Why Should You Be Scared of Inflation!

Inflation means different things to different people. In financial world, it is a much greater driver of financial market than changes in economic activity.

• A rise in inflation usually increases volatility of economic growth, which in turns reduces P/Es and the willingness of the private sector to take risks.

• Inflation typically takes a much meaner bite out of margins than a recession does. It is inflation, not growth, which wreaks havoc on profit margins.

• A surge in inflation typically means interest rates will be rising in the near future. That means investors get to lose money on both bonds and equities. For example, from 1966 to 1980 – the last inflation surge period – US bonds shed 2% per annum and US equities fell 4.9% per year.

Fear is understandable because growth almost everywhere around the world is slowing while inflation is still accelerating.

There is little doubt that the weakness in the USD, often associated with the spike in commodity prices, is the key parameter to the whole equation. This is more so in the emerging economies, where food and energy represent a much bigger slice of the average family’s spending than in most OCED countries.

Of course, USD is part of the problem. Like the saying of the late Milton Friedman that ‘inflation is always and everywhere a monetary phenomenon’, the excess liquidity creation is, however not the work of central banks, and it will not be a valid criticism to them. The narrow money growth, M1 has not seen much of a rise in recent years suggesting that the pace of monetary creation has by and large been tame.

So if this is not the creation of central banks, then the natural choice of candidate will be the commercial banks. Banks have ridden the ‘financial revolution; as hard as they could possibly be, evidently from the rapid expansion in corporate paper outstanding in the period between 2003 and 2007. The challenge now is whether the velocity will remain as buoyant over the next two years, as it did in the 2003-2007 period, especially with bank balance sheets now under severe strain. As such, the willingness to take risk from private lenders would be very surprising.

Last but not least, the US current account deficit, which in essence, is providing the world with its working capital. When the US current account deficit improved, the US deflated other countries and vice versa. To-date, the US current account deficit still stands at a rather large 6% of GDP, and large of the reflating situation is much related to oil producing countries. The fact that the US is no longer reflating non-oil producing countries is a very important element to our economy, which resulting not only us, but a number of countries as well to save more than they earned!

There are countries that are today dealing with the largest inflation threats because of the need to reflation their economies, and the large US current account deficit propagates the belief that the USD could only fail, and thus encouraged large borrowings of USD outside of the US.

In short, inflation is proving to be massive headwinds for financial markets, and part of the fear is that if the central banks will have little choice but to tighten the policy in the coming months and the leadership of equity markets should go through a serious adjustment.