Everything You Need to Know About Inflation

Why is inflation important?

High inflation was the main culprit behind a tumultuous decade of the 1970s. Investors learned their lesson back then - inflation meant higher interest rates and bear markets while a period of declining inflation of the following two decades brought a great bull market. Developed economies have not witnessed such high inflation levels since then - until recently. 

What a lot of people are now aware of is that low and stable inflation is actually a desired phenomenon. It’s the grease of economic growth that helps planning business and manage costs. Without inflation some prices would be falling and that would be challenging for affected businesses.

However, let inflation rise too much and it’s becoming a problem. First of all, it introduces uncertainty. Businesses cannot plan their budget, households do not know how much exactly their incomes are worth. Mortgages are becoming expensive, currencies are losing competitiveness and equities suffer from higher interest rates. Consequences are abundant; there's just too few investors remembering them. The last episode of high inflation seems remote, but it can be closer than many think.

Can we learn from the past?

The similarities to the first half of the 1970s are significant even if looking superficially. The war (then in the Middle East) and the associated rise in oil prices characterise both periods. Amazingly, even the scale of the commodity price increase was similar. 

In 72-74, it was 182% as measured by the GSCI price index, while now (April 2020 to June 2022) it is 199%. However, there are even more similarities. Let's start with the positives. In 1974, a peak in the commodity market also meant a peak in inflation (for several more years). The commodity price index peaked in November 1974, and that's when the highest inflation was recorded, while core inflation (excluding energy and food prices) peaked 3 months later. Superimposing the index and annual inflation shows a clear correlation.

This would seem to validate the market's expectation of a decline in inflation, confirmed recently by the much lower ISM Prices Paid Index. Here, however, both show a decline in the index even before the GSCI peak, and the inflation relationship itself seems to be stronger just with the GSCI index, so the ISM's component of prices paid is rather of secondary importance to us.

What does the future hold?

With the strong labour market and high inflation, the Fed may ignore persistent inflation at their own risk. Relaxing monetary grip too soon resulted in another inflation spike in the ‘70s and the Fed - despite promising signs from the commodities market, could be looking at a very similar scenario. 

It now has two options:

• Option 1 - PIVOT. This is what the markets are looking for. The hope is that the Fed backs off from the policy tightening and allows for economic recovery. That would most likely result in inflation return, but for the markets it would be a worry for the later. The Fed pivoting could be positive for US indices, oil, precious metals, crypto currencies and negative for US dollar. 
• Option 2 - rooting out inflation. This is what the Fed keeps communicating: we want to make sure inflation is down at the 2% target and stays there - they say. The question is - could they keep tightening monetary conditions in the face of a potentially painful slowdown? If the answer is “yes” that could be negative for US indices, oil, precious metals, crypto currencies and positive for US dollar.

Which markets should you keep an eye on?

There’s an ongoing debate on the relationship between equity markets and inflation. Equities are physical in the sense that they are backed by actual companies. Since inflation reflects prices of goods and services, it should eventually find its way into revenues of companies selling those. From that perspective equities can be seen as an inflation hedge. However, looking at historical patterns, there’s certainly no linear relationship between company revenues and stock prices.

On the other hand, commodities are considered a leading indicator of inflation as prices of goods and even services are highly dependent on raw material costs. Therefore, there is a perception that commodities are good inflation hedges and the first that comes to mind is gold. But, does that still hold true?

The whole world is highly dependent on conventional energy sources like oil, natural gas and coal, so we can find a clear link between energy commodities and inflation. When a price changes moderately, producers do not change prices immediately as they can benefit from the economy of scale. However, the problem is when the price multiplies several times and producers' costs have to be passed on consumers. Does that make commodities an attractive asset during inflation?

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