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In this week's episode, we’re talking inflation with LCP’s Jon Camfield. We catch up on the latest inflation stats, how investors and pension schemes should think about these, and get onto the big question: Is this a temporary or a structural shift into a new regime? Have we got lazy over the last two decades with low and stable inflation? And what conventional assumptions would need to change if we enter a new regime?

The last time we spoke to Jon was June 2020, and we were facing a vastly different environment. Listen back to our previous episode to see how things have changed!

We discuss: 

Inflation – a recap of facts:

• Inflation is the rate at which prices of goods and services increase measured as a % per annum
• Lots of averages – each person experiences different, ONS measure different households, and with/w/o housing, but broadly not much in it – eg 0.5% to 1% differences
• Inflation has run for 2 – 3% pa for years, even during crises such as the 2008 crash. Even when it has been on an upward trend it has always looked under control
• It's now rising steeply – the latest figures for October were 4.2% for main inflation measure and 6% for the historic RPI measure. Its been the highest numbers for many years
• With interest rates still very low and no brakes on the economy, we are expecting CPI above 5% next year, and RPI even higher – perhaps 7% or 8%
• What matters for pensions/investors (eg Sept RPI print)
• If inflation is high, and if your investments don’t keep pace with inflation, you will lose out
• There are two ways of getting more inflation protection – index-linked gilts is one. It's very expensive, but you could find they do very well. It's very good for people who MUST pay inflation and don’t want to take a risk like DB schemes
• The other one is Inflation-linked items like equities infrastructure and property. It should be OK in the long term but could be a very bumpy ride. Inflation works it's way through the system in a haphazard way
• A key question is whether this is transitionary or not – the BofE are saying yes, but of course they would!
• Another key question is the impact on salary growth – if salary growth kicks off, then this points to longer-term inflationary pressure. It has the potential to return is to 70s and 80s where there was long term sustained inflation eg 10%+
• It also has a big impact on currency – so we need to think about inflation relative to other economies, and hedging, for overseas investments

Market pricing – what are gilts expecting and pricing:

• A reminder on upcoming RPI reform 
• We can look up expectations of inflation and future interest rates from gilt markets – the price people are willing to pay to protect
• The absolute levels in the longer term are arguably impacted by big supply/demand forces, but the trends are very interesting
• Looking at inflation firstly, if you go back a year, still in the middle of the pandemic, markets expecting what was always the case – around 3% inflation – and this is RPI inflation
• RPI is due to be reformed from 2030, and the underlying formula become a CPI measure – which is expected to be around 1% pa lower
• And we saw that in the markets – so in the super long term, markets were implying a steady fall of inflation to around 2%, which not surprisingly is in line with the BofE target for CPI
• In recent months, there has been big moves: The market is now expecting inflation above 5 % for a few years, before falling to 4% for around a decade and then once again drifting down to around 2%. For the time being, markets believe long term ability of BoE to get inflation under control, but they are saying it might take a decade to do so

Components of inflation:

• Different types of goods/services going up more/less eg crisps, renovations, taxis 
• Inflation is not uniform, it impacts different goods and services and people in different ways
• Core CPI inflation ignores housing impacts – some examples of particular high inflation have been crisps and snacks (delivery challenges, strong demand), second-hand cars (pressure on new car production, so turn to second hand), fuel and energy – well publicised, international, home DIY – pandemic, shipping, worker shortages
• This is a global issue and beginning to look embedded in supply chains

Drivers of inflation: supply vs demand:

• This is global 
• Starting with raw materials, computer chips, shipping costs – increasingly throughout the system
• Uncertainty in labour market with the pandemic and Brexit
• Jobs holding up BUT salaries are going up as there is demand in key areas
• If salaries go up, firms must put up prices, and people also have more to spend …
• The risk is that there is an upward spiral of prices, but growth is depressed. We could see stagflation – and this would mean the BofE has limited levers to bring inflation back under control
• Inflation has been seen as the enemy for a long time, but there are alternative viewpoints
• It could be helpful to reduce debt and rebalance intergenerational stuff. If Western governments take the brakes off and allow this, become important to position your portfolio

The big question:

• How permanent is this going to be and what’s the likely central bank reaction?

One thing to take away

Inflation is a real threat to investments. If you are a personal investor, consider how your portfolio is positioned. If a DB scheme, consider hedging in detail.

The most underappreciated thing about investing

 That inflation is a threat to fixed income bonds.

Recommendations

• Matthew Syed, Black Box Thinking and Rebel Ideas
• The Sunday Times

Further listening 

• Last week’s episode with Karen Ward interlinks with this week's discussion with Jon
• The Book Club - Rebel Ideas with Laasya Shekaran

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