So, inflation is finally here. Well and truly. As of March 2022, Consumer Price Inflation (CPI) in the UK stands at 7%, with similar numbers in the USA and the EU. RPI is even higher. And this after years – no, decades – of being bracketed comfortably between 0 and 5%.
The initial cause of inflation is not wildly surprising. The pandemic. It’s a fairly simple problem to diagnose: lockdown restricted the availability of goods and services right across the world – so prices went up.
And now of course we have a second factor that is turbo-charging inflation: the war in Ukraine. Or, to be more specific, the shock it’s causing to commodity prices. Oil, gas, metals, cereals.
That, in a nutshell, is source of the coming currency crash. Since I wrote about inflation in more detail in a post in February 2021 and then again in May 2021, I don’t propose going into any more detail here.
This purpose of this post is to look at what happens next. How will the currency crash ripple out across asset markets?
Watch the bond market
The first to fall will be the bond market.
Now the mere mention of the bond market might sound a bit technical – dull even. But please bear with me: the bond market is the single most important part of this story, which will hugely affect things that do matter to you.
The bond market is where investors buy and sell government and corporate debt – or ‘bonds’ to use the technical term. Inflation is one of the biggest factors that affects this market. It’s not hard to see why: if investors think that rising inflation will eat away the value of money over time, they will want to receive a higher rate of interest to compensate.
Now here's the crucial point to grasp: for any given bond to offer a higher interest rate, the price of that bond has to go down. Imagine a £100 bond paying 2% interest per year. For that bond to pay, say, 4% interest, the price has to halve in value to £50. In other words, interest rates and bond prices move in opposite directions.
Now that’s a huge over-simplification of how bonds work. But just hold onto this basic point: as inflation goes up, interest rates on bonds go up. And as interest rates go up, bond prices go down. Higher inflation leads to lower bond prices.
That, in microcosm, is how bonds work. How does the macro picture look?
Answer: not good.
Forty years ago, interest rates were at staggering levels. The Bank of England base rate (the interest rate that steers the market) reached a dizzying 17% in the late 1970s. There then followed four decades of ever decreasing interest rates. By the start of the pandemic, BoE base rate was down to just 0.25% - and was then lowered again in March 2020 to a scarcely believable 0.1%. That in turn pushed bond prices up to highs never seen before.
All of which means you have a very vulnerable bond market – hugely sensitive to inflation. And inflation is already impacting: since the 0.1% bottom, the BoE has raised the base rate to 1% and has signalled further rises over the coming year.
Remember: inflation causes bond prices to drop. Lots of inflation causes bond prices to drop a lot.
A crash in other words.
After the bond market comes the stock market
Where next?
Why, the stock market of course.
The stock market is priced off the bond market. It doesn’t always seem that way because micro fluctuations in the one generally happen independently of the other. Both markets are affected by a plethora of different factors, such that the linkage between them is mostly obscured. But it’s there.
Why?
Because stock market valuations depend on the perceived “risk-free rate”. What is the risk-free rate? That’s the interest rate you can get from holding UK Government bonds (these bonds are perceived as ‘risk free’, since the UK Government has always paid its debts). So if one of their bonds pays, say, 3% interest per year, investors will naturally expect riskier assets, like company shares on the stock market, to pay a higher return. We won’t get lost on how you measure the ‘return’ on a company share – suffice to say, share prices work a little bit like bond prices in this sense: for a share to offer a higher return, the share price has to go down. Unpacking that a little further: if interest rates are going up, then stock market investors will expect a higher return from their stocks - so share prices go down.
Now this isn’t guaranteed. Remember: stock markets are influenced by a huge range of factors – by inflation, by bond prices, by individual company performance, by the performance of the economy, by exchange rates, by government policy, and (…let’s not forget this one…) by geo-political events. The best way to think of the relationship between the bond and stock markets is like that between a tow truck (the bond market) and a car (the stock market), attached by a very, very long chain. For long periods of time, the two may move independently of each other. On a downhill section, the car may even roll ahead of the tow truck. But then, just occasionally, the tow truck will turn a corner and head in a completely new direction. For a long time, nothing may happen to the car until – bam – the chain runs taut and the stock market is yanked in the same direction. In this instance, a crash.
And so to the property market
Yes, the property market comes next, alas.
Up until now, we’ve been talking about stuff that might either seem nebulous (the bond market) or remote from the real economy (the stock market). The property market, however, may well bring the unpleasant economic realities home to us. Literally.
