Inflation: a hall of mirrors for the investor

John Harney


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LCP clarity:

With inflation varying by sector, it pays to get to grips with your investments’ specific inflation risk.

LCP insight:

Think about how inflation can impact your investment goals in the short and longer-term. Our experts are on hand to help you manage the risk of inflation.

Knowledge is power when it comes to investing. Knowing what is happening behind headline inflation figures is important. It helps to be aware of which sectors have experienced inflation and are likely to see prices change in the future. Depending on which industries and sectors are in your investment portfolio, you may have an exposure to more or less inflation risk than that represented by consumer inflation measures. But looking at inflation is a lot like walking into the hall of mirrors at a funfair. There are all sorts of distortions and illusions making it hard to see things as they really are. And with inflation maybe coming over the hill, as my colleague Rory discusses in his article, inflation is more relevant than ever for the investor. Inflation right now is a real mixed bag, with prices of some goods and services going up. Others are either going down or remaining stagnant. Inflation also depends on the basket of goods you use to measure it. For instance, housing costs rise faster than most consumer goods over the past 50 years, house price increases have averaged a very large 8.7% each year.

House price increases have averaged a very large

8.7% each year

I’m going to walk you through the hall of mirrors I explored when I did a deep dive into inflation in 2021 and the lessons I learned along the way.

Firstly, the movement in prices in sectors can be counterintuitive. According to the ONS, rising prices for pharmaceutical, medical and therapeutic products slowed in June 2021 compared to the same period in 2020. It would be easy to assume that as this industry opens to non-emergency treatments, prices would rise, but the data suggests it has not.

So that’s our first lesson: Do not always trust your gut.

Some of the headline annual inflation numbers we are seeing right now are large. Some of this is at least partly a result of using 2020 as a base – a low base, as it was a time of huge economic contraction. This potentially overstating is called a base effect. As the economy bounces back, we could potentially see some high economic growth and headline inflation numbers.

Our second lesson: Be aware of the base impact of 2020 on headline inflation statistics.

In any inflation measure at any one time, there are long-term and short-term drivers. There are some cases highlighted recently, such as container shipping issues and 4.4% second-hand car inflation in June (driven by short-term supply issues for new cars). These tell us very little about how we might reasonably expect inflation to look in 5 or 10 years’ time. This is not to dismiss short-term measures – they can give us important information about consumer, industry and market behaviour, and point us to trends that may become permanent.

For instance, and not to alarm you, but there is evidence that the price of your morning double shot mocha-frappe-latte with a shot of syrup may rise. There are several components of this possible increase.

In part, it is due to a very low coffee harvest in Brazil this year, caused by drought. Climate change is certainly playing its part here, alerting us that it is a risk to inflation in the short term, as well as over a longer time horizon. The logistical challenges of the transportation of coffee beans present a real issue too. In addition, political unrest in Columbia also halted the exportation of beans out of the country, further pushing up the prices.

The barista who makes your coffee, or the supermarket worker who sells you the beans, also needs to be paid. Wages had been rising before the pandemic, but as supply and demand evolve post-pandemic, pay is increasing even more.

Lesson three: It’s not just consumer demand that can drive inflation.

Speaking of consumer demand, let’s not forget about it. Although we may live in usual times, the simple fact remains that either consumers spend money, or they don’t. One of the big questions about inflation is whether demand will bounce back to pre-pandemic levels. The pattern of spending over Covid-19 lockdowns looked very different and we do not know the long impact on certain sectors yet, as well as what the spending patterns of ‘accidental savers’ will do. Habits are hard to change once formed. For instance, how many of us will take the tube to work daily?

Lesson four: Don’t forget about consumer demand either!

Our fifth lesson: Remember there is always a context.

We are operating in the midst of what is (hopefully) the tail-end of a global pandemic. With Covid-19, the world has experienced a large shock to society and the economy. Where this has occurred historically, we have seen that it can lead to hyperinflation, such as in 1920s Germany in the wake of the First World War.

Finally, those of a certain age will remember a spoken word song Everybody's Free (To Wear Sunscreen), where the narrator tells us to “Accept certain inalienable truths: prices will rise, … you too will get old- and when you do, you'll fantasise that when you were young prices were reasonable”. Maybe this song is about the huge increases seen in house prices! So, I’m minded to agree that prices will rise in the long term.

If investors are in it for the long haul, they simply factor this into their investment growth targets. If your timeline is more immediate, then these shorter-term drivers are more relevant and should be kept an eye on. This is particularly true if inflation is potentially on its way.

Our final lesson: Know whether your focus is long term or short term, and frame inflation accordingly in your strategy

Inflation is complicated, and, as you can see, more complicated than you might think. So, it is wise not to take macro inflation statistics at face value as or use them to shape your whole strategy.

That said, getting clear on your focus and doing a deeper dive on inflation statistics is a powerful way for you to assess your exposure to inflation risks in the long and short term. By looking behind the headlines, you can leave the hall of mirrors and hit the metaphorical bullseye when it comes to your investment decisions.

Key takeaways

1. Beware of your gut instinct

2. Look out for base effects

3. See beyond consumer demand

4. But don’t forget about consumer demand

5. Always consider the overall economic context

6. Be clear on long-term versus short-term concerns

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