, including countries with higher unit costs of production.
China is also rebalancing its economy away from being a producer of cheap exports and more towards a consumer-based economy, so the historical deflationary impact of Chinese production may well have been reducing anyway.
Demand-side & Policy
We could also argue that from the demand side (the big increase in government borrowing and fiscal spending), and policy actions (a big increase in money and credit) one can see inflationary pressures.
The main question that remains to be answered is how the newly printed money can get into the pocket of the consumer.
Obviously, consumers whose wealth is concentrated into financial assets, and to a certain extent into property, are getting more money into their pockets (in the case of property through re-mortgaging), and their spending can create certain inflationary pressures.
But many people have their human capital, i.e. their knowledge and skills, as the main and only source of wealth; and for these people to have more money, there needs to be a higher price paid for their human capital through higher wages.
It is also true that fiscal programs, through initiatives like furlough schemes, put money into the pockets of the consumer.
Low / no inflation
There is also a compelling case for no, or continuing low, inflation.
If we start again from the supply side, we are witnessing more than ever the ability of the consumer to perform price discovery on a global scale through mobile phones and e-commerce applications.
This has increased substantially over the last decade and due to the Covid-19 pandemic has gained further momentum.
This price discovery is deflationary as the goods to be sold first will generally be the ones with the lowest price.
The other main driver behind lack of inflationary pressures is the process of automation. Many jobs that require the execution of tasks that follow an algorithm are easily replaced by machines.
This has a double effect – it increases the quantity of goods produced, and it also increases unemployment, putting downward pressure on wages.
What about wages?
It is hard to see inflationary pressures through higher wages in the UK.
First, unemployment has risen following the impact of Covid-19 and it is historically unusual to see increasing wages coupled with high unemployment.
Government policy in respect of the minimum wage may help the very low-paid, but the nature of the additional goods and services that they will consume is unlikely to have a meaningful impact on inflation.
Borrowing and saving
There is evidence that some banks are tightening the supply of credit.
The UK household debt to GDP ratio is close to 90% and the unemployment rate is high. It is difficult to see inflation being driven upwards by increasing household borrowing, at least in the near future.
Another potential source of funding is via savings. The unleashing of a wave of existing savings seemed particularly unlikely in the UK, given the historically low savings rate.
However, the lockdown periods have helped many people to increase their savings more than they managed previously, as is evidenced in recent statistics. Mass working from home has brought a significantly lower burden from transport costs. Further, the closure of restaurants, pubs, hotels and recreation and cultural venues have become a source of savings as people cannot venture out and spend in a manner many consider to be ‘normal’.
Thus, while we see little evidence that the use of savings in the UK will lead to inflation, we acknowledge that saving levels have increased and have the potential to create inflation. Whether people decide to spend their savings, or actually increase them, is a question that’s difficult to answer, and will vary from household to household depending on individual circumstances.
We think it is highly likely that once Covid-19 is less of a threat the psychological relief will unleash a wave of spending from those who feel that they have job security. It is also conceivable that they will exhibit less price-sensitivity and accept higher prices as the necessary cost of being able to do what they want, when they want.
More money will almost certainly be pumped into the global economy, including the UK in the immediate future.
While central bank encouragement of inflation to reduce the real value of the high-debt burden cannot be ruled out, it won’t be to the extent that inflation gets out of control. There’s an established orthodoxy amongst Central Bankers that if the inflation ‘genie’ gets out of the bottle, it will be very difficult to get it back in.
The unknown path of recovery from a major global pandemic makes the judgement of what will happen to inflation very difficult to assess.
But we believe that modest and controlled inflation is the most likely outcome in the years ahead.
This document has been produced by LGPS Central Limited and is intended solely for information purposes. Any opinions, forecasts or estimates herein constitute a judgement, as at the date of this report, that is subject to change without notice. It does not constitute an offer or an invitation by or on behalf of LGPS Central Limited to any person to buy or sell any security. Any reference to past performance is not a guide to the future.
The information and analysis contained in this publication have been compiled or arrived at from sources believed to be reliable but LGPS Central Limited does not make any representation as to their accuracy or completeness and does not accept any liability from loss arising from the use thereof. The opinions and conclusions expressed in this document are solely those of the author.
This document may not be produced, either in whole or part, without the written permission of LGPS Central Limited.
All information is prepared as of 01/02/2021
LGPS Central Limited is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No: 10425159. Registered Office: Mander House, Mander Centre, Wolverhampton, WV1 3NB