The inflation vs deflation debate is crucial for investors

When I began my investing career back in 1997, you could get a real return on your money buying UK government bonds (gilts) or even having money in a savings account. Inflation back then was running at an annual rate of 3.6 per cent. The Bank of England base rate was  6.25 percent and the yield to maturity on 10 year government bonds was slightly over 7 per cent. 

Today, inflation is virtually non-existent. This week, the Office for National Statistics told us that consumer prices were increasing at an annual rate of just 0.3 per cent. Instant access savings accounts pay virtually no interest and 10 year government bonds yield 0.21 per cent.

Low general price inflation (in contrast to asset price inflation which has soared over the last decade) and the low interest rates that have come with it have pushed investors into shares in a search for a real yield. This trend has seen share prices in most markets increase faster than company earnings and cash flows. As a result, the earnings or free cash flows of many high quality companies as a percentage of their share prices (yields) are now also very low, at around 2-3 per cent.

This is not a big problem - although it’s hardly a sign of cheapness - when inflation and interest rates are negligible but if inflation were to take off and  get to, say, 5 per cent, then a 2-3 per cent yield on a share does not look particularly enticing, even with the expectation that earnings and cash flows can grow.

High rates of inflation have the potential to hurt stock prices as they did in the 1970s. This is because the real buying power of the expected  future cash flows is being hammered.

I don’t think we are going back to the 1970s. I say this because the world has changed so much since then. If you accept the cause of inflation is too much money chasing too few goods then for inflation to take off households and businesses have to be spending money at an increasing rate.