Sunday Supplement – Inflation and the Lost Decade

Apr 17, 2022

“Being lost isn’t the same as being nowhere. Being lost is worse because there’s the false hope that you might be found.” – Paul Tremblay

Welcome to the Easter version of the supplement – a day later than usual after a much needed rest on Easter Sunday. The past few weeks amongst other subjects have seen me address strategic planning, productivity and performance. In order to achieve anything like your full potential (and that’s a task doomed to failure by definition), you also need rest. Reflection. The world becomes more and more noisy, more and more messaging, more and more conflicting information, and our small moments of quiet can easily get crowded out. Some (including many of the rich and famous) address this directly with meditation. Like anything, it is not the only fruit – as stupid as it sounds, I took a walk yesterday without my mobile phone. For me, that’s a rarity – I stopped, listened, concentrated on breathing, used a number of the principles of meditation without actively “trying” to meditate – and it felt great. It made me realise I don’t do it often enough and have not yet built a life that allows me to spend 30-60 minutes a day on doing that sort of thing – so, that feels like an interesting development for me. I don’t recall the last time I even considered the benefits of rest, rather than just a way of feeling bored. 

As a complete counter to this, I also took some time to watch a short video about Elon Musk – snippets of him being interviewed by various people. What came across to me was something I haven’t seen since I watched a Gary Vaynerchuk video some years ago when he was talking about ambition. The big difference was that Vaynerchuk was talking very directly about his drive and ambition, and wishing it could go away – Elon was more discussing it in a reflective fashion, in a way that says “listen, I know I’m different to almost everyone I’ve ever met, not that that makes me better, it just makes me different – and so I’ve followed the path I’ve felt compelled to follow”. Really interesting, because in some of it he gets quite emotional and that invites you to consider why that might be – a bit of it, to me anyway, came across as though sometimes he just wishes he was normal. 

There’s a number of techniques being combined there. Complete abstraction – the presence of everything and the presence of nothing. Perspective. Reflection and philosophy. Learning about knowledge and “why” you do what you do, if you are lucky enough to have particular control over your wider destiny (we can all control our own actions, mostly, although we often don’t do that, certainly not in entirety – we can only influence or hope to influence the actions of others, of course). I thought it was worth sharing that on what I hope is a day of rest for the vast majority of the readership of the supplement.

So, that’s the Easter curve ball out of the way. I wanted to move on this week to talk about something that’s unavoidable and will have a major impact on the political future of the UK – and also to try and highlight something that we’ve done very poorly over the years, and are still no better at – learning lessons from other situations and countries that share some of our characteristics.

As we have often in the past 18 months, we need to start with inflation. There’s headlines this week that once again can’t go without comment – and at the risk of being the proverbial broken record, there are a couple of things that I need to repeat. Firstly – there is an extent to which perceptions will affect and shape reality. One of the major developments this month of the inflation numbers is that it has set the expectations for the year ahead at around 6.6% in the USA in consumers (from 6%), and at 6.1% in the UK for the year to come (from 5.6% the month before). This is distinctly different from the inflation numbers that have been released, of course, because they are simply backward-looking. Prices, as defined by the consumer prices index (CPI) are up 7% from March 2021 prices to March 2022 prices. You may note a few things here. One – that’s already happened. It’s done. If you are looking at construction costs in property (for example), you will note that the increases have been above 7% and are in fact in double digits (officially, and unofficially/anecdotally). The second is that this was not the expectation, generally, 12 months ago. It was far, far lower than this. So this inflation has occurred in spite of expectations, contrary to (general) expectations. A third point is that this has all occurred BEFORE the 54% rise in the energy cap which came into place on April 1st, and indeed “national price hike day” was coined as a phrase – energy costs aren’t everything, but this means there’s more to come as a guarantee.

