4 mins read
One of my favourite things to do after a good exercise is to grab some chicken from a local take away. It is well spiced and has a lot of protein – what’s not to like? Recently, however, I noticed it has become more expensive. I go to my favourite coffee shop, the same thing happens – my flat white is more expensive. I stumble upon a local second car dealership? You guessed it, the cars are far more expensive than a year ago. What is quite clear is that inflation has picked up – and it has picked up meaningfully but why? And what does it mean for your portfolio?
Why has inflation picked up?
One of the drivers are the so-called ‘base effects’. Inflation is usually reported as being the price level now compared with the price level a year ago. In the first and second quarters of 2020, prices fell significantly because of the Covid-19 crisis. This means that, as economies recover and prices start to normalise, they will be compared against a very low base a year ago. This causes a sharp rise in year-on-year inflation. This effect can be seen already in the US, and will emerge in other areas as economies reopen.
What’s the global impact (so far)?
The Covid-19 crisis severely disrupted global supply chains, leading to higher prices on goods as they have become harder to obtain. Shipping costs have increased sharply: for example, the cost of shipping a container from Shanghai to Rotterdam has gone up fivefold.1
Coupled with lower-than-normal production, this has led to a run on global business inventories. Demand has far outstripped the available supply, leading to upward price pressures.
Think cars. All of the sudden everyone wants to drive one instead of using public transport. However, buying a new car isn’t easy as manufacturers are struggling to get hold of parts. This had a major effect on the second-hand car market, with prices rising by approximately 50% over the year to March, according to Bloomberg.2 No wonder I couldn’t afford that used Audi in my local dealership.
This story is most visible in the commodity markets. Oil, copper, and other industrial metals are in great demand as economies recover and the supply side struggles to adjust. The Brent crude oil price, for example, has increased from just over $18 a barrel in April 2020 to nearly $65 a year later.3 Food prices are also strong, leading to upward pressure on the price of my coffee and chicken sandwich. The Bloomberg Commodity Index is up more than 41% in the 12 months to July 13,4 which could lift a range of annual inflation measures.
What does this mean for investors?
Inflation is any investor’s biggest nemesis. It eats away at buying power and can negate even record investment returns. In the short run, it might not seem like a big deal – especially when markets are flying high – but over time, it can have a major impact. Like interest, it compounds, and, if left unchecked can run through a portfolio quickly.5
Fixed income investors are at risk in particular because of the fixed nature of cash flows. Investors in equity markets are in a better position because of the real nature of earnings.
During Q1 2021, when the narrative of reflation took over, bonds sold off, equities broadly rallied with clear pro-cyclical rotations within. Some of that was undone during the second quarter. Going forward, if inflation stays above target, we would expect bond yields to rise and equities to do relatively better. However if bond yields rise too fast, that could harm equities too via higher discount rates – something we witnessed on several occasions this year.
With the US – where inflation is mainly appearing right now – a hugely influential financial market and economic superpower, investors need to be aware that what happens there can flip to other markets quickly, too.
Where does inflation go from here?
We expect many short-term inflationary pressures to dissipate as base effects disappear. Supply chain disruptions should ease and business inventories should be rebuilt, and shipping costs should fall as the global economy restarts. Commodity prices have risen, but they are unlikely to rise as much over the next year. Similarly, the cost of second-hand cars is unlikely to experience another 50% annual increase.
As these effects dissipate, we believe fundamental factors will begin to dominate. Labour markets look increasingly tight as companies struggle to attract new talent and people quit their jobs at a record pace. In the US, 942,000 people voluntarily left their jobs in June, according to the Bureau of Labor Statistics, the highest level since November 2016.6
This is prompting wage increases. A recent small business survey in the US showed that companies were either raising or planning to raise compensation.7 Wage growth pressures may prove temporary when governments withdraw pandemic unemployment support measures. However, we believe that as economies recover, labour markets will continue to be tight - leading to structural wage growth pressures.
Recent spikes in prices, coupled with a relaxed approach from global central banks, have moved inflation expectations higher. The Federal Reserve clearly believes price increases are temporary, and it is willing to tolerate inflation above its 2% target for a while (it hit 5% in May8). If inflation proves to be more structural rather than transitory, that could lead to expectations getting unhinged on the upside.
Inflation is trending higher because of temporary factors we expect to dissipate. By the time they do, however, we expect more structural factors such as wage growth and possibly higher rental price inflation to kick in. Coupled with higher inflation expectations, this should keep actual inflation measures elevated.
Over the longer term, I believe inflation should settle around 2% because that’s what central banks are targeting. Ultimately, they will set interest rates at whatever level is necessary to meet that goal.
A closing thought: what is the required rate of interest to ensure that inflation ends up at 2%? Certainly not where the policy rates are at the moment – 0.25% in the US, and -0.5% in Europe.
1 ‘Shipping-Container Rates Top $10,000 From Asia to Europe’, Bloomberg article, 27 May 2021. https://www.bloomberg.com/news/articles/2021-05-27/shipping-container-rates-top-10-000-from-asia-to-europe
2 ‘Used Car Prices Are Poised to Peak in US After Pandemic Surge’, Bloomberg article, 24 June 2021. https://www.bloomberg.com/news/articles/2021-06-24/used-car-prices-are-poised-to-peak-in-u-s-after-pandemic-surge
3 Brent crude oil price (monthly), Statista. https://www.statista.com/statistics/262861/uk-brent-crude-oil-monthly-price-development/
4 Bloomberg Commodity Index price: https://www.bloomberg.com/quote/BCOM:IND
5 ‘Beware of inflation: Assessing risks and investment implications’, Mercer document, June 2020. link
6 ‘More people than ever are unemployed because they quit their jobs.’ Business Insider article, 2 July 2021. https://www.businessinsider.com/jobs-report-unemployed-quit-pandemic-era-high-tight-labor-market-2021-7
7 ‘As Amazon, McDonald’s Raise Wages, Small Businesses Struggle to Keep Up’, The Wall Street Journal article, 20 May 2021. https://www.wsj.com/articles/labor-shortage-hits-small-businesses-as-some-workers-stay-home-11621512002
8 ‘U.S. inflation Is Highest in 13 Years as Prices Surge 5%’, The Wall Street Journal article, 10 June 2021. https://www.wsj.com/articles/us-inflation-consumer-price-index-may-2021-11623288303
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