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Why Wealth Managers Should Beware The Spectre Of Inflation

Tom Burroughes , Group Editor , London , 30 June 2010


There is a spectre stalking the corridors of financial policymaking – the spectre of inflation. And considering that a prime function of wealth management is to protect the assets of clients in real terms, inflation is an issue that must come high up the list of concerns.

There is a spectre stalking the corridors of financial policymaking – the spectre of inflation. And considering that a prime function of wealth management is to protect the assets of clients in real terms, inflation is an issue that must come high up the list of concerns.

The risk of rising inflation might appear remote at a time of current slack labour markets and low capacity utilisation. For example, US capacity utilisation stood at 68.5 per cent in May, way below a 1972-2009 average figure of 80 per cent. (Source: Federal Reserve). But such data will not tell the whole story. With central banks, especially the Fed and the Bank of England, printing money in large amounts (“quantitative easing”), the risks are considerable. Royal Bank of Scotland, for instance, has warned its clients to prepare for “monster” money printing by the Fed to keep a flagging recovery on track.

Such "monster" money creation is reckless, in my view, bearing in mind that the US authorities have already hosed financial markets with new money. My views are heavily influenced by the “Austrian" school of economics, a body of thought that regards money as a claim on real resources rather than something that can be treated like some sort of metaphysical abstraction. (The school gets its name from great Austrian economists such as Ludwig von Mises, Carl Menger and FA Hayek).

In a nutshell, the Austrian school says that if you print more money, then that additional money chases after resources, including human labour power. Because the money has not come from real savings (i.e. foregone consumption), then this creates a bubble, followed by an eventual “bust” as malinvestments unwind. (For more about such ideas, click here). There is no way to end a credit bubble painlessly, it argues. 

By contrast, monetarists such as the late Milton Friedman have argued that large-scale money printing by central banks is sometimes necessary to prevent a banking crisis turning into a slump, as Friedman argued was the case in the early 1930s. (The current chairman of the Fed, Ben Bernanke, is a big Friedman fan). But even so, Friedman did warn about the dangers of abusing the monetary system and regarded such actions as temporary, stop-gap measures. Very different in some ways is the Keynesian school, which believes central banks should print money as much as possible if that revives an economy. If higher prices result, well that is too bad as a bit of inflation is not a great problem, is the attitude. Keynes himself infamously argued that "in the long run, we are all dead". That is not a motto I would want any family office investment boss to adopt, for example. Wealth managers have to think long term.

There have been warnings that there are problems building. Just look at the gold price - now fetching around $1,230 an ounce in the futures markets in the US. In May, the UK consumer price index rose by 3.4 per cent, down from 3.7 per cent in April but still above the official UK inflation target. And remember that the CPI measure does not capture all price movements, such as for mortgage interest. The measure that does include such factors, called RPIX, was 5.1 per cent in May.

Warnings are coming from the likes of PIMCO, the giant bond fund management firm with an obvious reason to be vigilant about eroding money values. In a note published this week, the US firm said that for over a year, it has thought inflation would be unlikely to rise in the near term but further out, the chances of a more aggressive inflation problem will grow, it says. A lot of productive capacity in the US has vanished; if there is a surge in “demand” created by central bank new money, there will be an inevitable lag before new supply comes on stream, which means that in the intervening period, prices will go up. PIMCO is less worried about inflation in the euro zone, and has not yet made up its mind which way the dice will fall in the UK. But remember that until the last two decades, the UK had a terrible inflation problem running from the 60s to the 70s, which devastated returns on bond yields and encouraged wealthy individuals to scurry for safety into areas such as property, collectibles, art, gold and selected equities.

That may be starting to happen again. This week, for example, WealthBriefing reported on the amount of money people are now prepared to fork out on exotica such as autographs. (Yes, really). And there is now an index that tracks the value of such things. The PFC autograph index that tracks 40 of the most famous celebrity signatures has shown an average rise of 335.9 per cent in a 10-year period to 2010, chalking up an annual compound rise of almost 16 per cent. Just compare those figures with the 10-year annualised performance of the MSCI World Equity Index, of minus 0.24 (based on figures as of 31 December last year). Or take the case of fine wine: the Liv-ex Index in London has risen by 37.2 per cent year on year as of 31 May. (The index tracks mostly French fine wines). There have also been some bumper art auctions. And meanwhile, in more traditional territory, investment houses such as Sarasin & Partners are advising clients to avoid most government debt and go for equity dividend growth instead, not least because it is a smart inflation hedge.

This is sound advice, at least for the time being. Inflation, let it not be forgotten, can erode capital even when running at relatively low levels, due to the effects of compounding. Consider the Barclays Capital Equity Gilt Study of 2010, published earlier this year. It showed that from 1969 to 1979 – a period of high inflation in the UK – real investment returns on gilts were negative, at -4.1 per cent per annum, and equities also lost ground, at -2.1 per cent. As the-then Tory government of Margaret Thatcher got more of a grip on the inflation problem in the 1979-89 period, real return on gilts and equities were 6.9 per cent p/a and 15.6 per cent p/a respectively. The last decade has been dreadful for equities due to the bursting of the dotcom boom and the post-2007 crash: with gilts making a fairly meagre 2.6 per cent p/a return and equities down by 1.2 per cent.

So it is not surprising that wealth managers are having to consider ways to protect their clients’ portfolios from inflation. Besides the obvious ploys of broad diversification, dividend growth, and select investments in traditional havens such as gold, managers should also ensure they tell their clients about the risks without causing undue alarm. Over the past 20 years or so, policymakers around the world have had it easy on the inflation front due to the benefits of globalisation, weaker trade union bargaining powers, the price-reducing impact of the internet, just-in-time stock inventory systems and the deflationary impact of cheap Asian consumer goods. To varying degrees, these forces have been either one-off events or are now in partial reverse. For example, the regulatory tide is rising and other things being equal, is likely to hamper entrepreneurship and ecomomic flexibility.  

Alas, it appears that some policymakers seem to have forgotten the argument that ultimately, crises that were caused by years of cheap money will not be solved by even more cheap money. We must hope that previous mistakes are not repeated but it always pays to be on guard. Wealth managers must take note. Inflation is a silent killer of wealth.

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