Rising inflation & rising rates: A noxious cocktail?

Inflation in the US has not been that high since 1990. Some observers already predict a dangerous cocktail of high inflation and rising rates which would put the world economy into stagflation, just like in the 1970s. We spoke with Giles Keating, former Head of Global Research at Credit Suisse and current Board Member at Bitcoin Suisse, and with Prof. Dr. Simon Evenett, Professor at the University of St. Gallen and founder of the Global Trade Alert, about rising inflation, central banks’ reactions, and forthcoming attractions. Their expertise helped us gain more valuable insights, given the high uncertainty we are experiencing.

Both Giles and Simon think that inflation will be enduring, given that the pressure on global supply chains and trade remains high. Logistics companies still lack resources, and “the era of big trade agreements is probably over,” stated Professor Evenett. Countries cannot rely on imports to combat inflation as before the pandemic. However, we should not be too dramatic about trade, as the challenges are linked to goods but not to digital services, which are crossing borders like never before. In addition, oil trade keeps being problematic, with oil-producing countries becoming more hostile towards the West. The use of strategic reserves decided by President Joe Biden proves this lack of cooperation. Consequently, oil-producing countries will raise prices whenever they can, thus driving energy prices higher.

Regarding policies, central banks have focused on deflation risk for the last 15 years and must now change gears very quickly, even though it might already be too late. Giles pointed out that central banks have worried about the consumer price index (CPI) and disregarded asset prices inflation, which is misguided. It even goes against the monetary paradigm in which Milton Friedman advocates for moderate inflation of asset prices and mild deflation of consumer prices. The famous 2% yearly inflation target adopted by most central banks is an arbitrary number imagined by the Canadian central bank in the early 1980s. This asset prices inflation has widened the inequality gap between asset holders and non-investing workers. Therefore, the monetary policy can also be responsible for some populist uprisings in Western countries.

Central banks have also adopted more responsibilities than before and must now take employment into account and support fiscal policy, whereas previously, only price stability mattered. Central banks also have to provide the fuel for fiscal stimulus by buying government treasury bonds. Simon notes that central banks have not lost their nominal autonomy but have become more influenced by the government and must consider politicians’ interests.

Now that enduring inflation seems unavoidable, financial actors have to rebalance their portfolios. Giles stated that it is a time of reckoning for duration, which means that investors must avoid bonds because they will face increasing inflation and interest rates later. Any fixed income asset will thus meet two adverse developments simultaneously. Instead, tech companies can be exciting options, excluding big-tech companies since in Giles’ view they will probably become semi-regulated utility companies or lose their competitive edge. Investors should instead focus on smaller tech companies that bring real value to the table even though they might have high valuations. Simon warns against “zombie companies,” which are businesses with a lot of debt that can barely pay the interest. The stocks of such companies will surely suffer from the upcoming rise of interest rates, even if the latter is modest. 10% of large companies and 50% of small companies can be labeled as zombies, which means that investors should be particularly wary of small capitalizations. Simon suggested that an alternative for equity investors can also be companies that will benefit from climate change with either increased efficiency or more business opportunities because the government will likely fail to deliver its promises regarding climate change.

Crypto has often been touted as a hedge against inflation, but their volatility makes them risky. Giles points out that Ethereum is much less volatile than Bitcoin, given that the former has an actual business use and the latter is more speculative. Hence investors who wish to use cryptocurrencies as a hedge should consider Ethereum or other cryptos with actual use cases instead of Bitcoin. Private cryptocurrencies also face the uncertainty of central bank digital currencies (CBDCs).

“Central banks should target a moderate inflation in asset prices and a moderate deflation in consumer prices, but they got obsessed over the 2% target, which is an arbitrary number out of thin air.”

Giles Keating, former Head of Global Research at Credit Suisse

The era of big trade agreements is probably over. We are back to unilateral decisions, some governments will make smart decisions, and most governments will make dumb decisions.”

Prof. Dr. Simon Evenett, University of St. Gallen