Welcome And The Inflation Question

Gerald Ashley 0:00

Hello and welcome to Equital Conversations. I'm Gerald Ashley and as usual I'm joined by my good friend and colleague George Cooper. And today on the menu we've got really what I think is going to be a very big topic for people involved in markets and just people generally, and that is of course inflation. Now, George, we've sort of talked around a lot of the topics about inflation, maybe without naming it and getting down into the detail of what's going on. So once again, as usual, I'd ask you to set the scene and what are current prospects for inflation, obviously here in the UK and obviously globally important in the US. And um I sense you you've not got good news.

Bond Yields Jump And Debt Rollover

George 0:54

Um yeah, I think that's fair, Gerald. I think you know, first uh it's worth focusing on inflation at the moment because we've got a lot of we've got a lot of things going on in the markets and in the economy that suggest that inflation is about to tick up. Uh in fact, it's it's more than ticking up, it's it's surging. And we're seeing the symptoms of this already in the bond markets. We're getting a lot of press coverage about this. Um, but you know, if we look at particularly the 30-year bond yields, which are the most sensitive to inflation, we've got in the US 30-year bond yields have gone above 5%. Uh, in the UK, they're nudging towards 6%. I'm trying to find the chart here as we talk about it, but they're they're surging uh faster in the UK than they are elsewhere. And this is going to be a problem going forward because we've got a lot of debt outstanding. We economies around the world are very heavily indebted. US debt to GDP is now above 120%. You know, this was the sort of level that a few years back we were panicking about Greece's debt, uh, this sort of level. Well, you know, the US is there, the UK's there as well. And a lot of this debt as it rolls over, a lot of it was issued years back when interest rates were very low. Now, as it as it matures, it's going to get rolled over into much higher yielding debt, which means that the governments around the world are going to be paying much more of their tax income to bondholders and have less money to spend.

Gerald Ashley 2:40

To sort of set the scene politically, people are saying, oh, well, this is because of the uh the you know, the war in the Gulf, and wars are very expensive, and um it'll it'll all pass once if the Gulf settles down into whatever form of settling down, um, this will all fade away. But it you think it's more embedded than that.

Oil Shock Delays And Food Risk

George 3:04

Yeah, I do. I do think there's a there's a process that happens in the economy, which is once inflation becomes normalized, once you've had it, you've once you've been used to it for a few years, it becomes easier for consumers to accept that prices do naturally rise. And of course, producers always want to push up their prices if they possibly can. So it it has been normalized, and that that's an important dynamic. But aside from just the the normalization of inflation, we've got now with the energy shock that's coming out of the US-Iran war, we've got the immediate effect of that energy shock, which is probably being understated by the markets at the moment, and that's because we we haven't felt the full brunt of the oil shortage because governments have been releasing strategic reserves so far.

Gerald Ashley 4:03

It sort of feels like a phony war almost, you know. The real sort of shooting metaphorically in in finance hasn't happened yet.

George 4:12

Yeah, there's a process where you get a sort of delayed delayed response. I think first because we're we are literally burning through the oil that had been in transit at the start of the war. And it takes a few months to get oil out of the Gulf and into the rest of the world. So there's naturally a sort of two or three month grace period where the oil shortage doesn't hit the economy. And then in addition to that, we've had releases from strategic reserves. As all of that starts to fade, we're going to start getting the real shock, I think, you know, more or less from now on. In addition to that, we've got the oil products, which is you know, the chemicals, the fertilizers, things like that, which a lot of people, I'm not an expert on this, but a lot of commentators are saying this is already impacting the planting, the planting plans of farmers around the world, yeah, which suggests there'll be food shortages 12 months' time. So this this is what gives you potentially a rolling inflation shock from this that that lasts more than just a few months. It goes into several years.