Why will the property market be affected? It comes back to the bond market again. Rising interest rates in the bond market mean – unsurprisingly – rising mortgage rates. Rising mortgage rates mean two things: firstly, that people will be giving more of their salary to their mortgage and thus have left to spend on themselves (hence the impact on the real economy). And, secondly, that new mortgages will be smaller.
And this is the really key point.
If interest rates move higher, the average homebuyer on the average salary will only be able to afford a smaller mortgage. That’s just straightforward logic. If homebuyers can only take out smaller mortgages, what will that do to property prices? Exactly. They go down. This is when we’ll discover that ever rising house prices had nothing to do with our individual genius at picking the right house, or doing brilliant DIY – but everything to do with cheap debt (and population growth). Take away the cheap debt (and, very likely, the population growth too), and house prices will stop being the one-way bet that we’d become used to.
The story doesn’t stop at owner-occupiers. The mathematics will become just as forceful for owners of rental properties. The fact is, any asset that yields an income has a relationship with interest rates. If interest rates move higher, the value of income-yielding assets moves lower. Why? Simple. If you can earn, say, 3% by just putting your money in a savings account, why would you manage a rental property that’s returning only 3%? Answer: you wouldn’t. Prices of assets will fall until they offer a more realistic (= higher) return. It’s exactly what we said about the bond and stock markets: for returns to go higher, assets prices must go down.
The three Cs: Commodities, Collectibles, and Crypto’s
Thanks for bearing with me this far. We’re now in the endgame as we reach the non-income-bearing assets. I’m loosely calling these the “Three Cs”: commodities, collectibles and cryptocurrencies – although there are plenty of other kinds too.
The non-income-bearing assets will be affected last. As they don’t offer a return or income, they won’t be so immediately affected by rising interest rates. The impact is secondary. Rising interest rates will create an economic shock – and it’s that secondary shock which will knock them.
Let’s look at collectibles first. I’m talking now about stamps, vintage cars, expensive French wine, and so forth. It’s easy to see how these will be affected as newly impoverished billionaires start to tighten their belts.
Commodities are a more tricky one. After all, commodity prices right now are going sharply upwards – and are causing much of this problem in the first place. The answer to this seeming paradox looks something like this: commodities are helping to provoke the economic tidal wave which will in turn (and probably later) wash back over them too.
And then, finally, cryptocurrencies. For a good wee while crypto’s were heading upwards as a hedge against inflation. The theory being that, like gold, they could provide a store of wealth independent of the fluctuations in feeble fiat (paper-based) currencies. And maybe that will prove true.
Personally, I’m not so sure. If inflation spikes, the economy crashes, and asset markets are in disarray, will people really want to trust their wealth to blockchains? Maybe, maybe… I’m just not so sure.
So, who’s left standing?
I’m no investment expert and most certainly not in the business of giving advice. There is just one image that keep rotating around my mind. A cube, 20m x 20m x 20m. That’s the space into which you can fit all the known gold that’s above ground – all the jewellery, all the central bank deposits, all the coins and bars held privately. It’s a manageable amount, right? I mean, of course a cube of that size is probably bigger than you might think. And heavy too. Like, really heavy. But at least it’s something the mind can grasp. 20m x 20m x 20m. Compare that cube to the trillions of dollars of ‘value’ held in cryptocurrency blockchains, or the trillions of dollars of quantitative easing that has taken place since the credit crunch and… Well, you can probably tell what I’m getting at.
There is good news, though – if we’re patient
And so to the final question. Is it doom and gloom forever?
Answer: No.
Probably the opposite in fact.
In years to come we may come to think of inflation as the best thing that could have happened. The alternative, after all, was deflation. Remember, it was deflation that did for Japan. The massive burden of debt they built up during the 1980s just never went away. As their currency deflated, the debt burden grew over time, not shrank. The economy stagnated and the Japanese lost their optimism.
We were facing exactly the same deflationary threat until the pandemic. Two decades of low, or ultra-low, interest rates had created a debt overhang that just seemed to grow and grow. Quietly, debt repayments had crept up and up, threatening to stymie investment and spending.
As it is, we now have the auld enemy after all: inflation. A brutal medicine that’s going to trash our economy over the years ahead but will leave us cleansed at the end. Debts that seem huge and perilous now will be winnowed to nothing. An economic cycle that’s far longer than any economist will admit – a forty-year economic cycle – will finally be closed off and the chance to re-build will present itself.