Inflation & When Being Conservative Can Be High Risk

Written by Tom Stanley, Investment Adviser, 28th October 2022

While it is tempting to dive into the pain consumers are feeling right now, my note this month is a prompt to stop, think and consider the ‘what if’s’ around inflation and how it might influence your investment or retirement plans.  
In a presentation earlier this week, RBNZ Chief Economist Paul Conway said he was “hopeful” that inflation has peaked, with early signs of the economy cooling – but what if inflation proves to be stickier than expected? How should we position as investors? Being conservative in the face of uncertainty sounds prudent, but is it?
In life, sport, work, and investing what we want to happen often is typically very simple and tidy, but it often differs materially from what happens. That is why Amicus’ planning process leans into the idea of running ‘scenarios’ where we openly talk to, and model, the good, bad, and ugly. We can’t account for every possible situation as there are always ‘unknown unknowns’. But we can consider a scenario where inflation could remain higher for longer… and look at historical parallels to model the impacts of inflation on our investments and plans.

A case for higher inflation for longer…
Before working through a scenario, we need to unpack a couple points:

  • What is ‘normal’ inflation? & How do we combat inflation?
  • What can we learn from history?
  • What could drive persistently higher prices?

Inflation targets of developed nations around the world are typically around the 1% to 3% range (NZ’s target is 1% to 2% inflation per year). Inflation is one of the key metrics central bankers focus on as low and stable inflation generally means we have growth AND price stability. If inflation runs too high, it can lead to a vicious feedback loop where higher prices, lead to higher wages, further spurring on higher prices. Central bankers often have other goals such as maximizing economic growth, optimal employment, exchange rate stability and financial stability – but with 95% of G20 countries experiencing elevated inflation hiking interest rates to drive price stability is the primary focus of most central bankers currently.

Recent talk from central bankers has shown a willingness to hike interest rates even if it means breaking the economy with US Fed Chair Jerome Powell vowing to raise rates to fight inflation ‘until the job is done’ – But if we look back far enough, what does history tell us? Is there a case where inflation remains stubbornly high despite a cooling economy? Yes.
Patrick Saner, Head of Macro Strategy at SwissRe asked the question “What happens once inflation goes above 8%?” (as it has this year) and presented the below chart with data going back to 1920, his conclusion?
“Once CPI >8%, it takes around 24 months (!!!) to even fall beneath 6%. Yet current consensus expects us to be back at or even below 3% in just two years”

(Vertical axis: Inflation, Horizontal axis: Number of months since 8% inflation)

Reinforcing this perspective – Ex US Secretary of Treasury Larry Summers shared the below chart from Torsten Slok at Apollo outlining:

“This figure suggests to me that consensus inflation views are more likely too optimistic than too pessimistic”.

To put these charts into perspective, what are some potential reasons for inflation to run higher for longer? Below are a few that I have been mulling over:

  • War: War is typically inflationary as it can break supply chains causing countries to horde supplies (more here) and spend on war efforts (see IMF research here)
  • De-globalisation: If ‘Globalisation’ was deflationary (as we outsourced to countries such as China for cheap labour and manufacturing), moves to manufacture locally i.e., ‘De-globalisation’ will likely be inflationary (more here).
  • Green Energy: The move to reduce emissions, generate cleaner energy, and be better stewards of the earth is necessary and commendable. But this move will come at a price, it involves moving from cheap, dirty and stable energy sources (coal, oil, gas) to more expensive, intermittent alternatives that are less efficient (See EU energy crisis).
  • Financial Repression: While it might not be a popular perspective, post-COVID many governments are more indebted than they have ever been. Allowing inflation to run higher than interest rates for an extended period of say 10 years will increase governments tax take and reduce the value of their debt (See Russell Napier interview here).
  • The China Pivot: While most of the world has moved on from COVID lockdowns, Chinese consumption and growth has been subdued by rolling lockdowns – When China opens back up, there is the potential for further price pressure especially around energy and commodities (see Macrovoices podcast here)

I am not saying all of the above will play out and lead to higher inflation for longer, but with the above in mind I can imagine a period of 4% to 6% inflation for the next 10 years – now lets look at some scenarios…

The impact of higher inflation for longer…
To combat the forces of inflation central bankers have been raising interest rates faster than any other time in recent history. Raising interest rates off record lows, in combination with persistent inflation has led to the worst year in the past 100 for the traditional 60/40 portfolio (60% stocks, 40% bonds).

What is the primary driver of the above? Bonds. Usually the ‘safe’ and steady play, Bond markets have sold off alongside stock markets and to a similar extent with the Bloomberg Global Aggregate (Bond) Index down -21% year to date – Nothing remotely close to this has happened since this index started in 1976 – unfortunately there has been nowhere to hide.

Bonds are now offering much higher returns and can still be prudent and appropriate investment if the income stream generated works for the investor. But I would argue that most NZ based investors typically held bonds because the focus was always on holding an investment that didn’t bounce around much (not on income), but that all changes in an inflationary regime. With the pain felt across most asset classes this year, many have been talking to Term Deposits and how you can now generate a decent return of 4% per annum from just keeping your money in the bank – but is putting all of your eggs in one basket a good idea?
Scenario time!
If I am approaching retirement, it feels safe to have everything in the bank… but what happens if inflation runs higher for longer?
In normal times (inflation @2%) , a retiree with $300,000 in the bank at age 65 could draw $15,000 per year (after tax and adjusted for inflation) throughout retirement and not run out of money.

But if the same retiree was living (and spending) in a higher inflation environment of 6%… they are in the red by their late 70’s.

My note last month, highlighted that carrying 3+ years of your desired income in cash or term deposits is prudent, as it means you have certainty of your near-term income. But remaining deliberately invested in non-fixed income assets such as shares, or property should be a consideration of all retirees (or those nearing retirement). The value of stocks and property may bounce around more than bonds or term deposits, but these asset classes hold the key to maintaining your purchasing power if inflation does prove to be stickier for longer.
For me, being prudent is not about being conservative, it’s about being thoughtful, and making the best decisions based on the information available at the time. Having a plan and knowing what you are working toward makes forming an investment strategy and making decisions simpler.
If you would like to sit down and review your plan, please feel free to book a meeting with any of us through the calendar links below.
We’re locals investing for locals and are here to help.

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