So now our inflation expectations are more than double what they were 12 months ago. What does this mean? What do consumers do? Well, they prepare for the worst. 12 months ago we had not yet freed ourselves from a long and economically punishing lockdown – so there were major reasons for economic pessimism generally, although by this time in 2021 it was clearly “getting better” (everything’s relative, right?). What’s the single biggest thing that consumers are likely to do? Well, in their role solely as consumers, they are likely to save. This is counterintuitive because inflation is smashing money in the bank – accepting the CPI as a base measure, if you had 100k in the bank in April 2021, and you haven’t touched it in 12 months, that 100k will only now buy 93k worth of goods or services at April 2021 prices.

If we expand that a little bit – because, even when only considered as economic pawns, we are more than consumers or savers – this feeds through into wage demands. If the expectation is 6% or more for the next 12 months, then pay negotiations are going to be based around this figure. I don’t mean that everyone in employment is going to say “right, I monitor inflation numbers very closely and I need a 6% pay rise to stay where I already am, in order to afford to live in the way I already do – with no improvements”. I mean this is a good yardstick to understand wage demands. 

This is the single factor about inflation that scares central bankers more than others. If wages do move up at that rate, or even higher, then further price increases can be passed on, and the vicious circle can whirlwind upwards, with prices going up another 6%+ in order to pay for these wage rises – if they don’t go up 6%, the shareholders and business owners are having to cut margins for reasons that are mathematically obvious. 

7% actual inflation. 6% expectations. More to come. These are numbers that get central bankers fired. More than this – the incidence of this is on the people. Real, economic pain. Things moving in the wrong direction. Where do the public look when this happens? Who can they blame? (After all, much as I am an advocate of individual responsibility, it is difficult to see what 95%+ of the population could have done in the past 12 months to prepare for this, especially with the narrative being around transitory inflation and temporary difficulties). 

Well, there’s only one answer to that of course. Government. Regime change. My personal view around the last election is that “Alexander Boris De Pfeffel the Great” is an overplayed factor. I believe it was the election in all of modern times that people voted AGAINST one of the candidates, more than any other, rather than actively voting for someone. One reason for that is the relatively extreme left-wing position of Corbyn, McDonnell, and their Corbynites. The other is that the polarising Brexit debate had a remain side (Labour) and a Brexit side (Conservative). None of that particularly recurs in what’s likely to be the 2024 election. 

This doesn’t bear out particularly in the polling numbers on yougov or similar pollsters. Labour are a mere 4 points ahead at last count. Because of the shape of constituencies, and the first past the post system, this would mean a resounding hung parliament. Even the most maverick of pollsters cannot show Starmer in the lead enough to win a majority. There is a simple reason for this – the polls ask “what would you vote for tomorrow” whereas I am forecasting forward to a serious and measurable decline in living standards by the time we get to the next election – and I can’t see a great way out of it.

We’ve 6 months until the 2022 budget proper (roughly, we do not have a specific date as yet  we will do in a few months’ time). We can reasonably expect the start of tangible declines in living standards for a large percentage of the population before that happens. Not for the first time since the beginning of 2020, I do not envy the treasury. Many in the party will be looking to the great hope that is Mr Sunak, assuming his wife’s tax planning activities do not spiral yet further to see him hounded out of office, to bring them something that can enable them to continue in power. 

By 2024 it will have been 14 years of generally Conservative rule – again, historically this sort of term is time for a change, regardless – and it will not be regardless. 

When I read that back it looks like a compelling argument – and so, in the name of balance, I’d like to also look at the other side of the argument. Why doesn’t inflation bite quite as badly as all of this, in real terms, to individuals? Well, if they are on fixed incomes – it does. The retired. Those on long-term benefits. They are surviving on 3.1% increases for the next 12 months against a backdrop, from an expectations perspective, of double that. 

Others, however, are more mobile throughout the percentage of income threshold which they sit in. An extreme argument might be a student at a top-flight university – no income to speak of until they land the dream graduate job; some US law firms recruiting in the UK are now offering 6-figure compensation packages to graduates. “Zero to hero” in one easy step. This is, of course, extreme. If we look more at the mean or median wage – we still know that incomes tend to rise, as people get promoted throughout their careers, until they are in their mid-50s or so (I am talking about aggregated figures). So, a surprisingly small percentage of people are in the bottom 20% of households for income for long periods of time. It is very much transitory – as incomes post 55 or so tend to drop, dependents have moved out of home and there’s an empty nest and a paid mortgage, in the majority. People change up high-pressure demanding jobs for a quieter life or part-time employment to keep things ticking over. 

