**The End of the Inflation Scare? **
by Louis-Vincent Gave
investorsinsight.com/blogs/j … scare.aspx
While most economists and strategists spend time worrying about growth, changes in inflation are usually a much greater driver of financial markets than changes in economic activity. This is because:
1- A surge in inflation usually increases volatility of economic growth–which in turn reduces P/Es and the willingness of the private sector to take risks.
2- As highlighted in The Myth of Reverting Margins, inflation typically takes a much meaner bite out of margins than a recession does. As we wrote back then concerning the US growth/margin relationship: "Margins bear little relationship to the level of GDP or consumption growth. In fact, as the economy accelerated from the mid-1960s to the early 1980s, margins plunged. Similarly, as the economy slowed from the early 1980s to the present, margins accelerated… It is inflation, not growth, which wreaks havoc on profit margins (ironically, if everyone has pricing power, no one makes money).
3- Finally, a surge in inflation typically means interest rates will be rising in the near future. Which means that investors get to lose money on both bonds and equities. For example, from 1966 to 1980 (i.e.: the last “inflationary surge” period), US bonds shed -2% per annum and US equities fell -4.9% per year.
Unsurprisingly, given the above, fears are now running high that we may have reentered such an “inflationary bust” period (see The Inflationary Bust Threat). And to be sure, growth almost everywhere around the world is slowing while inflation in almost every country is still accelerating.
Now everyone knows where the slowdown in growth comes from: de-leveraging in the financial sector, overextended consumers needing to tighten their belts, transfers of wealth from the private sector to the public sector through high oil prices, etc… And there are of course myriad opinions as to how long the slowdown will last. But meanwhile, on inflation, our clients seem to be much longer on questions than answers. Where does the current inflation spike come from? How long is it going to last? And can inflation abate without a “Paul Volcker” like monetary policy from the Fed?
In this ad hoc comment, we aim to review some of these questions and, as we always tend to do–answer these questions with yet more questions of our own!