16 December 2022

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History of inflation

Luigi Campopiano

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Some financial events remain engraved in memories. For example, German people will tell you that one of their ancestral fears is linked to the explosion of inflation in the early 1920s. At the height of hyperinflation in November 1923, the cost of a loaf of bread came close to 450 billion German marks. 

You understand that the return of high cost of living to levels not seen since the early 1980s is scaring everyone a bit: central banks, politicians, entrepreneurs, and the average person who sees their savings progressively eroded.

In the West, Germany-style inflation has never been experienced, but we had to deal with that of the 1970s, which exploded following some events that are somewhat reminiscent of today:

• In the 1960s, especially in the U.S., to finance the enormous expenses of the Vietnam War, the federal state deficit exploded from $1.6 to $25 billion dollars from 1965 to 1968;
• When some countries began to ask for the conversion of dollars into gold, as foreseen by the Bretton Woods agreements of 1944, President Richard Nixon announced the suspension of the convertibility of the dollar into gold in August 1971, end of the "gold standard";
• The states felt free to print money without a balance sheet and conversion constraints. Moreover, on Oct. 6, 1973, the day of Yom Kippur, the armed forces of Egypt and Syria attacked Israel. Arab countries associated with OPEC doubled the price of oil and decreased exports to importing nations, blocking them for the U.S. and the Netherlands;
• In Italy, the inflation rate reached 10% and did not drop below double digits until September 1984 (it reached a peak of 21.7% in 1980); the U.S. also experienced very high inflation, and only the decisive action of Federal Reserve President Paul Volcker put an end to the phenomenon by raising rates to 20%, causing a double-dip recession.

Today we wonder when inflation will arrive, while it seems certain that central banks have underestimated the extent of the phenomenon and today are in an awkward position. They cannot help but raise rates to try to curb the price race, but they must not raise them too fast and stifle economic growth, which is already slowing down due to the outbreak of war in Ukraine.

The consequences on the financial markets were not slow. The Federal Reserve, acting belatedly, began the policy of monetary tightening and announced considerable increases during the year, leading to a forecast of a tightening monetary policy not seen since 1982. 

The markets were taken a bit by surprise because they did not imagine a change of pace of this magnitude: bonds saw the worst result in the last 50 years. For U.S. bonds, this was the worst time period since 1788.

The defensive part of the portfolios was unable to contain the market correction, with the equity component — thanks to the increase in rates and the slowdown in growth: between the war and new lockdowns in China — which experienced declines almost everywhere. This occurred especially for technology stocks, which are weaker in a context of rising rates.

Savers, disoriented by the strong fluctuations, have not yet adapted to the new reality made up of inflation and rising rates. With uncertainty brought about by the war and figures on current accounts, people face a certain loss deriving from the decrease in purchasing power. 

Inflation is a tough enemy to defeat because, often, the increases in an asset remain even if the price of the raw materials to produce it has fallen.

Savers no longer used to seeing the markets suddenly turn negative now see stocks that until the day before were among the most popular on the list being sold off. They also see losses on government bonds of more than 20% and the lack of support from central banks, always ready to intervene in the darkest moments of recent years. These are difficult conditions on the market today and various interesting opportunities, with portfolios that perhaps need to be adjusted but not dismantled.

Those who have built for the long term, based on their objectives, must not give in to being nervous. 

On the contrary, they can take advantage of the fear of others to make a profit, the so-called "risk premium." If liquidity is a port in the short term, safe in the medium and long term is always a loser. The average annual return from 1928 to today is 3.3% for liquidity, 4.8% for bonds and 10% for shares. 

To overcome this moment, we must be resilient, to use a term in vogue today.

As Charlie Bilello, founder and CEO of Compound Capital Advisors, said: "You shouldn't be rooting for cash to be your best investment; an environment where cash is king for a long time is not a good environment for investors."