Should we be preparing for long-term inflation?

One of the main effects of globalisation on the standard of living in the UK has been the low price of consumer goods and therefore low inflation, driven largely by the low cost of production in China, Taiwan and other parts of East Asia.

From 1993 to 2020 inflation for goods averaged just 1 per cent. Service sector inflation, in contrast, averaged 3.4 per cent.

We’ve seen costs steadily rise over recent years as China’s wealth grew and spawned an aspirational middle class, pushing up the cost of production and therefore the price of goods at the factory gate, which has slowly seeped through the supply chain.

It is a process that capitalism has become accustomed to over many years as the producers want a slice of the lifestyle afforded by their consumers.

What we’re seeing now is disruption to this supply chain on an industrial scale, caused by China’s adherence to a zero-Covid policy. Shanghai’s 26 million residents are subject to a lockdown at the time of writing, which is having a predictable impact on the cost of storage and shipping, causing sellers to look for alternative suppliers, and the cost passed on to the end consumer.

It is tough to predict when this cycle of lockdowns will end as we have seen multiple mutations of Covid and vaccination rates in Asia are much lower than in the West. If the policy remains zero-Covid, disruption will be with us for a while and seems likely to result in a permanent rise in prices from China.

Of course, it is not the only cause of inflation. We’ve mentioned the impact of the ongoing terrible conflict in Ukraine several times recently, as well as the global rise in energy prices. In the UK, the raising of the energy price cap in April and then October will be the primary cause of inflation.

The point here is those spikes in prices are forecast to fall back, as they have historically done when a sharp rise in the cost of energy has taken place. Put another way, in order for the current rate of inflation (estimated to be between 5 and 8 per cent) to maintain that pace, the cost of energy will have to continue to rise at its current rate, which would be very unusual and economists believe it won’t.

On top of that, employers are not expected to match the cost of living rise with pay increases across the board. This will result in a grim cost of living squeeze, but it will not solidify inflation, i.e. just matching the rise in costs with the rise in wages to devalue the currency – this is how hyperinflation begins, after all. We’ve seen central banks act to increase rates, which has the opposite effect to quantitative easing, the go-to policy during the height of Covid-19.

Where could growth come from?

As investors, you’re probably wondering where growth will come from in these conditions? In short, it’s incredibly difficult to say as many of the assumptions made about global growth have been impacted by unforeseen events, so a diversified portfolio invested for the long term is likely to be the most appropriate solution.

We’ve mentioned the “patchwork quilt” of investment returns in the past, so it’s worth including again. This is where you can see the relative performance for each sector over the years – and no single investment stays top or bottom of the charts for any given consecutive years.

We’re seeing a lot of policy changes as a result of the disruption in the world, including once in a generation defence spending, while the UK has announced a new energy strategy that will see eight new nuclear reactors installed at existing sites to rebalance its energy dependency.

Although inflation seems likely to be with us in an aggressive form for some time, the world has a way of uncovering new growth opportunities. The key for investors is to be in the market as that happens, as this chart illustrates.

The value of an investment can go down as well as up. Past performance is not a guide to future performance.

When investing your capital is at risk.

Brewin Dolphin / Refinitiv Data Stream

About the Author