Corona Virus Chronicle (XV) - Inflation - a real concern
'Think of this as the choice that a mid life crisis couple will make between buying a new Harley or maintaining a fully stocked larder. In reality there is no choice.'
The rate of inflation is the change in prices for goods and services over time. Measures of inflation and prices include consumer price inflation, producer price inflation and the House Price Index.” Source: Office for National Statistics (“CPIH”- Consumer Prices Including Housing costs)
According to the official statistic, “CPIH” inflation, was down in March at 1.5% from 1.7% in February and the direction for the statistical version of inflation is further decline. The chart shows year on year inflation in the UK, is on a downward trend. This is the case in other countries and regions. So, in a world of reduced wages, rising unemployment and general economic insecurity, the disinflation trend means the cost of living is not rising as fast as it used to and is perhaps one thing less to worry about. (Deflation occurs at the point where inflation indices point to negative year on year price changes). Or perhaps not? Technical issues can distort figures.
Collecting information on prices in this time of super-fast broadband and abundant data should be easier and more reliable than at any time in the past. However, the reality of inflation data collection is that it still, in part, relies on “shoppers” submitting prices to the ONS. Right now raw data of this nature is actually hard to compile.
The inflation basket of goods, over the years, has evolved to reflect expenses and purchases that form part of an average household’s costs. This means that as society has changed and our expenditure preferences have changed, so has the basis for the index.
If we were to look at the make-up of the basket of goods now and compare it with a basket that might have been used for CPIH from say, thirty years ago using “CPI”, they will look very different as digital cameras and even outboard engines form part of today’s shopping basket. Today's basket is diverse and drawn from a range of tech, holidays, flights and leisure activity items that would not have appeared in 1990 because they had not yet been invented or were not being purchased in sufficient quantity to warrant inclusion as a significant data point. The basket items that are persistent across time however are basic foodstuffs, even though these basic items may have evolved. What this points to is that household expenditure has been wider ranging and the weighting of basic items in the index has declined.
THE INDEX PROBLEM
This overall index basket, when viewed in light of the pandemic causes a problem. The “temporary” inability to consume a vast array of items that make up CPIH, may eventually evolve to a permanent decrease in their use within households. It is entirely possible that CPIH does not - and will not - reflect the true basket of goods households regularly use in this tightly focussed world. Potentially, we will see the composition of the index being rebalanced to a great extent and in a short period of time to reflect our rapidly changing world.
The UK’s index of inflation, the RPIH (remember; All items including housing costs) has fallen to an annual rate of +1.5% for the period ending in March. The “basket of goods” used to calculate the index covers not only consumable goods, but services as well, such as insurance and housing costs.
The data in this diagram, drawn from the ONS, details the shopping basket. With this we can take an educated guess that non-essential items, like air travel will provide lower cost inputs as demand has fallen dramatically, in time this price fall will reverse sharply, but the weighting of air travel will have to fall as flights will not be so regularly consumed. This “cancelled” purchase effect on many basket items is currently keeping the lid on inflation.
The basket of goods is heavily skewed away from basic items; Food & Beverages represent just 11.5% of the index, whilst Transport, Recreation and Restaurants make up for 34.8%. As these latter items are consumed less in the future, they should form a lower portion of the basket.
Problems caused by the virus may persistently affect food supply chains with attendant price rises. So, we should expect to see the proportion of the basket devoted to basic consumables actually increase at the same time pricing for non-essential or discretionary goods falls away. As basic items are currently a small index segment, it will take a long time for this to really affect the index and if we start to fly and travel again, those costs will once more outweigh the effects of basic price rises. Indications are that we will expect air travel costs to rise quite dramatically. We can all get by without air travel of course and the true effect of rises in these items on households may be minimal. The real effects of price rises for basic items will be felt quickly in terms of personal circumstances and unless there is a vaccine, non essential items will be ever more expensive.
In due course, we can also look forward to rises in taxes to pay for the ongoing relief costs. How this is going to happen is unclear, no one is talking about it, but perhaps a combination of tax increases to value added (GST), local rates and income will all add to the household burden? Concurrently, we expect that personal earnings will generally decrease as the effects of reduced employment time, pay cuts, loss of productivity, reduced income from savings and outright unemployment set in…. And of course, in the UK and Sterling arena, we have Brexit, which is seen as a potential inflationary force.
These are early stage conceptual thoughts, but there would seem to be a reasonable possibility of basic living costs rising, gradually causing a feedback loop into inflation as these items eventually assume greater relevance in the index at the time of an economic swoon. The problem is then what to do about this type of inflation? Hiking interest rates at a time of recession would be harsh, particularly as the concept of higher rates is supposed to take the edge off excessive demand led consumption. If inflation is caused by basic goods going up because of cost-push supply chain issues, then interest rate rises will place more of the population into some form of poverty.
The other point to consider is the two sided nature of rising prices. As prices rise, the seller receives more money for goods, whilst the buyer pays more money. If we also consider that basic goods increase at a time of low interest rates, the effect on the moderately wealthy; asset rich, cash poor segment who are now relying on small pension pots and cash savings, which do not provide any level of usable income, is quite stark.
On top of all this, as some companies fail and others merge in this difficult climate, a reduced segment of “remaindermen” producers, distributors and retailers will be left to pick up the pieces. These companies can benefit from reduced competition in terms of pricing, leveraging buying power as the business expands, whilst becoming more dominant. In this environment, margins can be increased.
Over time a higher percentage of consumer spending will need to be directed toward the essential basics of living. The declining baby boomer spending spree that has fuelled so much consumer led growth over the past few decades will fade out more quickly. Think of this as the choice a mid life crisis couple will make between buying a new Harley or a maintaining a fully stocked larder. In reality there is no choice.
The debate on inflation is only just getting started with several protagonist viewpoints encompassing areas such as the devaluation of money, against the effect of lower demand on the other. Other factors such as supply chain worries, corporate conglomeration and deglobalisation add to the debate mix.
Wither deflation or inflation?
Time will tell. However, for investors there is a real need to develop strategies that provide a hedge against the possibilities of both types of “flation”. There is no perfect hedge against the risk of rising prices at this time. Protection can be covered by investment in “short of supply” precious commodities such as Gold, combined with a diverse portfolio of Equities, or index linked bonds. Deflation strategies mean holding cash and bonds, where future income cashflows become highly prized - a difficult concept to embrace when interest rates are so low and probably turning negative.
Whilst the “flation” jury is out, it is better to keep one’s options open, remain vigilant and hold a balanced portfolio… and its probably best to put that new Harley on hold for now.
Head of Investments
SaSo Strategic Advisers
15th May 2020
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About the Author
Peter Smart, Head of Investments
Peter has been involved in investment markets since 1985, working within the private client areas of two global banks and for 22 years as the fixed income specialist for the UK Wealth manager, Brewin Dolphin. More recently Peter formed part of the investment team at bridport in Jersey specialising in the provision of specialist, income focussed portfolio’s.