Inflation is a topic I have returned to on a number of occasions. A rapid rise in the cost of living can destabilise societies but modest inflation can prove beneficial – not for everybody, it is true, but certainly for governments.
The opposite of inflation – deflation – depresses economic activity and dampens consumer demand. Why buy today if the object of your desire will be cheaper next week?
And deflation depresses financial assets. Witness what has happened in Japan. By contrast, a little bit of inflation can help markets along while it also devalues debt. As I have mentioned before, governments – particularly those of the over-borrowed nations – are all too aware of this. Of course, it also reduces the value of cash savings but someone has to pay the price.
But inflation is not something that governments can necessarily control. Presently, there is a catastrophic drought in the American Mid- West – the agricultural heart of the nation. Crops and livestock are being decimated. The price of many foodstuffs is soaring and the United Nations has asked the US to cut back on its commitment to use a significant proportion of its oil crop for ethanol production.
To put what is happening into context, July was the hottest month on record in the continental US. It was hotter even than the worst month in the devastating Dust Bowl summer of 1936. Seventy-five per cent of the country’s corn and soybean crop is grown in the area affected. Back in the 1930s, following as it did close on the heels of the Great Depression, the effects of the drought were devastating.
While no one expects the consequences of this natural disaster to be as bad as then, the implications for inflation are significant. Add to that the efforts of the Federal Reserve Bank to keep the economy on track by more quantitative easing if necessary and you can see a period of above-trend inflation emerging that will have knock-on effects all around the globe. The sufferers will be the holders of US Treasuries and they are as like as not to be Chinese.
For investors, the implications are equally emphatic. Ten-year gilt yields are down to just over 1.5 per cent in this country. Yet last week the Retail Price Index delivered an unexpected jump to +3.2 per cent (an unchanged +2.8 per cent was the likely figure, according to consensus forecasts), so UK government stocks are delivering a return less than half that of inflation.
Yet still money pores into bond funds. M&G has been actively deterring investors from buying into its popular – and now huge – bond funds. The risk-off mentality still prevalent among advisers and their clients is creating a situation that will leave many vulnerable to a change in sentiment.
While dearer food seems inevitable, given current conditions, there are some elements of the cost of living basket that may find themselves under downward pressure. Metal prices have been weakening of late, some significantly. Blame is being placed on the slowdown in China although the reasons are more complex than that.
True, the significant boom in the price of many commodities during the decade ushered in by the new millennium was driven by Chinese demand but it is the way in which commodity companies reacted that holds the key.
Back then, even inefficient producers found it easy to make money. The ensuing rush to invest in new capacity has created potential over- supply in many areas. With China slowing, it seems that the boom days of a decade ago are truly behind us. A strengthening dollar could exacerbate the situation. We may be approaching what Psigma’s Bill Mott would term an inflection point.
Brian Tora is an associate with investment managers JM Finn & Co