This article is a reboot of a piece that I wrote a couple of years ago while at Quilter Cheviot, which with the benefit of hindsight turned out to be relatively prescient. I know, I’m as shocked as you are.
In order to get a little more juice out of the orange, I figured I would give the original post a fresh lick of paint for this week. Enjoy.
Back in the heady days of summer 2022, when the country’s attention wasn’t consumed by rather more pressing matters, inflation was the topic de jour around dinner tables up and down the country.
Whenever economic matters enter the public consciousness it is rarely good news, and so it had proven again with a “cost of living crisis” sparked by the highest bout of inflation that the country had seen in a generation.
The financial media predictably made hay out of the issue, with talking heads lining up to debate the answer to “The Big Question”. Where was inflation heading next?
Broadly speaking, back in July 2022, there were four potential outcomes:
More inflation (prices continue to go up) - a really bad outcome;
Deflation (prices fall) - a far worse outcome than you might think;
Disinflation (prices continue to go up, but more slowly than they had been) - probably best case scenario; and
Stagflation (economic growth slows, but prices remain stubbornly high) - bad.
It was a time for humility for those charged with the thankless task of making economic predictions because we were living through a very strange period. We still are. A real time experiment of what happens when you shut off the global economy for a year, and then suddenly jolt it awake again.
When the starting pistol was eventually fired to signal the end of lockdowns, "revenge spending” drove up the cost of fun. Add in supply chains that were knackered, and higher energy prices due in no small part to Russia’s invasion of Ukraine. The inflationary picture was pretty ugly.
But, as they tend to, things began to resolve themselves. Capitalism (which exists to find a balance between supply and demand) did its thing. Supply chains sorted themselves out, and although the prevailing mood amongst consumers still appears to be YOLO, it does increasingly look like runaway inflation is yesterday’s problem.
Put another way it seems that for now we have ended up with the best of the four potential outcomes.
Long term inflation rates in the US, UK and Eurozone. Source: Factset, via @JonathanRaym X.com
The inflation numbers quoted on the above chart, and the most commonly used, refer to the rate of change in prices over the prior twelve months. So while prices are still higher than they were a year ago - they aren’t rising as quickly as they were and they certainly aren’t spiralling out of control.
You could even, if you were feeling brave, look at the above chart and conclude that Jay Powell was right all along. Inflation was transitory after all.
Eighteen months ago, in order to get a sense of what the impact on markets may be in each of the four potential inflation scenarios outlined above, I (along with Billy Ewins at QC) went and looked at the performance of stock markets going back to 1970 - and split it up into periods where inflation was rising, and where it was falling.
Here are the numbers, updated to include the returns for UK and Global markets from August 2020 to October 2022 when UK RPI topped out at 14.2%.
Source: MSCI & Quilter Cheviot. Inflation rates are UK RPI. UK stock market returns use the MSCI UK Large Cap Index, global stock market returns use the MSCI World Index (both including dividends & in GBP). All market returns are annualised.
Some observations.
The direction of travel for the rate of inflation (whether inflation is rising or falling) seems to matter more for equity market performance than the absolute rate of inflation (whether inflation is high or low).
Falling inflation seems to provide a tailwind for equity market returns. During periods of rising inflation, the average annualised return for the UK market has been 13.3% on average, while global markets returned 8.1%. During periods of falling inflation, on average UK markets returned 16.8% a year while global markets returned a whopping 24.5% annually.
The UK market therefore appears to outperform when inflation is rising, and underperform when inflation is falling.
This pattern has repeated itself since inflation topped out in October ‘22. Global markets (led by the US) have walloped the UK market’s performance - returning 18.9% versus 9.7% from 31st October 2022 to the time of writing. Again, these numbers include dividends and are in Sterling terms.
I reckon that the UK tends to outperform during periods of rising inflation due to its long standing, relatively high exposure to energy and commodity sectors. These sectors tend to do well when inflation is going up and when the economy is firing.
For us as investors then, is it as simple as buying the UK market when inflation is rising and switching into international stocks when inflation is falling?
Well sadly, no. First of all, we need to be sure that the above pattern will hold into the future - far from guaranteed. And second, we need to be able to determine in real time when the inflation rate has stopped rising and falling.
This is an impossible task. If you don’t believe me, then look at the below data showing the rate of inflation during the 1970’s. Massive swings in the inflation rate, and numerous inflexion points.
Getting a handle on where inflation was going next was like trying to juggle eels.
Source: Office for National Statistics
The world has moved on a lot since the 70’s but I think that the point still holds.
The inflation number will move around, and it will move around a lot from time to time. Deciding that you are one who knows when it has bottomed or topped out requires some combination of hutzpah and ignorance.
As ever, the best solution is to buy and hold a globally diversified basket of stocks so that you will always have some exposure to whatever is working at any given time.
Not exactly news, but one of the challenges with this job is working out new ways to say the same thing over and over again.
One final thought. Now that inflation increasingly appears to be yesterday’s problem, the period that we have lived through will hopefully serve as a reminder to us all about why we invest in the first place.
For a generation of investors, late 2021 into 2022 will have been the first time that they have ever encountered a proper move in inflation. I was one of them.
The 2010’s saw almost no inflation. We had largely forgotten that the problem could exist. It had got to the point where clients would stare blankly back at you when you outlined the need to invest in order to protect the real, inflation adjusted value of your money over long periods.
Not anymore. We have just lived through a, fairly visceral, reminder of why investing for the future is not just a “nice to do” - it is an absolute necessity.
Have a great weekend.
Past performance is no guarantee of future returns, and none of the above constitutes investment advice.
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