This week we’re looking at inflation and answering some of the questions around what’s going to happen.
If you’ve been looking for a simple guide this is it and we’ll share Adams findings weekly now.
The last supplement for the first third of the year - it seems ridiculous how quickly it is passing by! I thought today would be a great time to focus on inflation - because a few other really interesting posts on my own timeline have highlighted some really enlightening concerns, questions and debate points around inflation.
The idea here is that once we’ve covered inflation in more detail it will allow us to understand and perhaps forecast the effect of inflation on property prices, debt and what we might expect during the 2020s - although this is a massive topic, and will likely take a few weeks to get through!
I was challenged during the week on a forum and accused of wanting to talk property prices up in order that I could dump stock, when really I MUST believe that prices are going to crash at some point in the future! This made me chuckle - the “opponent” if you will was a new member of the forum and has not been seen since, and adopted the style that you see from many in the new world - there were a few good points, around a sea of “non-data” which was what the poster thought was happening, and thought had happened, without bothering to look anything up. However, it is always good to be challenged and it made me ask myself whether that could be the case.
The answer I came back with, on that front, was no. I’m a stickler for data - to a “dinner-party snoozefest” level, as regular readers of the supplement will know. If I think there’s a tough time coming, I will absolutely say so. I’ve also said, of course, that I see a couple of “wobbles” in the near future, but that they will be wobbles to knock fresh highs/peaks off the market, rather than the start of a true spiral downwards. So a “melt-up” (large increase in prices) over the next 5-6 years as I’ve pointed to a few times, is not necessarily going to look like a straight line upwards.
The overarching trend we have seen since Covid is “all graphs are rubbish” - inasmuch as you will point to historical graphs going back 40-50-60 years and the amount of volatility seen within 2020 makes the y-axis just look utterly meaningless. Things that had not moved more than a few % suddenly move 30 or 40%, or even more. You could include in this: GDP, unemployment, houses coming to market, new build stock, oil prices - the list is seemingly endless. This is the manifestation of massive volatility, and whilst it isn’t a daily or weekly event any longer which it might have been 12 months ago, it is still a phenomenon that comes from the back of Covid.
The other thing to watch out for is something I have touched on before - year on year (YOY) numbers. We are now at the ultimately dangerous point for these, because 12 months ago was something approaching the slough of despond in large parts of the Western world. China were already in recovery, but the rest of us were looking at historic falls in economic output and predicting some significant misery in general in terms of jobs, house prices and the future economy. When you see YOYs compared to March or April 2020 - BE CAREFUL! These are not good trends to be reading into. The 2020 figure is a false one, compared to the 2021 one - because the 2020 one wrapped in a lot of future pain that, as yet, has not occurred, and may not occur (or more accurately, may manifest itself in a different way somewhere down the line). Why? Primarily the level of government stimulus, but also the response, and then the uncertainty of whether there would ever be a vaccine which was a hot debating topic in April 2020 has already been answered.
So - onto why I am one of the “inflationistas” that is out there at the moment. Firstly - a little trip down memory lane. I want to look at nominal interest rates (the number you will see talked about on the TV) but also real interest rates. Real rates (and real yields) are likely to be an incredibly hot topic. Some positive news firstly which affects the whole debate - the stuff that doesn’t make the headlines. The future expectation now for the Bank of England and also for every significant economic predictor and commentator in the UK is that rates will NOT have to go negative. This is a plus. Negative rates have been used for 7 years in the Eurozone, and for longer in Denmark particularly where they are nearly in their 10th year. Indeed in Denmark they have now filtered through to negative rates on deposit accounts, and negative rates on mortgages.
I see that as particularly dangerous territory. It may not feel right that putting money in the bank will cost money (although, it is sensible to accept that banks have operational costs of running deposit accounts - a fact we have yet to accept in the UK but that will surely be coming someday soon). It is even stranger to understand that you might borrow money to buy a house and benefit from a negative interest rate. This doesn’t mean of course that you are ACTUALLY getting paid, because in a repayment situation, you will be paying more capital than the interest you are getting paid. Interest-only would be an interesting feature! Buy-to-let is unlikely to explode in Denmark for several reasons, but it is interesting to note that there is also a very strong set of laws in favour of the tenant (in case you think the UK is pro-tenant/overly biased, check out the Danish setup!).
What you can conclude, without an economics degree, is that when a system is doing the reverse of what it is meant to do, that the system is broken. And that’s absolutely the case. The global financial crisis of 2008 broke the system in many ways in several countries, and it had a very good go at doing that in the UK too.
