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Global Perspectives
Peak Inflation – Are we there yet?
The Bank of England has recently increased interest rates to 5.25%, marking the 14th consecutive increase. Interest rates and inflation have not been prominent concerns over the last two decades, but the resurgence of inflation has changed that perception. The causes of inflation are the subject of intense debate, with various complex and contested theories. Three prominent views on inflation are outlined below:
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Monetarist View
Some economists adhere to the Monetarist perspective, asserting that inflation is primarily a monetary issue. They argue that a sustained increase in the money supply relative to the economy's production capacity leads to inflation. According to this theory, managing inflation involves controlling the money supply through central bank policies.
Keynesian View
Keynesians view inflation as a result of aggregate demand outpacing aggregate supply. They emphasise demand-pull inflation, where increased consumer and government spending drives prices. Keynesians advocate demand-side policies, such as fiscal and monetary measures, to control inflation.
Modern Monetary Theory (MMT)
MMT challenges traditional views on inflation by arguing that government spending is not constrained by revenues or the need to borrow. In the MMT framework, inflation becomes a concern only when the economy reaches full employment and productive capacity. They propose that taxation can be used as a tool to control inflation.
Multi Year Highs
Recently, inflation has reached multi-year highs due to several factors. During the pandemic, central banks injected significant quantitative easing stimulus into economies, especially the Federal Reserve in the US. Stimulus funds from the Biden administration further exacerbated the situation.
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These events led to a significant increase in the money supply amid supply-side shortages caused by the pandemic. The war in Ukraine further increased inflation, with food and energy prices skyrocketing. In Britain, Brexit-induced labour shortages and rising wages worsened the inflation situation. Once wage inflation sets in, it becomes challenging to curb and a driver of core inflationary pressures.
Eminent economists like Mervyn King and Andy Haldane argue that central banks underestimated the monetary impact of quantitative easing and developed blind faith in the MMT inflation theory. This miscalculation has led to concerns that the current tightening cycle may not be enough to control inflation, especially in the UK, where labour shortages have been particularly acute.
The risks of over-tightening monetary policy are substantial, including business failures, mortgage foreclosures, unemployment, and potential recession. Central banks may adopt a more conservative approach due to criticism of their role in stoking inflationary pressures. However, excessive tightening can also be detrimental, as it takes 18 months to two years for the full impact of interest rate increases to materialise.
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Confidence in central bank modelling has been undermined as they initially predicted inflation to be transitory rather than structural. The Bank of England has enlisted the help of Ben Bernanke, former Chair of the Federal Reserve, to examine their modelling and recommend changes.
With faith in their models shaken, the Bank of England now makes interest rate decisions based on near-term indicators, analysing monthly data point by point. This cautious approach has drawbacks. It's akin to walking while looking at one's feet, leading to potential collisions with unforeseen obstacles, like walking into a lamppost.
Overall, the central banks face a delicate balancing act in managing inflation and interest rates, and their decisions will have significant implications for the economy, people's livelihoods and investment decisions.
The resurgence of inflation and the recent interest rate hikes have substantial implications for the private equity and funds industry, as well as international financial centers (IFCs) worldwide. As inflationary pressures continue to mount, investment decisions become more complex, and portfolio managers must adapt their strategies to navigate this uncertain economic environment.
Impact on Investment Decisions
The theories on inflation outlined above have diverse implications for investment decisions within the private equity and funds industry. Depending on the prevailing theory that holds relevance, investors may reassess their asset allocation and risk management strategies.
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Monetarist economists' belief in inflation as a monetary issue may prompt investors to closely monitor central bank policies and their effects on the money supply. Keynesian views focusing on demand-pull inflation may lead investors to analyse consumer spending trends and government policies to gauge potential risks and opportunities. Meanwhile, the MMT perspective could prompt investors to consider the implications of government spending and taxation on inflation dynamics.
Overall, the varying views on inflation underscore the need for comprehensive risk assessment and robust risk mitigation strategies within the industry.
Market Volatility and Asset Valuations
Heightened inflationary pressures can lead to increased market volatility, impacting asset valuations across various sectors. As prices fluctuate, private equity and funds may experience challenges in accurately valuing their investments, particularly in sectors sensitive to inflation, such as commodities, real estate, and energy. Additionally, investors may witness a shift in the performance of different asset classes, requiring agility in asset allocation to manage risk and capitalize on emerging opportunities.
Interest Rate Sensitivity
The trajectory of interest rate hikes in response to inflationary pressures directly affects the private equity and funds industry. Rising interest rates can result in higher borrowing costs, affecting leverage levels and financing options for acquisitions and investments. Funds with significant debt exposure may experience increased interest expenses, impacting their overall profitability. Moreover, IFCs, being hubs for global capital flows, may experience shifts in their competitiveness as interest rate differentials influence fund flows and investment attractiveness. Still there is a silver lining in the inflation cloud for some. Banks in IFCs have struggled with profitability in the era of ultra-low interest rates but are finally seeing improved margins and profits whilst rewarding savers with higher returns.
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Portfolio Diversification and Inflation Hedges
In response to the evolving inflation landscape, private equity and funds may consider adjusting their portfolio diversification strategies. Investors may seek to include inflation hedges, such as inflation-protected securities, commodities, or real assets, to safeguard against the erosion of real value in their portfolios. Diversification across geographies and industries becomes crucial to mitigate concentration risks and capitalise on regions or sectors better positioned to withstand inflationary pressures.
Regulatory Scrutiny and Reporting
As inflation concerns persist, regulators may intensify scrutiny on investment practices and risk management within the private equity and funds industry. Investors may face increased reporting requirements to provide transparency on strategies to manage inflation-related risks. IFCs may also revise their regulatory frameworks to ensure the industry's resilience in the face of inflationary challenges and to maintain their global standing as reliable financial centres.
Conclusion
Peak inflation presents a dynamic and challenging landscape for the private equity and funds industry and IFCs. As inflation theories remain contested, careful risk assessment and adaptation of investment strategies become paramount. The industry must be prepared to navigate the uncertainties, leverage diverse inflation views to make informed decisions, and remain agile in managing portfolio risks to ensure sustainable growth and value creation in the face of inflationary pressures.
For IFCs, proactively addressing market volatility and evolving regulatory demands will be instrumental in maintaining their status as attractive and competitive financial centres amidst the shifting economic landscape.
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About Mourant
Mourant is a law firm-led, professional services business with over 60 years' experience in the financial services sector. We advise on the laws of the British Virgin Islands, the Cayman Islands, Guernsey, Jersey and Luxembourg and provide specialist entity management, governance, regulatory and consulting services.
