Inflation can damage long-term wealth, especially in periods of vast liquidity injections. John Maynard Keynes, the influential 20th century economist, stated that rampant inflation is the most destructive force for an economy, one that “confiscates an important part of the wealth of their citizens.” In 2020, a wave of global monetary and fiscal stimulus tested the boundaries of economic theory in the fight against COVID-19. Approximately 16% of the US dollars in circulation were created in 2020. More liquidity has been created globally in 2020 than the liquidity that existed before the Global Financial Crisis (“GFC”) of 2008. Following immense fiscal spending by global governments, public debt-to-GDP ratios have risen to all-time highs, exceeding 100% for the first time in the U.S. Inflation expectations remain tame, but investors need strategic asset allocations to counter such economic extremes.
Inflation is caused by either rising demand (demand-pull inflation) or rising costs (cost-push inflation). Demand-pull inflation occurs when overheated demand outstrips supply, which could be due to a growing economy, consumers choosing to spend sooner rather than later ahead of expected price rises, and the expansion of the money supply. Cost-push inflation occurs when the cost of supply rises, which could be due to supply shocks from geopolitics and natural disasters, rising wages from the unionization of workers, rising cost of imports due to depreciation in the importer’s currency, the rising cost of compliance with government regulations, etc.
Inflation is not bad news for everyone. Borrowers tend to benefit from inflation because the revenues from the goods and services they provide rise while the value of their debt remains static.
Deflation, on the other hand, is when prices decline, stunting GDP growth. In the aftermath of the GFC, economists were baffled that the huge central bank asset purchases failed to trigger GDP growth. One hypothesis was that the cost reductions arising from the digitization of economies has suppressed inflation since the 1990s (see Figure 1).
The sheer quantum of policy responses to COVID-19 in 2020, dwarfing those following the GFC, raises the risk of inflation after a decade of undershooting central bank targets. According to the January 2021 Global Fund Manager Survey by the Bank of America, the percentage of market participants who believe that inflation will rise has increased to all time high of over 90% since the survey began in 1995 (see Figure 2). Central bankers have been targeting inflation levels above 2% to reduce the large debt burden of corporations and governments and encourage consumer spending to reduce the risk of deflation.
Figure 3 illustrates how inflation erodes the purchasing power of $1 million over 30 years. An increase in inflation from 1% to 3% inflation raises the loss in purchasing power from 26% to 60%. The losses widen over time, in contrast to the long-term capital growth with compounding.
Headline inflation is measured by the Consumer Price Index (CPI), based on what an average household spends on a weighted basket of goods and services. The Coutts Luxury Price Index measures the prices of high-end goods and services, with higher weighting on the price of restaurants, hotels and recreation. Since its launch in 2016 until the end of 2019, the Coutts Luxury Price Index has risen 4.7% annually, compared to 2.3% for the CPI. During that period, the price of luxury goods rose 17.6%, almost twice the CPI basket.
Several asset classes can hedge against inflation. The price movements of certain commodities, like gold and other precious metals, are independent of floating currency prices. Real assets, such as real estate and infrastructure, also hedge against inflation. Real estate prices and rental income tend to rise with inflation, while income from most infrastructure assets is linked to inflation through regulation, concession agreements, or long-term contracts. Mega-cap stocks also hedge against inflation as they can raise prices to counter inflation without sacrificing market share.
Inflation is among many risks that must be managed as markets change. The Family Office ensures that your investment portfolios are hedged adequately at all times. Our solutions aim to preserve investors’ wealth by spreading the risk across the most promising asset classes, sectors, and geographies to achieve the best risk-adjusted returns.
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