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This is the third
article in a series describing the disadvantages of inflationary policies.
There is a general belief that equities offer the
best protection from increasing inflation. This over-simplifies the
relationship between share prices and inflation and is only true in certain
circumstances. Gold and silver mining enterprises however are the true
beneficiaries of inflation, but for investors in bog-standard equities there
will be substantial losses before the final inflation protection kicks in.
The perception of the benefits of inflation to share
prices often arises from a comparison to bonds. But on a total return basis,
assuming reinvestment of income, the returns are actually not much different.
The annual return on the ten-year US Treasury bond over the last forty years
was 7.18%. A lump sum invested in this instrument in 1971 with income
re-invested would be worth nearly fifteen times as much today, while an
investment in the S&P would have grown only thirteen times, to which one
must admittedly add re-invested dividends.
A greater influence by far is changes in interest
rates. Over the credit cycle, interest rates are initially depressed by the
central bank to encourage business investment and economic growth. It is at
this point that equities are usually in well-established bull markets. The
pundits will tell you that equities are discounting improving profits; while
there is some truth in this the realty is that
equity prices are benefiting mostly from the expansion of money and credit
and low interest rates. But the longer that interest rates are held
artificially low, the greater the expansion of money and credit and the
greater the inflationary pressures that result. Eventually interest rates
have to be raised, to the detriment of both bond and equity prices.
The credit cycle in this simple theoretical example
should perhaps be completed by the excesses of money and credit being
withdrawn: in other words the mistake of an expansionary monetary policy is realised and corrected. In reality, there is a ratchet
effect, because the credit created in the previous cycle is allowed to stand,
and the general price level is not permitted to fall. Consequently, the
cumulative effects of these credit cycles are reflected in the long-term
trend for inflation. Share prices reflect this trend through progressively
rising cyclical highs and lows, supporting the contention that equities offer
a hedge against inflation, while conveniently overlooking the bear markets at
the end of each credit cycle.
The situation today is radically different in an
important respect. Interest rates are at record lows and have fuelled share
price rises, conforming to the first phase of our credit cycle model. But
instead of inflation arising from excess demand, we have stagflation, the
result of excess money in circulation. Consequently, the prospect is for
increasing interest rates without the usual economic recovery.
This statement needs further amplification: the
tentative signs of recovery are misleading in the US, the UK and much of
Europe. The unprecedented quantities of raw money injected into these
economies have been about as effective as trying to kick life into a dead
body. Meanwhile, the emerging market economies, which have fuelled
export demand for the West, are over-heating; credit is tightening and these
countries are in the later stages of a conventional credit cycle. The
potential for emerging markets to create a tide of rising employment in the
mature economies is not there, because this tide has turned and is now on the
ebb.
So corporations in the Western economies now face a
future of rising interest rates and deteriorating earnings. Not only will
this make their share prices vulnerable to rising interest rates, but it will
radically reduce hoped-for earnings. Therefore, stagflation has the potential
to undermine equity markets with a bear market of greater than normal
magnitude, destroying any link that protects investors in equities from
inflation. There is a good historical precedent: the 1972-74 bear market in
London reflected the last severe bout of stagflation, when similar economic
dynamics were in play, and when the All Share Index fell over 70%.
To relate inflation prospects to equity prices in
all their totalities we must broaden our debate. In the current economic
context, excessively high levels of monetary inflation from the US are
beginning to be reflected in growing price inflation in nearly all
fiat currencies. Keynesian economists and other wishful thinkers in the West
continue to attribute rising price inflation to external factors, dismissing
the monetary link. They say the demand for food and raw materials in emerging
economies is driving up the prices of essentials, and political disruption in
the Middle East is blamed for rising energy prices. Those in charge dare not
admit the obvious link between excessive growth in raw money and inflation.
Some, like the Governor of the Bank of England, believe there is insufficient
demand in the economy for prices to continue to rise at current rates. Others
claim that higher energy prices will reduce demand from cash-strapped
households for other goods, concluding that these higher energy costs are
actually deflationary for other prices, and implying that the wrong thing to
do is to raise interest rates. These are simply arguments by the authorities
and their economic advisors who are in denial, and they are consistent with
the uninformed level of debate usual in the early stages of stagflation.
Even though it is slowly becoming clear to
governments around the world that the rise in the general level of prices is
actually a real problem, policy responses will inevitably be too little, too
late. This is partly due to confusion among government economists and central
bankers, but also fears of the deflationary alternative. Furthermore all
central banks tie their currencies to the dollar in the belief this is
necessary to protect trade balances, so where the Fed’s monetary policy
goes, the others have to follow. For this reason the inflationary effects of
the Fed’s unprecedented levels of money creation are being transmitted
into all fiat currencies.
This is the principal danger to international
stability currently posed by the world’s reserve currency, and
government finances in the US today are so bad that it has no political
option but to continue with monetary inflation in accelerating quantities.
Furthermore, the Keynesian mindset justifies this flood of money as the only
appropriate response to a stalling economy. These circumstances lead us to
conclude that the current emerging period of stagflation can only be followed
by hyperinflation, not just for the US dollar, but for all paper currencies.
And when inflation rises to, say, thirty per cent, interest rates will be at
least in the upper teens or twenties.
It is this background that investors have to
consider. Those seeking protection in equities from this deteriorating
outlook will have to allow for more interest rate rises, escalating raw
material costs for companies and collapsing consumption. Essentially, the
companies that survive a hyperinflation will do so by winding down their
operations. There will be little or no escape for investors in companies with
foreign earnings, because today’s inflationary problem is global,
thanks to the Fed’s money-printing. The eventual rise in equity prices
at a time of hyperinflation will therefore reflect the flight out of paper
money more than anything else, and in this respect will behave like any other
physical asset in a currency’s dying moments. It is Ludwig von Mises’s crack-up boom, and there is no point in
investing today in any assets based on this eventuality.
The only sector that truly benefits from the death
of paper currencies is precious metals. The miners will enjoy rising prices
for their output, and dramatically falling costs of production, measured in
gold or silver. Net income, measured in paper money, expands exponentially,
even without any increase in production. The costs of raw materials and
equipment will rise in paper currency terms, but will be falling heavily
priced in gold and silver, reflecting the general collapse in economic
demand. The cost of labour will also fall in real
terms, and the cost of capital will become immaterial, as legacy debt is
inflated away and operations are funded entirely out of escalating profits.
So investors who think that investment in equities
offers the benefits of inflation protection in this uncertain economic
environment will be in for a rude shock, unless they restrict their interest
to gold and silver mines.
Alasdair
McLeod
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