We have all been brought up in a world of inflation and therefore tend to assume it is fact of life. However, looking back into history suggests that this is not the case. There are long periods when the world had inflation and then ones when prices gradually declined and consolidated. We are about to enter that phase now and it will have major implications for wealth management.
What history teaches us about inflation
Inflation tends to follow cycles of periods of price rises followed by periods of near-zero or declining prices. The first clear evidence of this was seen in Ancient Rome. It can also be seen in the UK.
Source: Phelps-Brown and Hopkins (1956) and ONS
The underlying trend is being driven by competition for resources and population growth. However, like many financial trends, such as share prices, it follows a wave-like pattern as prices get too far ahead of the trend and have to consolidate.
Once astute investors spot that prices have broken out of the consolidation phase, they seek investments that will hold their value in the coming inflation. The key asset is land and housing, but shares are also bought. Investors take out loans to buy them, as they know the true value of these debts will be eroded. This process increases the money supply and so creates a general increase in prices. An inflationary mindset sets in. This feeds a vicious cycle, as more people want to exploit the inflation and seek higher pay rises and also feed the money supply. Governments also encourage the inflation as it allows them to overspend knowing that inflation will eventually reduce the value of their deficits and accumulated debts.
Source: Inflation Matters (2015)
There comes a point when prices get too far above the underlying trend, or demographics alter the underlying demand. Prices then typically suffer a deflationary shock where they decline by a half over a period of around five years. Although prices then recover, they never get above their previous highs. Over the following 80-100 years prices gradually trend downwards as productivity and technological improvements reduce costs.
The inflationary wave is ending
The UK is 115 years into its latest inflationary phase. Historically, they have lasted between 85-140 years and so the pivot point could well happen in the next couple of decades. We are already seeing many deflationary forces around us from lower commodity prices to competitive devaluations. In addition, populations are ageing fast in the developing world and with them spending. Add to that overall declining birth rates and it is clear that the underlying demand curve is shifting downwards. If it were not for the efforts of central bankers' money creation exercises, the world may well have already transitioned into the consolidation phase after the 2008 recession.
However, for us to fully switch into a deflationary world, some conditions probably need to be complied with to ensure that inflation does not take off again. World debts need to be made more sustainable either through default or restructuring and excess money creation over the last few decades needs to be resolved. That can either be by prices rising substantially or more likely by reductions in the money supply.
Although it is impossible to predict what circumstances might comply with these conditions and when, it is likely to be some form of major financial crisis - probably centred around sovereign debt. The chain of events triggered by this would ensure the remaining debts became more sustainable and the accompanying wealth destruction would resolve the latent inflation issue.
The difficulty of managing wealth in the coming decades
Managing wealth over the coming decades is going to be very difficult as no one strategy will consistently bring in positive returns. In the short term, the world is likely to experience a 'lowflation' world as central bankers attempt to manage the economy to increase inflation rates to 2 per cent. Their money printing exercises will favour assets such as shares and property. An economic recovery of sorts could well propel the FTSE to all-time highs. However, anyone with cash-based savings will continue to see them eroded year after year, as interest rates remain low.
The transition period could be turbulent. Those very assets that are doing well now will suffer substantial losses in the next big financial crisis. Defaults on bonds will also have major implications for pension funds that have been forced to be the primary holders of such instruments. Even cash holdings may be bailed-in as banks fold and governments cannot (or will not) save them. During this time, the key asset to hold might be gold. But who can tell whether even that asset can withstand confiscation by governments or even a collapse caused by the unwinding of paper gold contracts. If digital currencies have come of age by then, they may be an alternative.
The aftermath is likely to lead to reformation of the processes of money creation to ensure that such a crisis does not happen again. This means that in the long term, prices of land/property and shares will be more stable. There may be little capital gains to be had from holding shares; merely a dividend of 2-3 per cent. However, remember this will be in a world of slightly declining prices; maybe -1 per cent or -2 per cent a year. Therefore, net returns on shares might revert to historical levels of 4-5 per cent. Although interest rates may stay low, long-term savers may still get a positive return with deflation.
Money will revert largely to its original purpose - ie, a method of exchange and store of value. The perversion of being able to make money from nothing may be extinguished and the principle of risk/reward return. However, how we get to that state is going to be a challenging time for any investor.
•Pete Comley's book Inflation Matters: Inflationary Wave Theory, its impact on inflation past and present … and the deflation yet to come is available in Kindle format priced £6.99 and will be shortly available in hardback from Amazon. You can download a free special Investors Chronicle Lite version of it featuring key chapters at: inflationmatters.com/investorschronicle.
