Inflation becoming a growing concern for investors
Recent inflationary numbers have been contrary to the strong disinflationary forces over the last forty years, to such an extent that there had been fewer and fewer people that think of inflation as a threat. The combination of globalisation, a surge in the size of the global workforce, technology and falling union membership have crushed inflationary pressures.
Recent headlines have at least started to reignite interest in inflation, with Google searches for the word “inflation” in the US standing at the highest they have been since they were first measured in 2004.
Before we dive into the reasons for the latest rise in inflation, it’s worth considering two trends that have coexisted with falling inflation: rising asset prices and increasing inequality.
During the bout of inflationary pressure that took place in the 1980s, then Federal Reserve chair Paul Volker raised interest rates to 20% to bring these inflationary pressures under control. Since then, however, the last twenty years have seen central banks reduce interest rates to ever lower levels to fight the risk of deflation. Steadily falling interest rates have done wonders for asset prices, pushing up the value of houses, art, commercial property, stocks and bonds around the world. Clearly then higher inflation, particularly if accompanied by higher interest rates, would be a threat to the price of some assets.
This is important: a portfolio designed to thrive in an inflationary environment looks very different to one that’s set up for a low inflation regime.
US Consumer prices spike
US Consumer Price Inflation (% Year on Year) 1978-2021
Inflation has been muted both for the price of goods and for wages as the expanded global workforce has encouraged companies to move production to countries with cheaper labour. Most affected have been those workers with lower salaries, who also tend to own fewer assets than those with higher salaries. Stagnant wages whilst asset prices soar is a sure way to fuel inequality and populism. US voters first turned to Donald Trump to level the playing field with his promise to bring manufacturing back to the US and Make America Great Again, and populist leaders have sprung up in other nations throughout the world as similar trends gripped other economies. Last November, American voters backed a more traditional champion of the workers: A Democrat candidate who promised to redress the balance, in the form of Joe Biden.
Thus far, Biden has proposed a wide-ranging set of policies designed to support growth and combat this rise in inequality. His Build Back Better fiscal plan is designed to combat inequality in several ways: by providing free education to the very young and those entering community college, by making childcare more affordable and by helping pay for family and medical leave. Biden aims to fund this spending by raising taxes on both corporates and those earning more than $1m annually, which would help to arrest and reverse rising inequality in America. Ongoing stimulus will fuel faster economic growth and has the potential to reverse the low growth, low inflation environment.
Impact on markets
Turning to the impact on markets, the response of central banks to rising inflation will be critical to asset prices.
The Federal Reserve has been consistent in its messaging: it views the current inflationary pressures as temporary or “transitory” in their words. For the Fed there are two critical questions – how long is this transitory period and what is the outlook for the longer term?
In the short term, inflation has spiked due to soaring commodity prices and comparisons with weak data a year ago. Bottlenecks in both the production and shipping of commodities ranging from copper and lumber to semiconductors have caused prices to spike higher. This has also impacted the price of used cars, which were also fuelled by the demand created by fear of using public transport in a pandemic. This has had an outsized impact on headline consumer price measures.
Wage inflation is more complex. The global economy is recovering rapidly, and job openings are running at record levels. However, unemployment remains high and many of the global furlough and unemployment benefits are in the process of being rolled back by Governments. How unemployed people returning to work respond to this dynamic and whether they can push for higher wages remains to be seen.
US unemployment fallen but above pre-COVID
US Unemployment Rates (%) from 2005-2021
Over the longer term there are signs that some of the structural headwinds to inflation are starting to fade, and with time will become tailwinds to rising prices. The first is demographics, where there is a reduction in the growth of the labour force and an outright decline in the number of workers in many economically important countries such as Germany, Japan and China. Secondly, globalisation is slowing and there is an increased focus on re-shoring as the differential of wages between countries narrows and the fragilities of long, complex supply chains are re-assessed. Thirdly, shifting demographics to an ageing population leads to increasing numbers of people that consume but do not produce, as argued by Charles Goodhart and Manoj Pradhan in their book The Great Demographic Reversal. Finally, the old tend to spend rather than save, so the downward pressure on yields may ease as the “savings glut” diminishes.
The fiscal and monetary stimulus that global governments are injecting into the economy combined with the success of the vaccine rollout in the UK and US has seen a sharp increase in economic growth. This stands in stark contrast to ten years ago when austerity was a drag on the recovery from the last recession.
There are of course risks of an uneven recovery as other parts of the developed and emerging world lag behind in their vaccination programmes and whilst the vast majority of the world has yet to be vaccinated, risks of virus mutation are clear. This environment presents significant opportunities as well as some risks – an ideal environment for multi-asset investing.