inflation

Please see the below article from AJ Bell received over the weekend:

Inflation has soared to a 10-year high and everyone is feeling the pinch, whether it’s in their weekly shop, their energy bills or when they’re heading out to buy a new car. But not everything has risen in price and some areas of our lives are getting pricier than others.

“The single biggest price rise of the year will dismay DIY fans or anyone working on a home renovation: MDF (or Medium-density fibreboard). The man-made wood has got 63% more expensive since the start of the year, as supply chain issues and a surge of people doing up their homes has put it in strong demand. And the biggest faller of the year? Computer games, which are a third cheaper than the start of the year, following a boom in demand during the pandemic that has died away now.”

Travel and transport

Car hire has soared in price, rising by 30% this year, shortly followed by air fares which have risen by 28% as more people hopped on a plane to get some sun. And anyone thinking of going on a jaunt to France will be shocked that EuroTunnel prices have risen 21% this year.

But if you’re willing to travel in the UK you’ll find costs haven’t risen that much, with coach fares actually falling by 24% and rail fares only rising by 3%, meaning a UK holiday could be much more affordable than setting your sights abroad.

Everyone knows that second-hand cars have been among the biggest risers this year, increasing by by almost 25% since January. But electric or hybrid cars haven’t seen the same increases, staying the same price across the year, meaning now could be a good time to go green. Adding literal fuel to this argument is that petrol prices have risen by more than 18% this year, while diesel prices have risen 17%.

Clothing

Now is not the time to be buying formal clothing and workwear, as it’s shot up in price after everyone realised they needed to upgrade their work wardrobes for the return to the office. If you’re pondering a new coat for Christmas you’ll need to dig deeper as a men’s coat has risen in price by more than a third, while a woman’s coat has risen by a more modest 15%.

But those still working from home and who didn’t max out on comfy clothing in the pandemic will find their clothes shopping is less pricey, as men’s jogging bottoms are 5% cheaper than at the start of the year, while women’s exercise leggings are 2% cheaper.

The food shop

The biggest price rise of all food items is fruit drink bottles, so things like Fruit Shoots, which are a staple in many parents’ weekly shop. A pack of them has risen 32% this year. The other biggest risers are a pack of yogurts, which is up 19%, and low-fat spread, which has risen 18%. It’s going to cost more to make a spag bol now, as tinned tomatoes have risen in price by 17%. As it’s not summer people might not be too disappointed that Magnums and other ‘chocolate-covered ice creams’ have risen by 13% in the year.

And the food item that’s fallen the most in price? Prepared mashed potato, which is down 13% on the year, followed by self-raising flour, which was hugely in demand during the pandemic, but people have now ditched their home-baking causing it to be more than 10% cheaper than the start of the year.

As for booze, wine drinkers have found the cost of their tipple increase, with new world red wine and European white wine up by 5% on the year, while a glass of plonk in the pub is up 4%. Beer drinkers haven’t been spared, with a pint of draught bitter or lager both up by 4%. But if you’re willing to ditch the pub for a beer at home, you’ll find a pack of lager has actually dropped in price by around 2%.

Christmas presents

Anyone wanting to buy the bookworm in their life some new material will find costs have shot up, with ebooks costing 23% more than last Christmas and hard-cover books rising by more than 20%. Even children’s books have shot up in price, up by 12%.

If you’re thinking of getting a new TV to watch the Christmas specials you’ll find they cost around 10% more than the start of the year, while the family Christmas board game is around 5% more expensive. But jigsaw fans can rejoice as they are 15% cheaper – once the hot ticket item to have in lockdown it appears their favour has waned a little. The same is true for smart speakers, which are 14% cheaper than the start of the year.

And sports fans will have found their weekly golf trip has got pricier, with golf balls getting 3% more expensive while green fees have shot up 19% in the year. But football players have fared better, with football boots staying the same price and the cost of an actual football rising by around 3%. But those wanting to get the new kit for Christmas will find prices have shot up, with official shirts being 19% more expensive than the start of the year.

Our Comment

These views should be taken in context. Please look at our other blogs that cover inflation as this is a topic we have been regularly posting about.

Rising inflation is currently a global trend due to high demand and issues with supply chains. These supply and demand issues along with rising energy prices are pushing prices up globally.

It may continue to rise in the short term before falling back but it is important to note that inflation is still viewed as transitory by Central Banks.

Please keep checking back for more updates on the current inflation situation, along with our regular content, including our ESG related content and economic updates from some of the world’s leading investment houses.

