Many people are too young to know what high inflation is like – and the damage it does to business sentiment and growth. They weren’t around when the UK consumer prices index (CPI) ballooned to 24pc in 1975, or 18pc five years later, before rising over 8pc again in 1990. They can’t recall the spiralling wage claims, industrial unrest, sharp cost of living rises and the crippling impact, on both indebted firms and households, of sharply climbing interest rates. 

​

Either way, it appears that inflationary pressures are now upon us again. The Bank of England insists this situation is transitory and we should “look through” rising prices. So why raise ultra-low interest rates or rein in quantitative easing (QE), the ongoing expansion of our central bank’s balance sheet? 

 

Annual UK inflation more than doubled in April 2021, with CPI jumping from 0.7% in March to 1.5% in April. Consumer prices are climbing at their fastest rate since before the pandemic. Inflation, for now, is below the Bank’s 2pc target, but for how long? Manufacturers’ input prices were up almost 10pc last month – a clear warning that supply chain inflation will feed into consumer prices. It’s already here – domestic electricity and gas bills jumped over 9pc in April, partly due to the lifting of a price cap. Clothing, food and footwear prices soared, as the high street opened up. And the temporary VAT cut introduced last July for some sectors expires in September, which will also push prices up. 

 

As the global economy recovers from Covid-19, a demand explosion is meeting supply constraints across a range of sectors, as producers everywhere struggle to respond after a year of lockdown. Consequently, US inflation last week hit its highest level since 2008. Keen to mollify financial markets, the Federal Reserve insisted it was in no rush to raise rates. However, history suggests that “base” rates set by policymakers matter less than rates set by the market. The US 10-year Treasury interest-rate yield – the return investors require to lend – now stands at 1.6pc. That’s up three-fold since the start of this pandemic and way above the 0.25pc rate set by the Fed – a clear signal that, whatever central bankers say, there are growing fears, backed by the weight of money in the markets, high inflation will soon be here. 

The US government is borrowing and spending huge amounts and Joe Biden’s stimulus plan which, if fully approved, amounts to another 15-20pc of annual GDP – dwarfing the rescue packages launched after the 2008 financial crisis. The ‘helicopter money’ cannot continue without consequences. 

​

The dollar ( for now at least) remains the world’s reserve currency, meaning that if the current money printing across the Western world sparks another credit crunch, the US currency will likely benefit from “a flight to quality”. Whilst the UK is a stable and mature economy, Sterling is no longer a leading ‘reserve’ currency and the danger from ongoing monetary stimulus is greater. 

The UK is forecast to grow by around 7-8pc this year – the fastest expansion since the Second World War. Retail sales are surging as the high street reopens, up 9.2pc last month. The Bank of England reassures us that UK inflation is “transitory” but history tells us that inflation can be a stubborn beast that can take many years to bring under control. Yet, at the recent Bank of England’s Monetary Policy Committee meeting there was only one vote to scale back the Bank’s long-running QE scheme… 

 

Since this Covid crisis began, the Government has borrowed well over £300bn, which has only been possible because the Bank of England has been hoovering up much of this bond issue, using newly created QE money. Yet even in this rigged market, UK gilt yields are up three-fold since this pandemic began – another clear inflation warning sign. 

​

The House of Lords economic affairs select committee is now investigating QE – the first official inquiry since this (previously theoretical) policy began. Some of the evidence has been eye-opening, making clear pre-Covid QE (largely contained within the banking system) is very different from the post-Covid variant (injected directly into the economy via furloughing and business support schemes). 

So, what are the implications for you and your investments and pensions? History tells us that the assets hit hardest are those which pay a fixed return, with no potential for growth or protection from the erosion of inflation. So, cash deposits and long duration bonds (particularly low yielding government bonds) tend to be hit particularly hard. Equities (and particularly ‘value’ equities paying regular dividends) tend to perform better in periods of moderate inflation, as growing profits and dividends compensate for the inflationary erosion. Best of all tend to be real assets not dependent on static incomes, such as commodities, infrastructure and gold, particularly in periods of hyper-inflation. 

​

As you will probably be aware, our investment process uses actively managed ‘core’ funds for much of your asset allocation and these funds have been making tactical shifts in recent months to take account of the inflationary threat, increasing their holdings of index-linked bonds, gold, infrastructure and ‘value’ equities. For lower risk investors, our bond funds are ‘strategic’, meaning they can buy across the whole bond universe, and again, they have increased exposure to index linked and short-duration bonds as a hedge against inflation. 

​

It remains to be seen whether inflation will be a prolonged outcome of the developed world’s QE experiment, but we take the threat seriously. As touched upon above, the immediate outlook for the global economy is one of strong recovery in economic activity following last year’s recession. This short to medium term outlook is likely to be positive for most investment markets but we need to be also aware of the longer term potential for damaging inflation. We believe our portfolios are well positioned for this threat.