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LGT Investorama: The armed robber as a sentiment killer

July 1, 2021

Concerns about inflation have increasingly been dominating the headlines in the financial press again recently. In a recent Bank of America Merrill Lynch survey, 35% of respondents ranked higher-than-expected inflation as the top threat to financial markets. Why is the fear of increasing prices so great?

Economic theory provides us with an answer: loss aversion. Loss aversion implies that most people lack the rationality that any economist should have. People usually and irrationally have stronger feelings when they lose something than when they gain the same thing. The pain of losing 1’000 Swiss francs will therefore outweigh the joy of gaining the same amount of money. Even an annual inflation rate of the 2% targeted by the central banks is enough to halve the purchasing power of money every 35 years. Former US President Ronald Reagan therefore considered inflation to be “as frightening as an armed robber”. In other words, fear of inflation has recently become a potential killer of upbeat sentiment in financial markets.

Paul Volcker, the very tall chairman of the US Federal Reserve in the Reagan era and an inflation-tamer in the early 1980s, successfully fought inflation, which was rampant at the time, with massive interest rate hikes. The Volcker shock ushered in a decades-long period of falling inflation rates and less pronounced real economic shocks. Expectations have long since been adjusted accordingly, and year after year the proportion of the population that has grown up in an environment free of inflation worries has been growing. However, the fact that inflation has been in steady retreat since the 1980s is not solely attributable to the Volcker shock but also to a number of structural supply-side developments. The integration of Eastern Europe, China, and other emerging economies into the world trading system expanded the global labor force by about one billion workers in the 1990s almost overnight. Combined with labor market reforms in industrialized countries, the decline in the clout of trade unions, and the spread of new technologies in general, this has created downward pressure on the prices of labor, goods, and services in large parts of the global economy. Moreover, the period was marked by a retreat of the state through privatization and deregulation. While technologization continues to gain ground and has even received a strong boost from the recent crisis, other disinflationary forces are weakening. For example, all major emerging markets are now integrated into the global economy, which means that one factor driving the long-standing disinflation will no longer figure in the future. On the contrary, in recent years the pace of globalization of ever longer value chains has actually slowed and the pendulum may even have swung back. Moreover, national states are once again increasingly taking action (“big government”).

All this does not per se point to an increase in inflationary pressures, but the structural forces driving ever cheaper prices have weakened. Moreover, a look further back into the past shows that phases of low inflation or even deflation have been followed by longer periods of high inflation. Obviously, there were specific reasons for each of these episodes. These include the monetization of government deficits from war financing, the destruction of production capacity during wars, or the shying away from the political and social consequences of anti-inflationary measures. Often, the change between these phases was also associated with a change in monetary policy regimes, such as the introduction or abandonment of the gold standard or Bretton Woods. In the end, however, it was also the collective experience of prolonged periods of low inflation that made people gradually forget about the dangers of inflation and led to increasingly rash and ultimately completely reckless financial behavior on the part of state institutions. Today, for example, the increasingly unholy alliance between central banks and governments, as well as initial tendencies towards a softening of inflation targets, harbor long-term inflation risks.

The risk of higher and economically damaging inflation should therefore prompt prudent investors to take inflation scenarios into account in their investment decisions. For example, adding gold or inflation-linked bonds helps to diversify the portfolio. Inflation-linked bonds are securities whose payouts are effectively linked to consumer prices and therefore provide protection against inflation risks. They also offer higher expected returns than nominal bonds in future scenarios with rising inflation expectations. In general, adding gold and inflation-linked bonds to an investment portfolio improves robustness and keeps inflation as a sentiment killer at bay.

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