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Is 70s-style inflation really consigned to history?

The political, economic and social calamity caused by double-digit inflation in the 1970s is (thankfully) a distant memory for most UK investors, but could the increase in short-term employment contracts and freelance work lead to a distortion of inflation in the opposite direction?

the gig economy

The value of investments can fall. Investors may not get back the amount invested.

The car icon beetles its way along a digitised roadmap as a passenger waits patiently in the cold – two minutes until arrival. Next comes the almost imperceptible hum of a Toyota Prius as it pulls up at its destination, followed by a verification of the client’s name by their ‘driver-partner’. And so another journey begins.

This is the experience of 3.5 million Uber users in London every time they use the app on their smartphone; taking part in a transaction often seen to epitomise the ‘gig economy’.

Paul Brain, bond manager at Newton, says: “The term gig economy generally refers to low-paid, flexible work which is fed to workers through an app or website. This enables them to do it piecemeal.

“Around 1.3 million Brits are employed in the ‘gig economy’, while five million people in the UK are self-employed and one-in-ten British workers are deemed to be in ‘precarious work’.1 Is this a desirable state of affairs? That is not for me to say, my main occupation with the gig economy is the potential impact it has had on inflation,” Brain continues.

Where are wage rises?

With many economies implementing higher minimum wage levels and attempting to protect domestic industries through imposing tariffs on imported goods, Brain says, the pressure for higher wages should be increasing and then feeding through to overall inflation. But despite all of these factors, wage inflation is still relatively benign.

“In addition, unemployment in most major economies is relatively low. Under normal circumstances this would lead to an increase in wages, yet there has been very little of this,” Brain says.

In the 1970s, inflation in the UK peaked at 25%.2 This was fuelled in part by rising wages as workers in many industries were bolstered by unions, while the oil price shock of 1973 lead to a quadrupling of oil over six months.3 Today, the consolidation of a ‘gig economy’, enabled largely by the proliferation of smartphones, means workers in some instances are on far shakier ground.

There are also clear cases where the gig economy has created greater efficiencies, says Brain. Combined, these are some of the factors he believes have suppressed wage growth over the past few years.

“The automation that enables the gig economy does not do away with the jobs but it does make them quicker and easier to do in a lot of cases. For example, black cab drivers in London were a protected sector and drivers had to take ‘the knowledge’ in order to be accepted into the club. This took between two and four years and was a significant investment for the driver.

“Then Uber came along and increased the number of cars available, which lowered costs. The app has essentially digitised ‘the knowledge’, something that used to require a great deal of time and energy to learn.”

He says the predominant view in from investors is that bonds as a sector are looking at some significant changes – the return of higher inflation and higher yields – and that this will make it more difficult to make money through investing in them. Yet, he points out, if inflation continues to be supressed, this will not necessarily be the case.

“Either way, we think there are ways investors and fund managers can cope if they give themselves enough global opportunity within bonds and think about investing in economies where interest rates are not rising.”

There are a number of investments Brain uses to take advantage of their lower volatility profiles (such as developed market government bonds) while others are seen as more risky and therefore can offer higher returns, such as high yield and emerging market bonds. 

“Even in an environment where there is an inflationary backdrop you can find companies that are doing well and countries acting differently,” he adds.

Will inflation ever return?

Central banks such as the Bank of England, which decide the 'base rate' within countries or regions, are said to be taking a more aggressive stance against inflation in 2018. (This means investors believe there is a greater likelihood central banks will raise interest rates.) But Brain believes this change in tone has been so well telegraphed that it is not a huge concern: “This is probably not as big a negative for government bonds as people would assume because markets tend to take account of this information long before it happens. In my view it is risk assets (such as shares) that are more vulnerable to a sudden increase in volatility.”

Brain says Moravec’s Paradox could be a further factor behind limited inflation over the longer-term. He explains: “This paradox looks at one of the more intriguing elements of automation: that it is easy for machines to do the things humans find hardest. For example, they can diagnose illnesses based on analysing scans or symptoms, which traditionally required a qualified doctor, or scan through pages of documentation to find precedents in court cases, which previously required a qualified lawyer.

“Yet machines find it harder to do the tasks that humans find easy, such as the service of food and drink. The professional service sector, covering sectors such as law and medicine, has been the biggest employer in the UK for the past two decades and that is where we could see the biggest change and impact on wages, to the downside. That pressure is not going to go away, which is why I question if inflation can ever return to trend, or whether we could even see the foe of Japan come to the UK’s shores: deflation.”

The relationship between inflation, bonds and yields

Q. What happens when we have higher inflation?

A. When inflation in the UK ticks higher, the Bank of England will generally raise interest rates, unless it thinks the increase is a temporary uplift that will revert to trend soon. This is designed to moderate economic growth if the Bank thinks it is in danger of over-heating – growing too much, too quickly. The cost of borrowing and mortgage interest payments tend to increase when the base rate is moved higher because many financial products are priced off the Bank of England’s base rate.

Q. What does this mean for bonds?

A. When the interest rate (or yield) of a bond increases, the price of the bond decreases – this is known as an ‘inverse relationship’. As the holder of that bond, the value of the asset has decreased. This is why inflation is referred to as “a bond’s worst enemy” by Investopedia.4

Q. How do investors mitigate this risk?

A. There is no way to absolutely mitigate the risk of rising interest rates when it comes to investing in bonds, but forewarned is forearmed. It is for this reason that investors pay so much attention to the announcements and minutes of the monetary policy committee of the Bank of England and other central banks around the world.

  1. 1 Guardian, as at March 2018
  2. 2 In 1975, UK inflation was 25%. Source: Office for National Statistics, accessed May 2018.
  3. 3 Federalreservehistory.org
  4. 4 Investopedia, ‘Understanding interest rates, inflation and bonds’ 24 Aril 2018

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