Negative rates were first posited in the UK when the Bank of England changed their language on this, something they had always had a strong position on, in October 2020. As recently as early February ‘21, the BoE announced that deposit-takers had 6 months to consider the operational and pragmatic impact of negative rates. Due to a solid enough re-opening so far, the prospect has currently melted away. The current consensus between the central bank and the 50 top economic forecasters is that interest rates will remain at 0.1% into at least the middle of 2022.
I wouldn’t panic too quickly if holding variable rate debt - the market now feels that the likely base rate by the end of 2025 will be somewhere between 0.75% and 1%. If I was a gambler, I would still be selling at this price - purely because of the desirability of inflation, and also the nature of the pendulum - we were too bearish at the start of this year, in a long lockdown, not knowing whether a vaccine would work - we are now too bullish and have forgotten that we are coming out of this on the back of an economy which was stuttering at best in 2019, and have fresh problems to solve that are significant. The beauty is that time will tell.
There are some figures that it is worth considering right now however. The property world loves to look at cycles, and trends, and “selective history” I think it is fair to say. Here are some figures on interest rates: The 10 year BoE base rate average has been 0.48%, 15 year is 1.7%, 20 year is 2.44%, and the 25 year is 3.22%. Worth considering when the PRA perform another mortgage market review and what stress testing rates should be, I would suggest - although I don’t think they will want to change the buy-to-let stress tests on terms shorter than 5 years because it helps to keep a lid on the market. You could of course use the argument that the rate has been affected by 2 one-offs - a massive recession on the back of a credit crunch, and then a “once-in-100-year” pandemic. I’m not sure that the market volatility won’t be really significant on the next “event” when it comes along however. Remember Gordon Brown’s famous words around the cycles of boom and bust being over, just before a massive bust…..the raw amount of money in the system, plus the algorithms that cause “flash crashes”, plus the alternative asset classes that now exist that are seducing giant cash injections (e.g. crypto) just mean more and more possibility for prices to move more swiftly, and more to the downside - downsides happen around 6 times faster than upsides tend to in terms of duration, and the last 14 months has certainly shown how bearish things can get so quickly (and arguably, how overheated they can get on the upside!)
So what are the “other side” talking about while all this is going on? The contention from the inflationistas is that there is 1) A giant desire from the governments and central banks to inflate away this debt fireball, in the same way that it was inflated away in the post-1945 era in the UK, after WW2. 2) A massive increase in the money supply. 3) A mechanism enacted in 2020 to actually get cash into the hands of the people, rather than just the banks. Not quite helicopter money, because it tended to substitute for wages (furlough), although bounceback loans and grants would certainly be very close to helicopter money for small businesses! 4) Big government is BACK! It is now desirable (I would argue, from what we have seen and heard so far) to expand government and spend big on infrastructure and other projects. This is a return to the approach of the pre-Thatcher years, and where there is a significant policy differential between Thatcher and Johnson.
Let us “steelman” the other side of the argument. Very low interest rates or ZIRP (A zero-interest-rate policy suite) lead to sluggish growth and deflationary environments (this is what we’ve observed in Denmark, Switzerland, Japan (although there are other challenges and nuances in Japan), and the Eurozone in general since negative rates have been in use). Deflation is a bigger challenge than inflation, and keeping above 0% has been harder (and not always achieved) in that timeframe. That is a statistical fact. What we have seen is asset inflation on the back of the many billions that have been pumped into various financial systems, via quantitative easing. This has been criticised for only helping the small % lucky enough to own financial assets (although in reality, of course, many do within their pension schemes they contribute to or draw down from). Massive extra QE does not change this and QE is deflationary from a consumer price point of view not inflationary. The central point of the argument is that QE shrinks net margins for banks, caused by lower government bond yields.
Again, I think this argument is dangerous and misses the point between relative and absolute. Just because this is what HAS happened following QE does not mean this was caused by QE. We would have to consider whether QE was successful in preventing actual deflation from occurring, and thus did the job it was supposed to be employed to do. This is actually quite likely and QE (in other forms) has got plenty of historical precedent in use, contrary to popular opinion. We had sluggish growth and low inflation throughout the 2010s, but was this just an elongated recovery period from 2008-9 rather than taking all of the pain then and having much better growth figures, but from a much lower base because the first crash would have been much harsher? This seems very probable to me.