Longitudinal analyses (those that look over time, rather than a snapshot at one point in time) are extremely valuable and extremely thin on the ground, for the UK, I’m afraid. I have to place an element of faith that the US data translates relatively well across to the UK (and indeed, the UK does not have the inequality problems that the US does, although it certainly does have problems). The other problem is that to follow people over 40 years, your data is 40 years out of date (or the start of the data is, of course) before you start. In the US in one of the more recent studies, 56% of households spent 1 year or more in the top 10% of income earning households, and 73% spent 1 year or more in the top 20%. That, hopefully, shows you just how much mobility there can be over time, and why the problem might be in danger of being overstated if we don’t appreciate the nuances of this argument.

When you start to piece some of this together, and also look at the spread of the votes at the 2019 election, you start to see why (at a cynical level) the incumbents might well be in the place where they would be serious about levelling up – and once again, we come across the dangers of looking at data solely in aggregate. If living standards were to improve in the old “red wall” seats – or stay the same – or even, dare I say, get better comparatively to the safe blue seats of the south and some of the midlands – that might secure votes for the 2024 election. One other point is that surgically deployed regional funds really could make a difference – but this would rely upon a level of efficiency that normally escapes the government, so I am not holding my breath on this point.

There’s a further problem too – any long-term investments won’t be vesting by 2024. So it relies on people ignoring short-term pain to see a positive in voting for the incumbents once again. You’ll note here there’s been no mention of partygate or similar – I expect this is a factor today, but forgotten by 2024 (not by those who couldn’t attend a funeral whilst Nero was fiddling in the garden with cheese and wine at number 10, but by the vast majority). 

So if I was picking a winner today, “hung parliament no bet”, I would be on the Labour bus. There’s so many challenges, limited solutions, and much to worry about. There’s time, and there will be backs and forths aplenty, of course. Yet there’s one more reason that I’m thinking will make a significant difference – and that’s where we go for the rest of today’s efforts.


The lost decade(s)

It struck me some weeks back that one of my favourite lessons from economic history had not yet been expounded in any way in the supplement, and we are at the perfect backdrop to do so. Regular readers will know I refer to the economy of Japan on occasion, because there are similarities with the UK economy. The current capitalist system, with floating fiat currency, doesn’t do much to explain or study Japan in many ways. If you have watched Ray Dalio’s excellent recent video around principles in a changing world, it forgets the dominance that Japan was exhibiting in the 1980s (or sees it as too irrelevant to mention versus the current rise of the Chinese economy). I think we have lessons to learn and thus I want to lay some of them out.

As a whistle-stop tour, Japan was the very largest of the “Asian Tiger” economies in the 1980s. Others kicked on whereas Japan experienced a gigantic asset price bubble which popped in 1991. After the gigantic haircut in the stock market, and the initial crisis that ensued, what’s happened since then has in many ways been like pressing a pause button in Japan.

Inflation has been very, very low indeed. Almost nothing at all, in that 30 year period since, with many years of deflation (which can be very damaging to an economy indeed). There is also a relative anti-immigration stance in Japan with around 2.3% of the population being born outside of Japan (compared to the UK – 11.3% – around 5 times as much immigration, very much representative of the percentage in Western Europe). 

GDP per capita, measured in US dollars, is still not back to where it was in the mid-90s in Japan (comparison to the UK, if we measure in US dollars – we are 20% below where we were in 2007, and where we were in 2004 – but don’t underestimate the amount the currency exchange rate makes a difference, with a false exchange rate on the dollar in 2007 thanks to the US being the world’s capital of the global financial crisis, of course). Japan, by comparison, is back where it was in 1993.  