Gerald Ashley 5:21

Right. Now, I mean, if I um took no interest in markets and took no interest in economics, which I think the vast majority of the population would be in that camp. I'm slightly being sold a story of inflation because of this war, but uh the government are going to manfully get on top of it, and that the Bank of England has got this 2% target, which is obviously way out of court at the moment. But don't worry, because these guys are gonna get it back under control. We will get back to normal. If I take my sort of view, or I indeed your view, the a more cynical view, is to a degree inflation is not a problem for governments.

George 6:08

Well, this is this is one of the great um fibs, if we if we're being generous, that uh that is that is collectively told by you know finance textbooks, central bankers, and governments, and that is that they all try to keep inflation down. The reality is actually the the monetary system is designed to create inflation because inflation is a very convenient thing for governments. Inflation is effectively another form of tax, but it's a tax that a government can apply without legislation, yeah. So and without most people knowing it. In fact, a lot of people actually sort of experience inflation in a sort of positive way. They see their house prices going up, they see their investments going up, and they kind of like that. They see their salaries going up. So inflation is maybe one of the least unpleasant taxes, and and and they need to keep it going.

Gerald Ashley 7:02

One's tempted to say, of course, if it gets to a critical mass and runs away, and then indeed the game is up, because you you talked about long-dated um bond yields, and at some point bond yields um will move to a point that there is no buyers, whatever the price is. Now, I mean, I don't know if we're gonna have a go at guessing where let's say the guild market suddenly doesn't want to buy government bonds, it's probably what two or three hundred basis points away, maybe even four hundred. But once this engine gets rolling, it can be quite difficult to stop from a government's point of view, isn't it?

When Higher Yields Scare Buyers

George 7:44

Yes. Well, essentially the bond markets can work in two different modes, uh which is really important to understand here. The first mode is if the bond market thinks that you are a sound borrower, in other words, they think that you've got the capability of repaying your debt, then as yields go up, the the investors will see that as attractive. They'll say, Okay, we're going to we're going to get a higher yield on our debt. Uh, we will we will be willing to lend because of those higher yields. But if you flip into another mode where the yield is high enough that the lenders start to worry uh that you can't afford to pay those yields, then the higher yield actually starts to f signal a greater default risk. So the the higher the yield goes, the lower the demand for the debt.

Gerald Ashley 8:40

So so the sentiment actually flips around, and in the common parlance there's a tipping point somewhere.

George 8:47

Yeah, this is very common in or has been very common in the past in the different ways that the markets responded to what we used to call emerging market economies versus developed market economies. Yeah, yeah. Bond yields went up in developed economies, generally there was more buyers for the debt. But when bond yields went up in emerging economies, like for example, Turkey, Zimbabwe, Argentina, people started to say they can't afford these yields. So we we really don't want the debt at this point. Now, I think the issue here is that the debt sustainability levels of the developed economies like Britain, the US, Europe, Japan for that matter, they've now flipped into the emerging market zone. The debt level is too high, it's unsustainable, and the bond markets are beginning to panic.

Gerald Ashley 9:39

Which is an extraordinary state of affairs, really. You know, that I remember we had a guest on last year talking about how the United States could, by some criteria, could be judged as an emerging market.

George 9:51

Yes. You know, there's there's other symptoms of it other than just the debt load. You know, we've got uh we've got Donald Trump going to China, and interestingly, his second visit to China with without um without it being reciprocated, but he's going to China and he's trying to sell oil and soybeans to the Chinese. Yeah. These are commodity exports, these are traditionally emerging market exports. Uh, and on the other hand, the emerging market economy, China, I say that tongue in cheek because it's patently not true anymore, they're selling the high-end manufactured goods back to the West. So there has already been an inversion.

Gerald Ashley 10:31

Yeah, I mean, this is quite remarkable. Is there any light at the end of the tunnel here? What would um maybe suppress this scenario a little bit? Um, I'm I'm gonna struggle to think of anything, but the only thing I can think of is is fairly radical government cuts, but there's two problems with that, as far as I can add spending cuts. There's two problems with that. First, politically, and secondly, if you if you really go for it, you you risk uh a downturn in the economy.

