A closer look at inflation in 2022 - the outlook for investors

Inflation has been the dominant topic affecting investment markets for a year now and rates are continuing to rise. This has been driven by two different factors: 

Firstly, the COVID-19 lockdowns meant that most of us were stuck at home with little or no outside activities and we all gorged on buying goods for our home, work, entertainment or healthcare. In principle, this one-off surge in consumer spending should be ending soon as we run out of extra savings and have satisfied our home improvement needs.

Secondly, unfortunately, the double whammy came with the Ukraine invasion, sending energy and commodity prices sky-high literally overnight, in an eerie reminder of the 1970s. As a result, the dreaded word 'stagflation' (meaning high inflation and low economic growth) has resurfaced.

How does 2022 compare with the stagflation of the 1970s?

To determine where we stand now, and what may be to come for investors, our investment management team has looked at the comparison with the 1970s and also at a longer historical time frame. When we look at the stagflation of the 1970s, we can see that it has superficial similarities with our current experience, in that commodity prices soared and fed into inflation for the economy as a whole.

The differences, however, overshadow the apparent resemblance – as this graphic shows:

A brief history of inflation

Taking a longer perspective, we have hundreds of years of inflation history to rely on (mostly the cost of grain and other foodstuffs, but even metals). Periods of inflation were visibly followed by deflation and vice versa. Indeed, the graph below looks almost symmetrical on the upside and downside.

It was the two world wars that boosted inflation beyond recognition. Obviously, when countries spend a large part of their resources building weaponry whose sole purpose is to destroy, we waste money and the price of everything skyrockets, triggering inflation.

After WWII, the world gave itself a break from past horrors and decided to go all out in the opposite direction, caring for humans beyond any previous experience. This 'welfare state' had a huge cost for western countries, particularly with the post-war baby boom, and spawned an inflation time bomb waiting to explode, which it duly did in the late 1960s and early 1970s.

Forces that kept inflation low

The world wars and the creation of welfare states are therefore exceptions in a long history of moderate inflation. Where are we right now? The forces that have been keeping prices down for the last generation are as follows:

1. Demographics: population growth has turned low or negative in many advanced countries. The US, as an immigration country, is still the odd exception but could well have flat or negative demography soon. Population growth correlates with economic growth and in turn with inflation. The best example is Japan, where a falling population has caused inflation to be flat or negative for two decades. Other rich countries are likely to follow at some point
2. Globalisation: 20 years ago, China joined the World Trade Organisation and Chinese industrial products flooded the world, helping to keep manufacturing costs down. Despite posturing among western politicians who want to repatriate supply chains home, very little is happening. Indeed, cheaper countries like Vietnam are helping to perpetuate this system
3. Technology: as difficult as it is to measure productivity, we all use more data, information and services than we did five or ten years ago and are not paying more for it. This is keeping inflation down.

These three fundamental factors have not changed post COVID-19 and are not likely to change post Ukraine. Once energy price surges are behind us, inflation should revert back to historical levels, closer to the 2% target followed by most central banks. 

There are risks, though. If the Russo-Ukrainian war drifts into another cold war (or worse), the additional military expenditure will add to inflation. The end of the cold war was a boon, due to the peace dividend (spending less on defence) which brought budget deficits and inflation down. A reversal would be costly.

Also, the longer the current spikes in energy and supply chain bottlenecks last, the higher the probability that firms may be forced to grant higher salaries to their employees.

Investing during inflation means investing for the future

On balance, the structural forces keeping prices down are likely to win out, perhaps not over the next couple of years, but afterwards. It is vital that we invest for inflation right now, but this may have to be superseded at some point by another investment policy as inflation subsides.

At Canaccord Genuity Wealth Management, we’re managing our clients’ discretionary portfolios for inflation – for both the short-term and long-term challenges. If you would like to talk to us about our portfolio management services or have any questions about the impact of inflation on your investments, you can arrange a complimentary consultation with an investment manager.

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