Prepare for Inflation

New Normal

The role of data, computing power and ubiquitous networked communications have changed the fundamental structure of our world and have delivered previously unforeseen consequences. We are now living at a time when data is the new oil, AI and quantum computing are becoming a reality, the post WW2 rules of the World order from the Bretton Woods agreement, the role of Central Banks, the soundness of our money and the credulity of our media, have all been undermined or called into question. Western democracies seem unable to deal with the consequences of the rise of China, and even the certainties of financial theory, that markets tend towards equilibrium and efficiency, and that asset prices revert to a mean, are ideas that have been cast into serious doubt.

How Did We get Here

If 9/11 signalled the political inflection point for the unfettered advancement of Western Liberal democracy, the banking crisis of 08/09 delivered its financial equivalent. The policy response to save the financial system was to inflate asset prices by means of Quantitative Easing. This policy ultimately disaffected those sections of society who did not own financial assets. These were the very same sections of society who were already being disadvantaged by the march of globalisation and in particular the rapid growth in the share of World trade accounted for by China, following its accession to the WTO in 2001.

Radical Uncertainty

This great labour arbitrage exported low income jobs from the West en masse, from which we are now starting to see the political consequences. One consequence is that the financial viability of Western democracies, including that of the US, is now in jeopardy. Indeed the policy response to our current COVID crisis takes the financial risk of the West to a new level. In addition to injecting financial stimulus into the banking system by large scale asset purchase schemes, Western governments are now also beginning to distribute money directly to their citizens. This so-called “helicopter money” is typically described as a short term measure, but so was the introduction of QE in 2010 and income tax in 1799. Our new normal is becoming a greater caricature of our previous normal.

Inflate Away

The reality is that once financial assistance is introduced, it becomes habit forming to the recipients and difficult for the benefactor to terminate. We are thus likely to see the acceptance of a permanent form of Universal Basic Income, justified on the political grounds of “levelling up”, making good on previous injustices inflicted on the working poor, and more expediently, to avoid social unrest. The financial burden is significant and growing, and the most likely payment method would appear to be the financialisation of debt, a fancy word for printing money, or inflation.

Inflation vs Deflation

While this measure may take some time to overcome the countervailing deflationary effects of the lock-down, the impact of an artificial and manipulated government bond market, quantitative easing and helicopter money will lead to higher inflation over the longer term. Bonds have become political, not financial assets, they are the central instruments in the sleight of hand that is being perpetrated upon us.

Equities vs Bonds

While bonds have become uninvestable, the consequence for equities is however, less clear. The two main components of most investment portfolios are equities and bonds, and the strong recovery in the equity markets since the initial phase of the COVID lock-down is testament to the fact that equities are currently identified as the least worst place to allocate capital, with gold or Bitcoin other minority contenders. As the unwinding of bond markets continues, equities look most likely to be the main beneficiary in terms of the flow of funds, as no one wants to hold cash.

Inflationary Impact

But inflation is cancerous, and those of us who can remember the 1970’s know that the value of money diminishes rapidly over time, such that we can buy less of the things we want with it tomorrow, than we can today. Additionally the time value of money becomes distorted, which matters, as the time value of money is fundamental to understanding financial markets and the economics of investment. The value of an equity is the sum of its discounted future cash flows. In the old world, the discount rate was always measured in terms of a premium to the risk free rate, the rate the government pays to borrow money. However, increasingly we will need to adopt a more realistic measure that allows for the faster erosion in money’s purchasing power, or degree of debasement. We may yet see the return of Constant Cost Accounting.

Here's What Happened Last Time

By way of  reference, in the period from 1970 to 1980 the average UK house price went from £5 000 to £25 000 (5x), the price of gold from $38 per oz. to $600 per oz (15x) and the price of a barrel of oil went from $2 to over $100 (50x). The lesson is that the things that were in relatively fixed supply fared well. House prices only just beat the rate of currency debasement over the decade, but gold and oil both did significantly better.

Protect Yourself

It makes sense to have an exposure to real assets over the coming decade, these could include gold, real estate (selectively), but may also include other exotic assets such as wine, stamps, coins, Rolex watches, vintage cars, works of art or Bitcoin. I also believe that a selective portfolio of growth equities with some important characteristics also make sense to own. More of that later….

J1960

London, UK

July 2020

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