Inflation - mothballs in the closet?

We might think of inflation as moths nibbling on a knitted jumper
Cahir Gilheaney

WE'VE seen another period of government bonds under the spotlight for investors, as yields rise, and the associated prices fall across the globe.

While stock markets have made little to no material movement at the index level, below the surface, the rotation away from some of last year's winners continues.

Underpinning these moves, a key debate remains around the matter of inflation. Has this crisis, and the response to it, brought us to a turning point: the start of a period of inflation? If so, how can we protect ourselves?

Problematic inflation may seem like something from a bygone era, and of little consequence today. Even if inflation is 2 per cent or 4 per cent in the years ahead, is this a big deal?

To offer a loose analogy, we might think of inflation as moths nibbling on my knitted jumper collection. Here, the jumpers in my wardrobe represent savings. Like inflation, well-fed moths compound as they breed. The effect they have on my jumpers accelerates as they multiply exponentially, ultimately turning a nibble into downright decimation.

Similarly, one's ability to use relatively inert savings to purchase a basket of goods which, becomes ever more highly priced, deteriorates over time: the same money can buy less.

So, even in periods of moderate inflation, like most of the last decade, finding a way to get our savings to keep pace with that ever more expensive basket of goods is important. One obvious solution is to put your savings to work in the world's capital markets.

However, investors must be mindful that the more you try not just to match the pace of inflation, but to beat it, by seeing the real value of savings grow, the more risk you may need to consider.

As always, beware of wild claims of returns on investments in the face of inflation: there is no single investment that does well at any level of inflation. Much depends on the difference between what is already expected by investors (and therefore incorporated into asset prices) and the actual outcome. We can't know either of these from our current vantage point, even if we can make educated guesses at both.

Turning back to look at the prospects for inflation, and given the impact of a global pandemic, humility is appropriate. The Bank of England expresses this humility statistically, with its two-year inflation forecast showing confidence intervals twice as large as normal. They see a one in three chance that inflation will be either below 0 per cent or above 4 per cent in 2023 – a huge variance range. The reason for this uncertainty is that it's still very difficult to know what the world will look like post-Covid.

Granted, some of the policy moves of the last year bear some resemblance to the opening exchanges of past wrangles with problematic levels of inflation. The difficulties of the late 1960s and 70s owed much to persistent deficit spending and permissive, cowed or dependent central banks.

However, we must always be wary of a straight application of history: no two sets of circumstances are exactly the same. The ability to explain past episodes of inflation via a couple of consistent factors is non-existent. The relationship between growth, inflation, monetary and fiscal policy is still relatively poorly understood, and continues to defy academics and central bankers alike.

For our part, we do not yet see the seeds of the next inflationary bust. The pandemic has punched a sizeable hole in the global economy and we are still only guessing at how big. Which lifestyle and economic changes will remain when coronavirus is finally in meaningful retreat?

For some, the joyous mutiny of children, pets and home broadband may have permanently replaced the quiet hum of the office tower. This shift alone will have major implications for the nature and number of jobs available, how property is used, city centres are configured and all manner of other vital inputs into the future inflation equation.

The fact that monetary and fiscal policy is set to remain supportive for the foreseeable future should not be a source of wild panic. Nor should the sharp move higher in bond yields. For the moment, that can still be read as investors grappling with a better than expected outlook for the world economy.

After a long period of not really having to think about inflation, investors are now busily evaluating the potential threat and incorporating it into asset prices.

While we remain sanguine about the risks of a more permanent inflationary surge, this should not take away from the core message: even a little inflation is going to gnaw away at your savings if you don't put them to work. Just like my jumpers, when next winter comes around, they could be a lot less useful than initially hoped.

:: Cahir Gilheaney is a wealth manager with Barclays Wealth & Investment Management team in Belfast.

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