An executive summary of the full inflation report for anyone who would like a brief overview of the key points.
The cost of everyday living is affected by a variety of shifting forces throughout the global economy. Understanding what’s driving inflation and where it’s heading provides a useful insight for long-term investors.
Since the Brexit referendum in the summer of 2016, the annual rate of inflation in the UK has been rising steadily. One of the main causes is the dramatic fall in the value of the pound, which has pushed up the cost of imports. However, over the longer term, the prices we pay for goods and services are influenced by many different forces, including demographic trends, shifting patterns of global manufacturing and trade, and the changing nature of work. The connections are not always obvious.
In the UK, the annual rate of inflation is published every month by the Office for National Statistics (ONS). The shopping baskets of items used in the calculations are reviewed each year to make sure they provide an up-to-date representation of consumer spending patterns. At the start of 2017 gin and cycling helmets made a return to the basket after long absences, while menthol cigarettes and basic mobile phone handsets came out.
Inflation in the UK has averaged 2.1% a year over the past 25 years but during the preceding 25 years it averaged 8.4%. In the 1970s, inflation rose above 25%. The causes include the oil crisis when Arab members of the Organization of Petroleum Exporting Countries (OPEC) imposed an embargo during the Arab—Israeli War, a credit-fuelled consumer spending boom and labour union wage pressure. However, looking back over a longer period reveals that low rates of inflation are a more typical state for both the US and UK economies (figure 1).
No matter how reliable, a single measure of UK inflation cannot account for different rates we experience, depending on our personal circumstances. However, our analysis reveals a surprising consistency between the rate of inflation that affects different age groups and income brackets.
Inflation erodes the value of wealth, which is why it is vitally important to consider when investing. It’s a concept many people ignore because they tend to think in nominal rather than real terms. In other words, they mistake the face value of money for its past purchasing power, otherwise known as money illusion.
To determine how inflation might impact the real value of your wealth, the Rathbones research team have analysed the three main forces we believe are likely to drive prices over the next 20 years — demographics, globalisation and employment trends. We have also explored the different investment and asset allocation strategies that could work best under different inflation environments.
Figure 1: Low inflation is not unusual
Consumer price inflation (shown here as the five-year moving average rate) has been low for most of the past 300 years and rarely strayed beyond low single digits.
Source: Bank of England and Rathbones.
Ageing and saving
Demographic changes alter the way people consume, save and invest. They also affect the size and skills of a workforce, rates of productivity and the way in which income is distributed. All of these factors push inflation in different ways that are difficult to interpret.
A widely accepted view is that an ageing population tends to push inflation lower, with Japan the popular example. From the mid-1990s, it was the first wealthy nation to suffer a shrinking workforce and its inflation rate has struggled to stay positive since then. However, closer analysis reveals Japan’s situation is unique and other countries are unlikely to go the same way.
Data from the US and Germany shows that consumption does not fall with age (figure 2). Spending continues to increase throughout the average lifetime. We believe ageing creates both inflationary and deflationary forces according to which age groups are growing or shrinking most rapidly.
The crucial factor is the dependency ratio, which describes the number of people of working age relative to those who are not working, namely those who are in full-time education or have retired. This key ratio has reached a tipping point in the UK; an increasing number of non-workers are competing for the goods and services produced by relatively fewer workers, and ageing is likely to exert modest upward pressure on inflation.
The impact of globalisation
Similarly, globalisation actually exerts both inflationary and deflationary forces.
The world economy has become increasingly integrated over the past few decades, pushing down the prices of manufactured goods from cheap labour in developing countries. But globalisation has also led to soaring demand for commodities and agricultural products to feed rapid economic expansion. Meanwhile a growing middle class has pushed up demand for the goods and services that fill advanced economies’ inflation baskets.
However, the next stage of globalisation could involve emerging markets capturing larger shares of the global trade in services — from computer programming and design to accountancy and call centres. As services require less infrastructure, this shift is unlikely to exert the same upward pressures on commodity prices. Still, the ongoing growth of middle classes with money to spend across the world’s major emerging markets is likely to continue to push up global demand for goods and services.
Jobs, wages and prices
One economic theory says that inflation tends to rise as unemployment falls. This relationship is called the Phillips curve after the economist who developed the idea in the middle of the 1950s. More recently, inflation has been less responsive to levels of employment and there are several possible explanations.
One of them is globalisation, whereby the increased global competition between firms has distorted the relationships between wages and employment at a domestic level. Better and more credible central-bank policy has also been credited with making prices less sensitive to domestic and global conditions. The changing nature of work has also contributed. Notably, the increase in the number of people working part-time may be suppressing productivity and slowing wage growth. Lastly, some statistical relationships between unemployment, economic growth and wages, which had remained stable for decades, appear to have shifted.
Confidence in central banks’ ability to use monetary policy effectively and maintain stable inflation rates over the long term is also helping to hold down price rises across the developed world. We believe inflation expectations are likely to remain anchored and under control.
In this environment, we believe a balanced, multi-asset portfolio with equities at its core would have the best prospects for risk-adjusted returns over the long term. Government bonds are likely to struggle as interest rates rise from their current historically low levels.
Though unlikely, we see technological change, pushing inflation down to an extent that central banks struggle to fully offset, as the most significant risk to our view. As long-term investors, we will continue to look for investment ideas that can provide a source of returns well into the future and regardless of the economic cycle.
Figure 2: Spending patterns
Income and consumption by age, expressed as a percentage of average income for
30- to 49-year-olds.
Source: National Transfer Accounts and Rathbones.
— Inflation erodes the real value of wealth, and is an important factor in any investment strategy.
— Demographic changes, globalisation and the shifting nature of work influence inflation and are undergoing important shifts.
— However, we believe inflation will remain stable over the long term and that multi-asset portfolios with equities as a core holding remain an appropriate investment approach.
— The forces driving inflation across the economy present additional opportunities for investors.