The impact of inflation on investors - July 2020
Three very different historical episodes can help us understand the impact of inflation on long-term investors in different scenarios. While these cases are not necessarily representative of what will happen in future, they provide useful perspective on a range of outcomes that have historically prevailed.
Germany funded their World War I campaign entirely with debt, planning to repay their creditors with the spoils of victory. After losing the war, the country’s financial situation continued to worsen as a result of the very punitive war reparations required by the Treaty of Versailles, which had to be repaid in either gold or foreign currency. To try and meet these obligations, marks were printed indiscriminately and used to buy foreign currency, resulting in a complete collapse in its value. When this inevitably led to default, France and Belgium occupied Germany’s industrial heartland, intending to exact payment in commodities and goods. German workers resisted this invasion and went on a general strike, further reducing productivity and increasing demands for financial support from the government. Eventually sanity was restored by
accepting that the central bank cannot fund government debt directly and by issuing a new currency indexed to gold at the same rate as the pre-war mark.
Impact on asset classes
Government bond holders were wiped out by hyperinflation in less than three years (by 1925, 2.5% of the value of bonds were reinstated). In turn, the German stock market increased significantly during hyperinflation, with equities increasing in value by approximately 3.5 times (measured in US dollar), according to JP Morgan estimates.
The 25 years post WWII was an era of economic expansion, known as the ‘long boom’. The global economy expanded by 4.8% per annum and unemployment in the UK fell to 1.6%, compared to an average unemployment rate of 13.4% in the two decades prior to WWII and 6.7% in the 1970s and 1980s. Financial crises were rare. Energy costs collapsed after the war, agricultural productivity increased and new industries such as aviation, radio and television all contributed to growth. This expansion was further supported through significant investments in infrastructure, growing the welfare state and better international co-operation. However, this period was not completely benign from an investment perspective. To deal with elevated debt levels, governments introduced progressive income, capital and inheritance taxes and in the case of the UK, resorted to financial repression, consisting of higher inflation rates, lower interest rates and capital controls.
Impact on asset classes
Rapid growth was supportive of the UK equity market, which on average produced an annual return of 10% ahead of inflation during the 1950s and 1960s. Financial repression created a less happy outcome for UK bond investors, who received an annual return of 1.9% below inflation over the same period.
Monetary policy was too loose, allowing high inflation expectations to become entrenched.
The Phillips Curve, positing a fixed relationship between unemployment and inflation, neatly fitted US data during the 1960s and thus became conventional wisdom. It theorises that as the unemployment rate falls, labour market conditions become tighter, forcing employers to pay higher wages. The reverse would happen when unemployment increased. If this holds consistently, policymakers can target desired employment levels for a small, predictable change in inflation. Unfortunately, this relationship broke down in the 1970s, as predicted by Milton Friedman’s monetarist theory. His explanation was that informed workers would, over time, adjust their inflation expectations and demand higher wages, causing the shortterm relationship between inflation and unemployment to break down in the long term. Monetarists believe prices need to adjust to the level of economic output, not the other way around. The need to anchor inflation expectations is why we still have inflation targets today.
While inflation was increasing, the US economy disappointed. The 1973 OPEC oil embargo caused fuel prices to increase nearly fourfold, the US lost global competitiveness relative to Japan and Germany, debt levels soared as a result of the Vietnam war and experiments in price controls caused a major economic contraction, which led to stagflation: low economic growth coupled with stubborn inflation and high unemployment.
Impact on asset classes
Both US equities and US bonds performed below the long-term trend. Equities still did better than bonds though, beating inflation by 0.5% per annum, while bonds underperformed inflation by 1% per annum.
What about South Africa?
We have already moved closer to financial repression locally, with policy interest rates moving from 6.5% in January (around 2.5% real), to 3.5% today, which is less than 1.5% head of the inflation rate at the end of May 2020. Longer-dated income assets still provide the potential for above-average real returns, reflecting the bond markets’ concerns about the rapid increase in South Africa’s government debt. In July 2020, the 10-year and 20-year government bonds yielded 9.5% and 11.5% respectively.
We have already moved closer to financial repression locally.
We expect inflation to remain at or below 3% until early 2021, which creates room for further interest rate cuts this year. It should be noted that inflation indices have become less reliable during the social distancing era, with significant changes in behaviour and reduced availability of goods and services as a result of lockdown rules, making the basket less representative of actual spending.