Andrew Milligan: Inflation is the key to full recovery in financial markets

Published on Saturday 7 November 2009 16:37

CLIENTS often ask me: what is the single most important factor which will determine how financial markets perform over the next few years? Many expect me to talk about the economic cycle in China and America, or perhaps political developments in the UK and Europe. My answer is one word: inflation. Let me explain.

Inflation is so important for investors. At its simplest, we must always consider how the returns we receive from any investment compare with changes in the price level. After all, it is no use making a 30 per cent profit over five years if inflation has been 40 per cent in that period.

More fundamentally, inflation is a key driver of stock markets, corporate bonds and the gilts market. After all, it is another word for a company's pricing power, affecting cash flow and profitability, while government bond prices must include market expectations of future inflation.

Even more importantly, though, inflation levels and their change from year to year have a major impact on investor confidence. The 1980s and 1990s were decades of low and, more importantly, stable inflation; moderate business cycles meant investors could price in future profits growth over a longer time horizon. Since the early 2000s, though, we have seen more volatile inflation and a more extreme business cycle. Lower investor confidence is not a surprise.

Against that backdrop, where do we see inflation going in the next few years, and what are the risks?

Inflation has recently followed a textbook cycle. During the recession, unemployment rose, housing costs fell and commodity prices plunged. Eventually, the headline Retail Prices Index turned negative broadly for the first time since the 1950s. The official Consumer Prices Index, which the Bank of England targets, was as low as 1.1per cent a year in September, close to the level where the Governor has to write another letter to the Chancellor.

Where next? The good news is that headline inflation should move back into positive territory during 2010. The bad news is that under the surface disinflationary pressures remain in place, which could have adverse implications for company profits. Hasty fiscal or monetary tightening could be dangerous.

Why should inflation turn positive? There are one-off factors, such as VAT rising in January, while oil prices are some 50 per cent higher than their spring lows. Sterling is also important, having fallen about 25 per cent against the other major currencies since 2007; indeed this helps explain why core inflation here has been rather stickier than for many of our neighbours. Headline RPI inflation could reach 3-4 per cent a year by next autumn.

Investors need to look underneath the surface, though. There are still major headwinds restraining inflation, especially wages and salaries growing at the slowest rate in more than 40 years. History tells us wages lag the end of a recession for some time, even more so this time round. The UK economy has become unbalanced. We need to become more competitive, and while sterling can help, it can only be part of the answer – wage restraint is another.

What about inflation in 2011? That will partly depend on how the UK prospers within the wider global economy. Just as importantly it will depend on some decisions by the Bank of England and the government. For example, will VAT rise to 17.5 per cent or even 20 per cent to help bring the enormous public sector debt burden under control? How and when will the Bank of England exit from quantitative easing? It faces some difficult calculations.

There is considerable technical disagreement among economists about the degree of spare capacity, the size of the output gap. Similarly there are technical discussions about how QE is working, about the money multiplier mechanism. It is no surprise a vociferous debate had begun between "hawkish" and "dovish" elements in the Bank. In view of these risks, we suggest central banks in the UK and other countries will prefer to be cautious, and hence interest rates in most major economies will remain lower for longer, only rising slowly from late 2010 into 2011.

Investors are understandably anxious about the inflation outlook, as this is a driver of bond, credit, equity and property markets. I have concentrated on the UK experience, but warn that inflationary pressures are starting to differ from country to country. This reflects the variable impact of the crisis, different problems in the financial sector, how effective are each government's policy response, as well as currency movements.

Across the major economies, deflation fears have eased. However, it will not be possible to say they have disappeared until well into next year. All in all, 2010 will be a vital one for central banks, and the risks of policy error are unfortunately high.

Andrew Milligan is head of global strategy at Standard Life Investments