The Return of Inflation

For almost thirty years from the early 1990s through to the Great Financial Crisis (GFC) in 2007, inflation was subdued, replacing the inflationary 'boom and bust' period of the 80s and early 90s. During the 'Great moderation' as it became known, the UK enjoyed 63 quarters of unbroken economic growth, the longest period in British history. In tandem, the US economy saw strong growth over the two decades preceding the GFC.

Economic orthodoxy increasingly held that Central banks had tamed inflation and that low prices could be secured whilst enjoying stable growth. The Goldilocks Economy had arrived, neither too hot nor too cold, but just right, culminating in the British Chancellor, Gordon Brown, declaring the end of 'boom and bust'.

Fast forward to 2022, and the inflation outlook is very different. A combination of loose monetary policy, supply chain regionalisation, rising post-pandemic demand, and the level of unspent savings accumulated in lockdown will boost inflation everywhere, especially in the US.

Food supply disruption in Ukraine has caused wheat prices globally to rocket, with a third of the world's wheat crop supplied by Russia and Ukraine. This dependency is so concentrated that dwindling supply will lead to many poorer countries experiencing much higher prices. And shortfalls in staples such as bread looks set to trigger social unrest.

So, if inflation is getting out of hand, what are the implications for the global economy and international Financial Centres?

Inflation tends to drive an unlevel playing field. If you are retired living on savings, high inflation reduces the actual value of your income; every pound, dollar or Euro doesn't go as far, as everything costs more. If you are poor, the surge in energy and food prices will immediately and disproportionately impact your cost of living. However, if you have borrowed substantial sums at fixed rates, you may not be too concerned as you see the value of your assets climb whilst your borrowing costs remain fixed. Overall high inflation puts the post-pandemic recovery at risk, with the spectre of a recession looming.

The challenge of high inflation for the business world is making business and investment decisions less predictable. So far as International Finance Centres and cross border investment are concerned, there is the potential for a slowing of transactions whilst investors appraise the new environment and the impact on expected returns.

However, there are forces that we expect will counteract the impacts of rising inflation. Institutional and UHNW investors have substantial equity, and the impetus for putting that to work is even more significant in an inflationary environment. Investors will want to ensure the value of their capital isn't eaten away by inflationary forces and will be even more motivated to invest.

Investment practitioners who have never experienced severe inflation will see new pricing and revaluation strategies added to the customary cost-efficiency playbook. Companies will re-learn how to pass on inflationary price increases. And underlying valuations will benefit from an inflationary uplift at the exit. On acquisitions, target companies' degree of price elasticity for goods or services will become a more significant factor in target selection. The agile investor will utilise volatility to hold or improve exit multiples. And given the drive to further lessen carbon fuel dependency, renewables investment looks set for a further significant boost.

Debt, traditionally an essential building block of private equity in leveraging the equity component in funds, will already have received attention through debt restructuring. Fixing long term debt costs whilst generating higher alpha through greater pricing power and higher exit valuations can have the effect of increasing rather than diminishing returns. The fleet-footed will seize the opportunity - In every cloud, there is a silver lining.

So firms will adapt and reposition for the new environment at the investment level.