An old married couple have just moved into their dream home.
They are surrounded by half their life savings in the form of new furniture and decor. As the husband puts his feet up in front of the fireplace, his wife suggests they talk about buying home insurance, you know, just in case of flooding or a fire.
He replies, 'Nah, the chances of a flood or, indeed, a fire burning down this house are so slim, it’s not really worth considering.'
On a scale of one to 10, how loudly would you scream at this couple to act on the possibility of a fire anyway; not because the chances of it happening are slim, but because, if it did happen, the impact would be cataclysmic?
Where markets are concerned, uncontrolled inflation is as close to a house fire as you can get. Left to rage, the impact could be devastating for economies, markets and portfolios that are not appropriately prepared. Like the couple in our story, it would be reckless for investors not to think about how their portfolios will fare if the worst were to happen.
Inflation remains the single biggest investment risk on the horizon. On this point, it seems most market participants agree. Similarly – along with industry and central banks – they are largely united in the view that present inflation is transitory and will likely remain under control.
On the whole, we share this view. But inflation has, in the developed world, been so well constrained for close to 40 years that the market has been quick to shrug off the possibility – slim as it may be – that all of us could be wrong. It is this complacency that concerns us.
There is no crystal ball, and history has a way of telling us what we want to hear. After all, there is a history to support every possible point of view.
Parallels can be drawn between where we are today and the Great Inflation of the 1960s and 70s, when policymakers put rapid inflation down to transitory factors – droughts, oil prices and union activity – and were ultimately proved wrong.
When inflation woke from its decade-and-a half-long sleep in the spring of 2020, there was the widespread presumption that it would fade away by the summer.
Now, on the cusp of another winter of rising prices, even the chair of the US Federal Reserve admits that “we have to be humble about what we know about this economy”.
While we may be able to make educated guesses about the impact of current inflation on wages, economies, and demand, we are less certain about its impact on the most unpredictable of variables – human emotion. Enter, the turbo-charger effect.
Let us return to the couple in our story above and imagine they also own a jam shop. As they sit in front of their new fireplace watching the 10 o’clock news, they see a story about inflation rising to 10 per cent.
They nod along because they have, indeed, already begun to feel the pinch of higher costs. The next day, they go to their jam shop, pull out their pricing gun and discuss how high they should raise their prices to offset their rising costs. They dismiss hiking their prices by just 10 per cent because, after all, inflation is still rising; they do not know where it will end and they do not want to have to get their pricing gun out again any time soon.
Meanwhile, they see that the clotted cream seller across the street has risen her prices by 12 per cent. And, of course, there is no afternoon tea without clotted cream and jam, so they decide they can get away with raising their prices by 15 per cent.
Now, imagine this conversation is going on up and down high streets across the world. All over the globe, pricing guns are going off as people make a guess about how high they will be able to raise their prices without impacting demand.
With US inflation already at 6.8 per cent, the turbo-charger effect raises the real possibility of inflation hitting double digits before it eventually recedes.
As we look forward to the Christmas break, I hope I have not made it feel too much like Halloween. In fact there is much to be positive about as we look towards 2022, but I hope I have, nonetheless, made the case against complacency where inflation is concerned. I encourage investors to take a close look at their portfolios in light of all that we know – and all that we do not know – about the economic environment we are in.
Andrew Jackson is head of fixed income at the international business of Federated Hermes