Debt Deflation Trap And Cold Turkey

George 11:01

This I think brings us to an important point, Gerald. So the challenge here is if you've already got a high debt load and you're spending beyond your your income, and you've been spending beyond your income for a long time, then the economy has become used to that fiscal stimulus. Yeah. If you suddenly turn the fiscal stimulus off, then just mechanically, year on year, you'll go into a recession. And as you go into the recession, that will create a deflationary wave.

Gerald Ashley 11:32

Yeah.

George 11:33

And that's where you start to get into a debt deflation trap, which is where Japan has been, Japan's just coming out of it now. It's where Japan from the late the early 80s onwards, I guess, uh was in this debt deflation trap for decades. And the challenge with that is it's not easy to get out of it once you're in it. So trying to avoid that is maybe why we're seeing some very strange policies at the moment. In other words, what I'm saying is governments have done a lot of things over the last five or six years. They've done lockdown with huge stimulus. Donald Trump's introduced trade barriers and tariffs, which create inflation, the ICE program in America trying to turn or successfully turning net immigration into net emigration. That reduces the labor force, which creates inflation, the Ukraine war, the Iran war with the energy shocks that they've generated, they create inflation. There's a whole series of policies that has happened over the last five or six years, which have all been very inflationary. I think although all of those policies have been done for either reason for for other reasons, taken together that set of policies does show, let's say, a tolerance of inflation.

Gerald Ashley 12:53

Or a desire not to mix metaphors here a little bit, but not to experience cold turkey to not actually try and dry out.

George 13:03

Yeah, exactly. So what I'm saying here is I think the tolerance of inflation is now so embedded that you could actually go a step further and say that no, inflation is now a government objective. They and that is because they need, they need the inflation to allow them to pay for the debt that they've already incurred, but also because their deficits are so big that they can't service the deficit without the inflation. And remember, inflation is is a closet tax, as we talked about earlier.

Why Growth Politics Is Absent

Gerald Ashley 13:35

Being ever the cynic again, it makes me think the thing of the Bank of England writing a letter to the Chancellor because it's over 2% is at best it's pantomime. Um at worst it it's it well, it's it's it's nonsense. So another angle on this would be to say, well, of course, the the way out of all of this is to somehow promote economic growth. Um and we had Doug McWilliams on uh from the Growth Commission just before Christmas, and he he outlined a good half a dozen policies that could be implemented over time that would certainly boost growth pretty much in any open economy, certainly desperately needed in the in the UK. But politically, there seems no desire to get away from a very top-down sort of control view of the of the economy.

George 14:32

I don't see anywhere in in the West, in the developed economies, I don't see anywhere where there is that sort of deregulate, liberalize, get back to allowing pr private enterprise to create growth. We've we've actually got on both left and right, we've got very interventionist mindset. I mean, you know, Donald Trump is um he's very much not the the heir to Reagan. He's not a free trader, is he? Not at all. No, he's not a free trader, he's not a free markets person. He is intervening in in the US and the global economy in all sorts of ways. And you know, it's fascinating. We've just had the local elections in the UK where very clearly the Reform Party was the winner in that, with a big surge in in seats. And they're also not a free trade party. They they also want to do lots of stuff. Um, so there there just isn't this on the menu of the political offerings, there isn't an item that is pro-growth. There's nothing on offer.

Gerald Ashley 15:40

I think the language is interesting. When Trump announced that the US government had invested in Intel, taken a minority stake in Intel, um, that could have been characterized as part nationalization, but of course, isn't. Um, and as you say, there seems to be a lot of linguistic and terminological um uh sort of acrobatics going on here. But the the truth of the matter is that what one may call a free market economy, the direction of travel for all the G7 is not is not that way, is it?

