Why inflation, not pandemic recovery, is likely to be the biggest story for investors in 2022

As pandemic-inspired price rises ripple through economies worldwide, the focus is shifting to supply chains, money supply and slowing growth
With classical finance all but useless, the need to identify stories in modern finance has never been so important

Richard Harris

Published: 9:15am, 31 Dec 2021

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Over the past three years, I have been pursuing doctoral research in narrative finance – the study of how stories move markets. It is a new topic for academic study, even though we have known for centuries that stories move prices. Even so, it is now timely, as the need for identifying stories in modern finance has never been so important.

This is because classical finance – the aspect of the discipline that gave us powerful valuation metrics such as price-to-earnings ratios, cash flow statistics and other forms of higher mathematics – is now all but useless. Most of those metrics are based on relative relationships, which depend on the goalposts remaining in the same place.

The last new financial markets paradigm was in 1971, when the United States went off the gold standard. This made central banks, rather than gold, responsible for the strength of money and the custodians of low inflation.

Years of weak leadership by global central banks has meant interest rate policy has been excessively low for 25 to 30 years. This has placed the goalposts on the other side of town and well beyond the remembrance of most investors.

Central bankers would say in response that they have kept inflation low. This ignores the huge deflationary impact of fudged data, the technology revolution and China’s development into the world’s factory.

Those exogenous advantages are over. Inflation is likely to be the biggest single narrative for 2022 as pandemic-inspired price rises ripple through economies, driving advance purchases and eventually big pay rises.

Interest rates – the cost of money – are an uneasy co-narrative to inflation. The last Federal Reserve Board chairman with a backbone, Paul Volcker, increased interest rates to 20 per cent in the late 1970s to curb inflation. This tool is no longer available.

Debt is addictive, like an opiate. It can be used to buy assets, which can then be used to raise more debt. If money is too cheap, people will borrow a lot of it; when it becomes expensive, they will all head for the door at the same time.

There is now so much debt globally that interest rates cannot rise much without damaging the economy. The huge amounts of money handed out by the central banks in support of the economy has made prosperity come easily to the wealthy and spawned “get rich quick”, anti-establishment sub-narratives such as bitcoin and meme stocks.

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The one tool left is for global central banks to reduce liquidity. This could cure inflation, not by reducing “too much money chasing too few goods” but because of asset deleveraging.

In the investor’s 2022 narrative handbook, the pandemic is no more. This narrative has mutated, like Covid-19 itself, into disrupted supply chains, bloated money supply and an economy perceived to slow because of the base effect of the 2021 boom time.

Across 50 years of economic cycles, economic slowdown and inflation are followed by the narrative of unemployment. Rising unemployment means a falling standard of income, social unrest and poverty. It was Volcker who said in 1979 that “the standard of living of the average American has to decline” as he gave the economy the tough medicine it needed.

The US provides an early warning about narratives as it is liquid and transparent with a free flow of news and narrative development, but that news is no longer just relevant to Americans. These narratives will be no less important elsewhere in an economically connected world.

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There is always a counternarrative, and many will point to supportive storylines such as an enduring willingness within central banks to print money should economies stutter. Another supportive narrative is real interest rates, which have risen dramatically in recent years.

US consumer price inflation jumped 6.8 per cent in November. This means that, with the US 10-year Treasury yield at around 1.5 per cent, investors can borrow at a real interest rate of more than minus 5 per cent.

A typical business should be able to pay around 3 per cent for money, but real interest rates have not consistently been at that level since 1999. Is it any wonder that many equity indices are close to all-time highs? However, betting on high real interest rates is for the very brave before economies collapse.

The final 2022 narrative is Harris’ Law of Quarterly Reversals, which says that the end of a quarter often sends the market the other way.

The past year has been sheltered by pandemic recovery. In 2022, the narrative might catch up with the times – higher inflation, interest rates and bond yields, rising non-performing loans and higher unemployment, inequality and public deficits.

The counternarratives are probably still too strong for an economic catastrophe next year, but one or two worrying bear markets should be expected. The markets are primed for an excuse – all they need to trigger a fall is a new, unknown narrative.

Narratives are the voice of the market. They come and go, rise and fall, split and merge with the mood of the market. Most importantly, they contain information for forecasting and are therefore worth analysing. As the behavioural psychologist and economist Amos Tversky said, the writing is on the wall, but the ink is invisible.

Richard Harris is chief executive of Port Shelter Investment and is a veteran investment manager, banker, writer and broadcaster, and financial expert witness

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