Government debt in Japan makes the rest of the world look extremely solvent in comparison. Japanese government bonds are viewed as so incredibly safe (and in vast majority, held by Japanese institutions) that they manage to hold stable despite debt being at 266% of GDP (of which around 45-50% is held by the central bank. UK comparison – 95% of GDP, 38% held by the central bank). Another way to compare that would be to say that the Bank of Japan owns around 126% of GDP as bond debt, compared to 36% in the UK, so for the true cynics, the ponzi scheme is 3.5 times larger in Japan than it is in the UK!

The lost decades started off as the 1990s, but have since been extended by commentators as “progress” has continued to drift. We need to be cautious – as I always am – with where we start the analysis from. We are looking back at a historical peak – in the 1980s, Japan’s corporates were so dominant that they made up 32 of the top 50 global companies by market cap. Now, there is only 1 left in the global top 50 (toyota). There have been significant investments abroad by the Japanese manufacturers that drove so much of this dominance in the 1980s, of course, so their GDP as so often is not the full story – and indeed today’s picture is a graph of the percentage of revenue that comes to Japanese manufacturers from overseas subsidiaries (think Nissan Sunderland, many times over).

So – the above tells a little about the similarities of the two countries, and the differences, and what we have seen in the past 30 years (supposed to be 10 years, then 20, then 30 – and is it all fixed yet? The jury is still out). What’s the relevance to the UK today?

Well, one particular stat that does translate well across borders is that during these lost decades, the degradation in real wages at its worst point from peak to trough was 5%. So, after inflation, wages were down 5% on average leaving the working population 5% worse off. Very significant.

If we look at the UK – the most recent ONS figures to February this year show a real terms drop of 1% in wages. March’s 2022 estimates see wages up 6% with inflation at 7% (confirming that 1% drop in real terms). Japan’s central bank over these lost decades has kept the interest rate below 1% in the central bank since the mid-90s, and it sits today at -0.1% as it has done for the past 8 years (and you thought our interest rates were low!) – so there have been no rates-inspired crankings causing recessions there. 

In the UK we are about to approach 1% base rate for the first time in 13 years. This makes money more expensive, in a bid to win the most obvious statement of the day. The current debt position of UK companies is that the large caps are well placed in terms of their debts – whereas the SMEs are not. Let us not forget SMEs employ 90% of the payrolled staff in the UK. SMEs have also had access to debt, which they have not yet defaulted on, that came very easy and “cheap” in the form of Bounceback Loans and CBILS loans. CBILS loans were generally issued as linked to base rate. I think you can see where I am going with this.

A problem (more expensive debt) in times of squeezed margins (now, thanks to inflation) that affects only a small percentage of SMEs can equal a big problem. One more factor in the equation – around 550k people are outside of the labour market compared to pre-pandemic (the great resignation). Living standards could reverse some of these decisions relatively easily – if half reversed their decision in the next 6 months that magically conjures up 275,000 unemployed people, and that makes the unemployment figures look nowhere near as good as a “shock” to the system.

What do I see as a real material possibility in the UK? The impact of the worst of the lost decades happening within a concentrated 3-5 year period, basically. Wages down 5% in real terms (otherwise, inflation will be higher than 5% for some years to come, as it becomes a self-fulfilling prophecy). This is one more major piece of the puzzle for the next election, in my view – so, get your bets on now on that front…..

So…….what if we do get a labour administration for the first time in 14 years? Well – there will, as always, be pluses and minuses. Some things will be done differently. As for property investment – well, the rental inflation (double digit now being recognised in some of the figures, even the ONS is up to 2.4% increase year on year) will mean some populist policies proposed, for sure – including rent controls and rent caps that will have a potentially distortionary and damaging impact in some of the UK. More barriers and even fewer pieces of stock will not be positive.

I will sign off with one more interesting snippet that today’s research uncovered – there have been 175k housing starts in the UK in the past 4 quarters (declining, each quarter, by the way – so much for build build build) – Japanese housing starts for the past 12 months are 788,000. The population is nearly double – but not quite – but the housing starts are 4 and a half times larger. The broken parts of the system are getting worse, not getting nearer to repairing themselves.

Until next week – when I will go into some further detail about how we can navigate through these potentially lost years ahead of us – have a good one!