So what’s different this time, since there is once again gigantic QE in play? The helicopter money piece for a start, or the more broad application of stimulus. The scale of the money printing is also another “off the chart” graph to behold. What’s also different? The US is broaching its all time high in terms of national debt (not just in nominal terms, but measured as a % of its GDP). They have never been above 120% but they will be fairly quickly. The UK is somewhat different having been around 250% in the post-WW2 years, and at 110% which is where we will be at in the next few months, are not looking in anywhere near as bad shape in historical relativity terms. Or framed a different way “We’ve done it before, why can’t we do it again”. There are of course the considerations that 90% has become the “key number” (for no really good reasons apart from data mining) even though the internationally agreed number around 30 years ago was 60%. Of course, what’s also changed is monetary theory in that time - a good part of it built around what has happened and is happening - but that’s of limited use I would argue because we need to know what WILL happen if X and Y happen, not what has happened and then extrapolate that going forwards (which is basically what Modern Monetary Theory does). MMT is a dangerous antidote, although the choices really are limited.
So - even if we buy the inflation argument - what is the figure that we need to consider? Is it RPI, or CPI? Is it the stock market as a proxy for asset inflation? Is it house price inflation that is actually more serious? Is it the cost of a Big Mac, or a Netflix subscription? All of these things are potentially valid. There is a Harvard Business Review approach which actually uses data from Visa and Mastercard, to see what people are ACTUALLY spending money on, which one would think is the absolutely ideal approach to RPI or CPI. The figures tend to come out a bit higher than the headline numbers, but not to the sorts of numbers that some commentators claim is correct - they were in the 2-3% region last year, versus headline rates of 0.5% to 1%. This is where it gets confusing to draw conclusions.
Any investment-led metrics would have to be adjusted by a rate of return or “risk premium” - it is worth bearing in mind. For example if you said the stock market performance of the past 25 years was 8.25% a year and the base rate was 3.25% on average during that period, the differential would really be the equity risk premium. You would THEN need to examine that premium and determine how much of that was thanks to QE (or, you might prefer the “too big to fail” argument which has reared its head in the past decade). Another approach might be to look at building materials - I have seen some robust figures suggesting a 12-13% increase in raw material pricing, and some commodities are absolutely through the roof - the US looks closely at lumber pricing because they use so much more wood in construction than we do in the UK (although that is changing of course) - our equivalent would be looking at brick pricing (a lot of which is determined outside of the UK!). The lumber mills in the US made a bit of an error last year because they cut production dramatically, wrongly calling the effect Covid would have - then the resultant lack of supply (still fewer than half the major producing mills are back open) has forced prices up massively. This is the danger in a pandemic - some things can react really quickly, some things take 6-12 months or more to get back online because they are supertanker operations, not lean operations.
It is hard to get away from the rise in commodity prices also being linked in inflation expectations. Where does money go when people expect inflation? Gold (and substitute crypto in here, not instead but as well - while there is belief in crypto as a store of wealth, there are lots of seductive arguments for this over gold - one being the storage and holding costs are nothing like as high - there are of course plenty of counterarguments and I remain a sceptic). Hard assets - i.e. property! Gold is like a bond with no yield, the only money made is on its price (same as crypto) - property can yield in the interim and is very strong in a low-interest rate, higher-inflation environment - the perfect storm for property prices, hence my bullishness. And also - commodities. Hard stores of value. If there are other uses (in renewables would be a really good example) then this is extra insurance. Of course you have the Musks of the world who are looking at asteroid mining but it is quite difficult to influence the supply of commodities too much - as prices go up, more expensive methods of extraction become viable but they are not incredibly quick things to do, it is not just the case of pressing a button and getting more copper, or whatever. So in times of massive price volatility (as we are in right now) it is not necessarily easy to exercise the option on a mine and double output in the next quarter - it is more a year-on-year basis and that needs stability that breeds confidence, rather than volatility that breeds fear. In the interim period, which is where we are right now, we just see prices going up and up on commodities.
If commodities are up so much - why doesn’t that filter through into pricing in a much more severe way? Simply because of the supply chain and the costs of it. The raw material may be only 10-15% of the final cost the consumer pays (sometimes less) - there are the logistics costs, the people costs, the overall cost of retailing something - So inflation has a lid kept on it. It should also be remembered that at the moment we have 5% VAT in a sector that is about to have a big bounceback - hospitality - and when that 20% VAT comes back in (which is being tapered, because the inflationary effect is known and is anticipated by the treasury) that has an immediate inflationary effect.
As promised at the start of this article - this will go on, and into next week I will seek to get further into real rates of return, real interest rates, and look at the historical figures around inflation versus equity pricing versus property pricing, and (spoiler alert) I already know there will be some surprising results from that analysis. As always, likes, shares and comments are much appreciated, well done for getting to the end (Or the end of part 1, anyway…..)
Source: Adam Lawrence, National Property Auctions Director
Partners in Property Sue Sims
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