Hello darkness my old friend

This was meant to be the recovery year. The year of moving past Covid. The year of the “reflation trade” – where markets and economic growth got back on to their pre-lockdown track.

Instead, 2022 looks to be the year that central banking intervention, globalisation and the unfortunate trends of the 70s will catch up with us. 

The UK economy was already sputtering as the year kicked off, and increasing prices continue to pile on pressure.  

The official inflation rate – as measured by the consumer price index (CPI) – is now sitting at 6.2% for the month of February. This is the highest monthly reading since March 1992. I’m sure the official central bank measure of inflation is completely detached from the true cost of living.

There’s worse to come. The Bank of England admitted last month that prices will rise further than they thought. Goody. That’s less money for fun stuff and more for the basics.

And more bad news has been dumped on the population ahead of Easter. Gross domestic product (GDP – the total value of the goods and services a country produces) grew by just 0.1% for February. That’s short of the 0.3% predicted by economists, and well under January’s 0.8%.

This later data dump shows that, even before things took a turn for the worst, the UK economy was fizzling. The impact of the Russian invasion of Ukraine isn’t part of this data, either. None of the March price distortions with oil or gas are factored in. The same applies for any of the local manufacturing that relies on components from Eastern Europe, where many factories sit idle.

Economist Thomas Pugh from RSM UK noted that things were bleak before Russia stomped over the Ukraine border. He has pointed out that things aren’t going to get much better this year, saying:  

Surging fuel prices, slumping business and consumer confidence and supply chain disruptions will start to be felt from March and will really kick into gear in April when consumer energy prices rose by 54%.

Indeed, our forecasts suggest GDP growth will average just 0.1% in each of the remaining three quarters of this year – so while we aren’t currently forecasting a recession, it would not take much of a rise in oil prices or a disruption in supply chains to push the UK into one.

Yet crippling consumer prices may not be the worst thing you face this year. Russia’s war on Ukraine  will likely leave us with even higher prices, and could drive up unemployment.

And we’re about to get an unwelcome visit from a phenomenon predicted in the past.

An old foe

Iain Macleod, a Tory politician in the 1960s, is said to have named the beast we are about to face. In the House of Commons, he said in 1965: “We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of ‘stagflation’ situation.”

Stagflation is a period during which a country’s GDP declines. Put another way, inflation continues to rise as productivity falls. For you and me, that means rising prices up against falling wages and increasing unemployment.

Prior to the 1970s, central banks and economists thought stagflation was impossible. They were convinced that rising prices equalled increased GDP. But that’s the thing about economists and central banks, they aren’t very good at checking their blind spots.

The biggest problem with stagflation, however, is that it builds slowly, so it’s easy to dismiss. Inflation can be talked down by leaders as a temporary problem. And that can be true until an economic shock comes along that disrupts markets and drives input prices higher.

Like the oil shock of 1973, where several Arabic countries ceased oil exports to the United States as retaliation to the latter for supplying the Israeli military with equipment. The reduction in oil saw crude prices rise 300% in less than 12 months, creating huge financial pressure for the population.

Source: Economics Help

The British government introduced emergency speed limits to conserve petrol, and TV broadcasts stopped after 10.30pm to save energy. Three years later, the UK government went cap in hand to the International Monetary Fund (IMF) for a bailout.

Think of stagflation as a crippling recession with uncontrollable price rises.

The biggest threat of this old foe is that it leaves people desperate. A population faces joblessness and poverty risk, not just an economic crisis, and also civil unrest…

A generation that only knows good times

When does a cost-of-living crisis morph into political instability?

Stagflation builds slowly, but hits hard when you least expect it, and it’s a reckoning the pollies are going to be faced with much sooner than they realise.

The problem for the rest of us, though, is that there is an entire adult generation that knows nothing but good times. Yes, there have been some market shocks in the last 30 years. We have seen the Iran-Iraq War, the dotcom bust, 9/11, the financial crisis and then Covid. All huge events, for sure.

What separates this period of uncertainty is the financial impact stagflation will have.

Any household savings gained during Covid will be quickly eaten away. Business may reduce hours or staff, meaning there’s less money to put towards essentials. Once stagflation is entrenched, it can last for years. Cash at the bank and passive exchange-traded funds are going to struggle to keep up with rising prices. This younger demographic will be forced to turn to alternative investments such as cryptocurrencies, gold and other industrial metals that tend to do well when economies stagnate.  

How? I’ll explain more on Thursday. 

Until next time,

Shae Russell
Co-editor, Exponential Investor