The Third Wave Inflation Forecast

George 16:21

No, it it's not. And that's why I think we're I think the the inflation issue is now embedded. I think what's going to happen is we're going we're going to go into what I'm calling the third wave, which is a it's a reference to a chart that a lot of people will have seen floating around the internet, which is comparing the recent couple of sort of spikes in inflation to those that happened in uh in the 1970s, between the period of basically uh about 1967 up to about 1982, there was three waves of inflation, with each one being bigger than the last, until the one that peaked about 1980 in the US, inflation peaked at about 15%. Yeah. I think the analogy is that the second wave of inflation that in that series was our wave of inflation that came after lockdown when lockdown was released. That process has sort of faded now. Inflation's dropped back. Um, so we're in the sort of three and a half-ish sort of percent. But now it looks like this new energy shock is going to take it higher. And I think we'll follow the same trajectory more or less as we did in the 70s. And that suggests that we're probably on path to get an inflation rate peaking in a few years' time at perhaps as high as nine percent, if it follows the same pattern.

Gerald Ashley 17:51

This scenario is doing nothing for our reputation of always being rather pessimistic about things. Um, one way of looking at this, or at least I'm more pessimistic than you, I think, in fairness.

George 18:04

I can see some optimism in this, but carry on. Carry on, Gerald.

Gerald Ashley 18:09

Um, uh maybe another element to all of this, again, looping back to a guest we had on in the autumn, Helen Thomas, who said from a political point of view, that this will just keep rolling along until there is a big enough crisis to, you know, politicians actually do have to do something. But would you think that we're not really anywhere near the crisis level yet?

George 18:37

No, I I I don't think we're it we're in the crisis level. I think this is exactly the the point. I think we've got to go we've got to go through this next wave of inflation to get to the point where it becomes clear that the inflation is is negative for the economy. Because as I said, there's a lot of aspects of inflation that people rather like. Governments like it because it it makes life much easier for them. People tend to like it because their wages go up, they see the value of their houses go up, things like that. It's only when you start to see the negative effects of, oh, hang on, inflation's going up, but the value of my house isn't going up anymore because interest rates are too high, and interest rates are too high, which is stopping companies from investing, which means the job opportunities are there, are not there. So it's when you get to the second round effects that are negative, then you start to change the political climate, and that's when perhaps we'll get some grown-ups coming back into the political world, and we don't we really don't have any at the moment, who will be able to respond to a change in the public mood, which is to accept that something needs to be done about this.

Investing To Beat Inflation

Gerald Ashley 19:50

Yeah. I I yeah, I think I think that's a uh a reasonable thought. Um looking at our own sort of um parish of investment and investment opportunities and maybe uh minefields to avoid, it's hard to make a case for being invested in bonds at all now, is it?

George 20:10

Um I think I've used this line before on on this podcast, but you know, I call them certificates of charitable giving. You know, you don't you you really don't want to be involved in the bond market at this point, because if if this third wave of inflation does come about as as we're discussing, and it does peak at something like 9%, well, there's no bond yields around at the moment that are anywhere near that, at least in government bond uh circles. So that means that you're going to incur a real loss on um uh on those bonds. So yeah, I that's not uh to say the least, that is not my favorite investment sphere at the moment.

Gerald Ashley 20:56

Which also brings back to another discussion we had in the past, which is assessing investment performance, looking at benchmarks. Um I know you've been a strong advocate, and I it's hard to argue against it. I think you're right, that the only benchmark that matters is the inflation rate. Now, you would like to have a basket of assets that is growing on a total return basis of greater than the annual rate of inflation. Um, there are a couple of twists and turns in that, aren't there? Because different people have different levels of in inflation. All these indices are flattering to deceive. We're seeing, you know, uh an absolutely vertical climb in the S P 500 over the last few weeks, with tech stocks, you know, blasting off literally into space, or will be with Elon Musk's latest vehicle. But is it time to actually say, look, it the only thing that really matters, and this is uh This is going back to the 1960s and Harold Wilson. Is the pound in your pocket. And if you're not beating inflation, you're losing.

