Why the markets hate inflation
I remember opening the mail with my mother at the letterbox one day in the late 1970s or early 1980s reading a letter from the bank that our mortgage interest rate had increased to…wait for it…18%. Inflation averaged 11.5% pa in the 1970s, peaking at 18% in 1980, as goods and services pricing adjusted to the OPEC oil shocks starting earlier in the decade: interest rates had to follow. It took around 30 years to tame the inflationary beast, namely from a solid combination of fiscal prudence and strict monetary policy focus so that we have enjoyed a benign inflationary environment for at least most of the 2000s.
And now we find ourselves in late 2022 with inflation rearing its ugly head again. Inflation has become central to our zeitgeist this year in a way that it hasn’t been for many, many years. It’s all consuming in each of our daily conversations. Those of us old enough remember the days of high inflation, the 18% and greater mortgage rates that I mention above, and we don’t want to go back there.
The latest inflation reports from around the world might not be as bad as commentators were predicting but still signify bad news. The latest CPI here in NZ was +7.2% for the year ended 30 September while it was nearly identical over in Australia at +7.3%. The US and UK seem to be able to calculate their CPI quicker than us (amazing given the US tallies prices of 80,000 goods and services!) so their October CPIs are 7.7% and 11.1% respectively. Yuk! To put these price rises in perspective, back in 2020 the US CPI was just 1.2%.
Where does this inflation come from? Why does high inflation hurt? Does anyone actually benefit from high prices? And importantly for us investors, what does it mean for the share market?
Inflation is the term used to describe the (hopefully) gradual rise in prices throughout an economy. We don’t like high inflation because it generally translates to a loss of one’s purchasing power, meaning your dollar will not buy you as much as it did yesterday. And it typically brings with it higher interest rates which borrowers dislike. Wages sometimes rise on the back of higher inflation but, at best, not quite as much.
Most of the time, inflation is the result of a booming economy, one in which people have surplus cash and tend to spend it: demand exceeds supply. If consumers are buying lots of goods and services businesses may raise prices because they lack sufficient supply. Or companies may choose to charge more because they realize they can raise prices and improve their profits. Over the past couple of years, we weren’t able to spend as much because of months in lockdowns but repeated government stimulus and support payments have helped consumption bounce back and this release of pent-up demand is at least partly driving our current inflation. Sometimes inflation can come from developments that have little to do with demand conditions. And this is probably the case this time round as limited oil and gas production is making energy expensive, supply chain problems are keeping goods in short supply and labour immobility is limiting services: Coronavirus responses caused factories to shut down, has clogged shipping routes, helping to limit global supply and definitely caused prices to rise.
Inflation is unequivocally bad, read my eroding purchasing power comments above. Inflation hits the lowest-income families harder because essential items make up a much larger portion of their budgets, leaving less for discretionary spending causing both a loss in quality of life as well as financial distress. By definition, savings levels drop when inflation is high as households need to spend more of their income on a given level of goods and services. Inflation also makes all our savings less valuable. If you’re not able to save as much as you used to, you may be less prepared for financial emergencies, unexpected bills etc. And if you have money saved already, that decreased purchasing power means your savings might not stretch enough to cover an emergency or unexpected bill or that holiday to the sun during wintertime.
And the most important part for us investors: high inflation typically spells trouble for companies and their share prices. Financial assets in general have historically fared badly during inflation booms, while real assets like houses have better held their value. A company needs to make higher returns to break even. Companies that lack pricing power, meaning that they cannot easily pass costs on to customers, suffer the worst, because they are forced to absorb input cost increases by taking a hit to their profit margins. Moreover, interest rates tend to rise during times of high inflation increasing debt servicing costs and the broader cost of capital. During periods of inflation, companies grapple with pricing issues, cost increase, probable margin squeeze and debt costs. And in the current inflationary environment, all the supply-side and labour issues are there to deal with too.
This is the reason why share markets are down so much over the past year: investors, fund managers and other participants have been adjusting expectations for the uncertain outlook. The downward move has simply priced-in all this uncertainty and likely lower aggregate profitability and expected dividend flow. That is also why we saw a surge in markets over the past week with the abovementioned US CPI coming in lower than the market thought. Maybe then, says the market, we’ve seen the worst of inflation and most of the increase in interest rates in the current cycle. For investors, high inflation means bad news.