Inflation in the UK is picking up. The consumer price index (CPI) was up by 1% in September compared to the year before, a little higher than expected. (RPI – the old pre-2003 measure, which has now been widely swept under the carpet – is at 2%.)
That’s not surprise. Oil prices have risen. The pound has fallen. Everything we import is more expensive.
And yet. This isn’t being driven by the falling pound yet, according to the Office for National Statistics. In fact, food prices fell.
And what’s more interesting is that this isn’t just about the UK. Over in China, consumer prices rose by just under 2% in September, far more than expected. More strikingly, producer prices (prices at the wholesale level) rose for the first time since 2012.
Is inflation about to return – not just in the UK, but everywhere? And if so, how can you profit from it?
Inflation is picking up – and not just in the UK
We’ve been waiting for the return of inflation for a long time. The world has massive overcapacity and huge debts, both of which are deflationary. But there are signs that this is slowly changing.
The return to producer price inflation in China suggests that “capacity consolidation” has seen some progress, according to Alex Wong of Ample Capital, speaking to CNBC.
Meanwhile, John Dizard in the FT yesterday took a look at the container shipping business. This has been a miserable place to be for years. As an industry, it’s been one of the most obvious examples of overcapacity in the world. The collapse in global trade hit it hard in 2008, and it hasn’t really recovered since, as China’s shift in economic strategy has left the world with too many ships.
Yet container rates hit a low in February, and they’ve been rising ever since. The Baltic Dry Index has rallied sharply this year, too. And the bankruptcy last month of South Korean container-ship giant Hanjin can only help.
None of this is necessarily a signal to pile into the shipping sector. There’s still plenty of pain to be worked through. But, as Dizard puts it, “the takeaway for macro investors… is that price levels incorporating freight rates are going up. The central bankers will be too late to stop inflation.”
What does that mean? “In the past, a good environment for shipowners – as in increasing freight rates for commodities and containers – has tended to mean a bad one for bondholders: rising inflation and rising interest rates.”
Which Winnie-the-Pooh character are you?
The deflation trade has been popular for a very long time. You just need to look at a chart of the asset class that loves deflation best – bonds – to see that.
The only reason people hesitate to call bonds a “bubble” is because it’s hard to reconcile the idea of what’s viewed as a low-risk, sensible, even somewhat gloomy market with the sort of champagne-cork-popping irrational exuberance associated with bubbles.
Bond markets are Eeyore. Eeyore doesn’t do irrational exuberance. However, he does do overwrought pessimism, and while it’s not as much fun as the exuberance, it can be just as damaging to your wealth.
Bank of America Merrill Lynch has just put out a research piece that I can see I’ll be mining for anecdotes for a while. But here’s one fun fact to illustrate the “misery vs frivolity” theme: US government bonds are now more expensive relative to diamonds – the ultimate in frivolous assets – than they’ve ever been.
And the level of overvaluation has really taken off since 2008 (which, of course, is when the US Federal Reserve started printing money to buy US Treasuries, rather than, say, diamonds).
Are we at a peak? Well, other indicators at extremes include the following. The ten-year annualised returns from investing in commodities are now at their lowest level since the Great Depression – 1933 to be precise.
Meanwhile, “real assets” in general (property, collectibles and commodities) are at all-time lows relative to financial assets (stocks and bonds), reports BoAML.
Now don’t get me wrong. This relative undervaluation can correct in a number of ways. Commodity prices can go up, yes. But the value of stocks and bonds can go down. Or the whole thing could fall – but commodities just fall by less than stocks and bonds.
So relative valuation can be a tricky thing. But on balance I suspect that we’ll get a bit of both – slipping financial assets and rising “real” assets.
Here’s an interesting inflation-correlated investment
What can you invest in? Says BoAML: “Our equity analysts expect companies in capital goods, mining, railways and other real asset-linked industries to be among the greatest beneficiaries of new fiscal spending”.
We’ve discussed the mining sector in MoneyWeek magazine regularly this year, and we’ll be looking at all of these industries soon as part of a wider look at investing for inflation in a forthcoming issue – so if you’re not already a subscriber, get on board now before this major trend shift takes place.
But I’ll just talk about one particular investment before I go – cash. Another interesting point made by the BoAML study is that “cash is the only financial asset positively correlated with inflation”.
At first glance, that might seem counter-intuitive. After all, cash held under the mattress at a 0% interest rate certainly won’t “correlate positively” with inflation. It’ll just lose value.
But of course, cash normally does well in an inflationary environment because you keep it in a short-term variable interest-rate deposit account. So as interest rates rise as a result of inflation, you do OK, because cash manages to maintain its “real” value.
Will that happen the next time inflation takes off in an era of financial repression? That, I’m not so sure about. But it’s certainly still worth having some of your portfolio in cash. If nothing else, it’s always useful to have the “optionality” – that is, the ability to buy what you want, when you want, should the opportunity arise.