Are we about to see a repeat of the bad old days of the seventies – high inflation combined with low economic growth? If so it could have some unpleasant consequences for stock markets and M&A activity.
The signs are not encouraging. The UK’s official inflation figures hit 3% in April, quashing rate cut hopes in the process. But who actually believes these numbers? The old UK retail price index – ie un-EU harmonised numbers – came out at a more realistic 4.2%, up sharply from 3.8% the month before. However, several fund managers have told TMN over the months that they believe inflation is closer to 7-8%. Even Stuart Rose boss of retailer Marks & Spencer seems to think they’re in that ball park.
In other words we’re already experiencing high inflation and that’s evident from utility bills, petrol and food prices and so on. Commodity prices have been on a rally for several years, some going up tenfold, and even China – once a source of deflation – is now increasing export prices, in many cases by 20%.
As workers become aware that their pay packets are being eroded, they will begin demanding higher wages, probably starting with the public sector where jobs are safer and unions still hold some sway. At which point inflation becomes firmly entrenched in the public psyche.
This is a dreaded scenario for central bankers who will then witness a self-reinforcing inflation spiral. Indeed, the governor of the Bank of England could see himself writing many letters a year to parliament justifying why inflations is over 3.1%.
Should the pace of price rises continue, and we may well be in a commodity super-cycle, it will only be a matter of time before central banks start jacking up interest rates aggressively. A scenario of raw material prices and hence inflation rocketing every time economic growth picks ups, brings back memories of boom and bust economics and highly volatile equities markets, reminiscent of the seventies. Still many central bankers think these are just short-term price spikes – they may well be in denial. Long-term economic cycles do tend to repeat themselves.
A sustained pick-up in the US economy would put that theory to the test and that should come fairly soon given the Fed’s aggressive rate cuts and the government’s fiscal stimulus.
But what impact will that have on Mergers and Acquisitions? Actually, it will be significant. A world of higher inflation means higher interest rates. That will generally translate into lower equity values and ultimately, that should mean less M&A. However, that is likely to see many manufacturers and retailers seeking to merge and get bigger. Super-sizing won’t be so much about trying to haggle over prices of raw materials, but more about having the power to pass costs onto to consumers and therefore sustain profit margins.
Overall, a return to seventies like conditions will hurt financial services firms and the LBO merchants who rely heavily on debt..
Indeed, boom, bust cycles and high inflation could even revive another seventies relic – the much despised conglomerate. Because of operating in a volatile economic climate, management will suggest that companies need to be diversified across several industries to offset the impact of boom, bust and to smooth profits. Admittedly this does look like a very far fetched scenario right now. But corporate fashions do come and go, just like they do in entertainment and clothes.
Let’s hope central bankers are right and this is only a temporary price spike and that stagflation will remain consigned to history like glam rock and platform boots.
Justin Pugsley is a UK-based reporter for Thomson Merger News, where this post first appeared.