The biggest risk for investors at the moment is high inflation. While the market places too much emphasis on short-term inflation, it also tends to underestimate long-term inflation.
The news that Powell might raise interest rates by 50 basis points next time was greeted with cheers, as it would bring inflation under control more quickly. However, the Fed will be able to live with inflation hovering between 3 and 4 per cent for a long time, although Powell will never admit that. In the eurozone, it is certainly not about fighting higher inflation.
Since Draghi declared in mid-2012 that he would do whatever it takes, it has only been about the survival of the euro. The ECB is not the guardian of purchasing power, but must ensure that there is no new financial crisis. Reflation or financial repression is part of the solution and, in that context, slightly higher inflation is more of a solution than a problem. And that financial crisis has been brought closer by the war in Ukraine. Russians want to get rid of their investments and holdings in euros, if they have not already been frozen or confiscated.
The Russian central bank has learned that reserves in euro are not worth much, there are more central banks that fear for their assets in euro. Arabs and Chinese will also conclude from the Russians’ approach that Dubai or Singapore are safer than London or Paris. On top of this comes the sharply rising trade deficit. If the Russians’ petrodollars are no longer exchanged for euros, we will soon have to earn hard dollars to import energy. Combined with the contrast in policy between the ECB and the Federal Reserve, the euro could weaken further and inflation could rise as a result.
Inflation was already high
Before the war in Ukraine began, inflation had already risen. It is primarily a problem caused by the central banks themselves. After the Great Financial Crisis the money supply was also opened, but it was used almost exclusively to plug the holes in the financial system. The money had been spent before then. Because running the money press then did not lead to more inflation, there were now far fewer inhibitions about using the same weapon again.
Much of that money also reached the real economy, causing the demand for products to rise sharply. By the way, a large part also went to houses and the financial markets, but these are not yet part of the inflation basket. Everyone may point to the supply side as the cause of the problem, but the supply side was faced with a 30 per cent increase in demand.
The increased prices of many products now provide a good excuse for the service side of the economy to raise prices as well, and with the tightness in the labour market, wages are rising with a time lag. A loaf of bread contains less than a kilo of grain, the price of which has doubled in the last year.
Of course, one loaf requires a relatively large amount of energy, approximately 4 Megajoules to bake. A cubic metre of natural gas contains 38.3 Megajoules. Natural gas is traded per Mwh and in 1 Mwh there are about 103 cubic metres and the price is now 107 euros per Mwh. That is still a price of more than EUR 1 per cubic metre, but per loaf of bread it is about 10 cents.
Now there are plenty of warnings that the price of a loaf of bread will rise from EUR 2.5 to EUR 5, but that should be manageable. With corona and the war in Ukraine as an excuse, the consumer is willing to pay it. Wages are also rising. It may not be visible in the statistics, but those who change jobs now can easily negotiate much better working conditions.
Energy and food are wrongly excluded from core inflation. In fact, these two components constitute the very core of core inflation. Food and energy are basic necessities of life. In fact, everything else is energy, so higher energy prices trickle down into the prices of many other products with a time lag. Bear in mind that interest rate rises to combat inflation take up to 18 months to take effect and the ECB has yet to start.
A further escalation in the Ukrainian war is enough to rule out an interest rate rise this year. Of course, inflation puts the brakes on economic growth and thus ultimately on inflation, but anyone who thinks that this will automatically bring inflation below 2 percent is engaging in wishful thinking.
Structurally higher inflation
At the moment, there are also many factors that make for structurally higher inflation. For example, we are in the middle of the baby-boom generation’s retirement. It is the first generation ever to have saved a lot. These are people who have worked one day a week for their pensions in recent decades. That means one day a week of producing, but not consuming. Now they stop producing and start consuming only.
Sometimes it is as simple as supply and demand. The bizarre thing is that everyone points to Japan’s ageing population as a cause of deflation. Japan’s deflation was caused in the first place by the bursting of a double bubble of unprecedented size. As far as ageing is concerned, there is a big difference here between correlation and causation. Inflation is structurally higher because of deglobalisation.
At first, it was because long production chains put us at risk in terms of supply. Sounds nice on paper, but in practice those chains are there for a reason, because the result is that with those long chains the lowest price can be realised, something producers are not so quick to give up. Since the Russian invasion, it is no longer just about this risk, but about autonomy. We want to become self-sufficient, in terms of energy, technology, military, finance, in terms of essential raw materials and also in terms of food. These are expensive pastimes.
Energy transition in particular is such an expensive hobby, but one that is being worked on in a concerted effort. With alternative energy, we are pricing ourselves out of the market, especially when the Chinese buy fossil fuels cheaply from the Russians at half the price. Corona and now the war in Ukraine have also made the government a lot bigger and there is a correlation and causality between a bigger government and higher inflation. Furthermore, in recent decades, prices have been pushed down not only by globalisation but also by the IT revolution.
It has resulted in several large tech companies effectively having a monopoly. Monopolies are not known for constantly lowering prices. What started out free is now all as-a-service and it seems remarkably easy to constantly raise prices there. In many ways, the war in Ukraine is also an IT war. Thanks to social media, Zelensky has won the PR war.
Hacking is rife and cyber-attacks have become a normal weapon. And crypto-currencies are used to avoid financial boycotts. All this cries out for more regulation, and thus higher prices. The internet and social media mean that companies can no longer hide. It is striking how many companies have stopped doing business in Russia. Millennials, both as employees and as consumers, want companies to stop doing the wrong thing.
There is also a pendulum swinging from the capital factor to the labour factor. The power of trade unions is gone, but on social media workers can organise themselves much faster and more effectively. Furthermore, we still underestimate the development of demand in the coming years. Consumption growth is huge thanks to Asia, while we have not invested in raw materials for years due to corona and sustainability, a recipe for structurally higher prices.
Investing with high inflation takes some getting used to
It takes some getting used to to being back in a period of higher inflation. This is something from a previous generation, or perhaps even two generations ago. We have to go back to grandpa’s portfolio to see what it would have looked like then. Back then, Royal Dutch Shell was the cornerstone of the portfolio and Schlumberger, Mobil and Broken Hill were true blue chips. Marc Rich & Co got rich trading commodities.
Only for private investors are the opportunities to protect themselves against inflation better today than in the past. There were, however, house prices, which offered good protection against high inflation for a long time. The weight of sectors such as energy and mining on the stock exchange is remarkably low, despite the above development.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. His column appears on Thursday.
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