George 22:09

I do take that view. I think that's that's the purpose of investing. The purpose of investing is to grow, is to grow your wealth in real terms. That means above inflation. Now, at the moment, of course, the the S ⁇ P is doing that phenomenally well. As you said, over the last few weeks, it's it's surging relative to inflation. But there is a there is a nagging doubt as to whether that's really sustainable, because uh although the the the multiples are surging, which is what's driving the asset prices ahead, it's getting more and more difficult to see that the earnings are going to continue to surge in the way that's needed when we we've got new costs hitting the economy, and the new costs being higher energy costs and higher interest rate costs, especially on the energy costs. We've got to remember that the reason the SP is surging is basically because there's a another wave of euphoria over data centers and artificial intelligence. But at the same time, you've got people rightly saying, well, if these data centers are gonna work, we're gonna need a thousand times the amount of energy we've we've already got. You know, sorry, that's just not gonna happen.

Gerald Ashley 23:25

That's self-uniting in a way, isn't it?

Book Recommendations And Final Thoughts

George 23:28

Yeah, and it's not gonna happen. And the energy costs are surging, so the economics of these data centers are actually deteriorating uh quite rapidly. So I have some I have some concerns on that front, but that's probably one for a separate podcast. Given

Gerald Ashley 23:46

this uh uh a good round round the parish, I think, in terms of inflation, um, we come to book recommendations. Um I'll get mine out the way fairly quickly. It's another, I'm afraid, rather large tome. I'm just thumbing through it. It's some 700 pages, this one. It's called A History of Money from Ancient Times to the Present Day, uh, by Professor Glynn Davis, who I think died a number of years ago. My edition is the original edition, actually, back in I think it's 95 or 96, and it has been updated by um one of his close collaborate uh collaborators uh a few years ago. In a sense, it's a period piece because it stops at the very point that digital money starts to look as if it might come into view. But it is the most fascinating. Um it's a reference book in a way, um, rather than you read it from one end to the other, but there's there's all sorts of things about debasement of money through inflation with Spanish gold and uh problems in medieval trade as a result. Uh the Romans had loads of problems, uh exactly the same. And it also explains how fractional banking got going. So there we are, a history of money by Glynn Davis.

George 25:10

That that sounds good, actually. Uh I'm surprised I haven't come across that one before, Gerald. Um I'm definitely going to get that uh get that book. Um, so for me, I've got um I've got a a recommendation which is a book I read recently, which is really uh fascinating. It's by um uh Simon uh Winlow and uh Steve Hall. Professor Steve Hall is quite active on Twitter, so you can you can follow him. And the the title of the book is The Death of the Left: Why We Must Begin from the Beginning Again. This book, it is very much written from, you know, I would say quite a hard left perspective. Um, but what I found really interesting about the book is it's an analysis of how the left uh sort of lost the plot. Uh and I I've got a lot of sympathies uh with the analysis of the of the book, and particularly it explains how the left moved from being essentially a group of people who were interested in the welfare of the less well-off. In other words, they were interested in social inequality, and how they sort of completely abandoned that issue and changed to focusing on other forms of perceived inequality, racial inequality, gender inequality, and uh essentially how they they gave up on wealth inequality and became uh obsessed with identity politics. There's there's a very good explanation of how that came about and and why it's a bad idea. Um, so I do I do encourage um the readers to read this book, it is it is uh very interesting. And I think the process they describe is perhaps responsible for the deterioration and the quality of politics generally. Because if you think of a of politics as a sort of tennis match between the left wing and the right wing, if you've got one side of the tennis match suddenly loses form, you know, can't return the ball, then the the other side is also going to lose form. And and that's sort of what happened. The left has literally lost the plot, and that's not providing the the tension or the the motivation for the right to um to raise its game.

Gerald Ashley 27:36

So it's uh it's a race to the bottom in terms of ideas and and new ways of thinking, maybe.

George 27:41

Yeah, exactly that. So um that's my recommendation for for this podcast.

Goodbye And Next Month

Gerald Ashley 27:46

Well, uh, I guess once again I've uh looked at history and you're really in a way maybe looking at future policy ideas. Um that's it from both of us for today on inflation. Um we will be back again next month, uh undoubtedly. And uh until then, thank you very much and goodbye. Thank you, Gerald. Thank you.