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What is the Inflation Narrative?
3 June 2021

 

 

BHP revised its proposed bid for Anglo American (AGL), the updated terms include:

A lot of news is currently circling about a potential pick-up in inflation causing the market to crash. Let’s be clear, there is no direct link to inflation having a negative impact on equity markets.  The impact on equity markets will come from the US Fed having to rise rates too soon and choking off any economic growth which could lead to a recession. Currently the US Fed have stated that they will not be thinking about moving rates until inflation is averaging above 2% and employment levels have returned to pre-pandemic levels. The Fed estimates this point will only be reached in the latter part of 2023 to early 2024. On the other hand, market sentiment is suggesting the Fed will move rates as early as 2022. While current Inflation readings are spiking above 3% as of the latest readings, the Fed suggest that these levels are transitory and are a function of easy year ago comparisons during the height of lockdowns and price surges due to supply bottlenecks. Additionally, looking at market pricing we barely see run-away inflation being priced into any inflation sensitive financial instruments.
  • US 10-year treasury bond are only yielding 1.62%; still at the bottom end of the last 5-year range.
  • While 5- and 10-year breakeven inflation rates are suggesting higher levels of inflation of approximately 2.5%. Yes, it is higher than previous years but hardly run-away inflation and certainly still within the Fed goals of “long term average inflation at 2%” target.
With all this being said, some very renowned economists are on both sides of the debate.

Demand > Supply = Inflation

From an inflation hawk’s perspective, they see Demand outstripping Supply and therefore driving inflation higher, causing a wage growth spiral that creates more “sticky inflation”.
  • Demand Driven Price Hikes – a combination of stimulus checks and lockdown restrictions have driven excess savings levels among US households to more than $2trln or 6% of GDP. As the economy unlocks, it is unleashing massive pent-up demand spending. This on top of supply shortages and logistical bottlenecks will drive prices higher and feed inflation.
  • Commodity Prices for almost everything have gone through the roof.
  • Sales to Inventory ratios remain at historic lows as supplies run out.
  • Service vs Goods Inflation – Another argument for a more sustained inflation push is the fact that Service inflation has typically averaged 2.8% while Goods inflation has been dragging down total inflation to an average of 0% for the last 20 years, as China and globalization drive down pricing of goods. We can see the reversal of trends as Goods disinflation declines due to the slowing of globalization as well as an increase in transport costs. All of this will drive overall inflation above historic levels.
  • Wage growth – Wage growth is one of the main components of structural inflation. Some economists note that employers are battling to appropriate workers and will have to increase wages in order to entice labour back into the work force.

Inflation is transitory and won’t be sustained!

On the dovish side of the argument, there are several powerful theories that are also put forward.

  • Prices have already peaked and are now rolling over – The price spike of raw materials and transport costs was primarily driven by a burst of pent-up demand with manufacturing remaining curtailed alongside transportation bottlenecks. We are already seeing prices of raw materials and transport costs rolling off their earlier peaks.
  • Global Debt at records levels – Debt is essentially deflationary once it gets above a certain level. We currently have global debt to GDP at levels never seen before. As the marginal return on debt declines it begins to weigh on demand.
  • Technologically enabled innovation continues to drive disinflation – Technology has been a huge driver of productivity and driving the cost/unit down. We have seen an acceleration of IT spending over the pandemic which will continue to drive productivity going forward.
  • Commodity prices have zero correlation to inflation – History tells us the rise in commodity prices has very little impact on structural inflation.
  • Wage inflation = NON-ISSUE– Wage inflation is the biggest driver of inflation and remains a non-issue. There are 9mln people unemployed within the US that had jobs pre-covid. The availability of workers will increase considerably over the next few months as pandemic unemployment assistance ends and encourages people to return to work. Inflation will only become a problem when wage growth significantly outpaces productivity growth and historically, firms tend to pass on these higher costs to consumers.
  • Inflation outside the US is not an issue

While the debate will continue to grind on through October when the easy comparison from last year begins to dissipate, pandemic benefits end and supply chains have time to catch up. Then only will we get a clearer indication of whether or not current inflation pressure is transitory or not. Until then we continue to see the market see-sawing between the Hawks and Doves and expect the US Fed to hold their position on keeping policy accommodative well into 2023. Meanwhile, strong monetary and fiscal policy support long-side economic growth and should be conducive to equity upside.