Andrew Lloyd DipPFS

22/11/2021

Please see the below article from Invesco received yesterday evening:

Key takeaways

1. Structural changes post-Covid are diminishing the global deflationary narrative
2. At the same time, a combination of fiscal and monetary largesse are providing a new inflationary force
3. We believe cyclically sensitive stocks and European stocks in particular could benefit from this new regime

One of the most significant top-down discussions impacting asset prices (bonds and equities) today is inflation: are we heading into a period of inflation or not?  The debate has been rumbling since the policy reaction to the Covid pandemic but is now reaching fever pitch as we’ve seen the first above trend inflation data.

As European equity investors, we believe we must have a view. While it would be nice to simply claim that we’re ‘bottom-up’ and ‘fundamental’, the fact is we can’t ignore the polarisation in markets of the last decade, underpinned by monetary dominance and fiscal repression.

Duration (defensive/Quality) assets have benefitted from the low inflation period and short duration assets (cyclical/Value) have suffered. This part is straightforward to understand: medium-term inflation influences the risk-free rate (RFR) and it’s the RFR that the market uses to discount future cash flows. If expectations are for sustained low inflation, then the discount rate is low and asset prices rise and vice versa.  

The problem is that forecasting medium-term inflation isn’t straightforward. Nothing causes normally amiable economists to become more tribal than asking them to explain the causes of inflation. In this article, we explain why we believe the arguments for transitory inflation are something of a distraction and point to areas of the market that could do well as mid-term inflation emerges.

Monetarists vs Keynesians and the case for transitory inflation

Monetarists can ‘prove’ inflation is a consequence of broad money growth while Keynesians will eloquently explain that as the demand curve shifts (to the right) faster than the supply curve, then prices rise.

Given we can’t even agree on the definitive cause of price moves then it’s not surprising there’s debate at any moment in time as to what the price moves might be.

The Monetarist vs Keynesian arm wrestle has, we believe, become more visceral since the global financial crisis (GFC) because excess money supply hasn’t led to significant inflation1. This has empowered the Keynesians to look for other rational reasoning of deflationary forces such as demographic trends (declining workforce), technology (increased productivity and labour marginalised) and globalisation (lower cost supply) with post crisis austerity the final straw.

Accordingly, when looking at the post-Covid world, Monetarists have less voice and the Keynesians argue these same three structural trends persist and, hence, any inflation we are seeing today is purely transitory.

This transitory narrative is a function of the severity of the enforced downturn which has impeded but, importantly, not destroyed supply (capital still exists). Therefore, as demand has recovered (surprisingly) fast, supply is temporarily struggling to cope and prices have risen, if only temporarily.

The effects have been exacerbated by the Suez blockage, lack of belly capacity in air transport, low inventories and even the weather in Texas.

If one believes that inflation is ‘only transitory’, logic dictates that it won’t impact the discount rates and therefore duration assets aren’t at risk and short duration cyclicality assets remain value traps….

Time to address the long-term deflationary narrative

The irony is that transitory inflation believers would likely claim to be long term and not worry about the short-term noise. However, we believe they’re perhaps missing the more fundamental structural changes happening post Covid.

We will try to outline why and in doing so will intertwine both economic theories, which we appreciate may anger more purist economists.

Firstly, we need to address some of the structural deflationary points:

• Demographics. These are hard to argue with. European demographic trends are unhelpful albeit, net of migration, the data to 2019 suggest population is broadly stable. An aging population likewise doesn’t help. To us it remains an ongoing pressure but not incrementally so.
• Technology. Often touted as a deflationary force. It increases productivity and hence pushes the supply curve to the right (we can produce more for lower prices). However, importantly, this is nothing new, innovation has been a relative constant over time. We also wonder if, in the post-GFC period, dominated by monetary policy, corporates were rewarded for ramping shareholder returns (dividends and buybacks) at the expense of investment and so exaggerated the deflationary impact.
• Globalisation. We believe this is most contestable as a structural cause of deflation. Transferring production to Asia has undoubtedly been a key deflationary force for at least the past 20 years. China has been both a source of cheap labour and then, through policy, a source of excess production assets. In addition, at times of stress, China has devalued its currency, thereby easing inflationary pressures.

We strongly believe that it’s no longer so obvious. Reaction against the offshoring of US manufacturing jobs to China was a key source of Trump’s appeal. His firmly anti-China policy is one of the few policies the Biden administration has continued to pursue and, with China GDP set to rival the US by 2030, it is unlikely to stop being a vote winner. Within China itself, policy has shifted from emphasising the producer economy towards the consumer with some producing assets being forced to close.

This has been aided by Environmentalism being part of the domestic policy agenda. Lastly, it’s perhaps notable that despite strong domestic wage inflation, and the recent Renminbi appreciation, there’s been no talk of China devaluing – could China actually be exporting inflation?

We should also be aware of emerging market monetary policy setting being more traditional than developed markets currently – it’s developed markets running the largest ever deficits, while China tightens.

Figure 1. The Covid crisis will lead to further de-globalisation

The key point is that these structural deflationary forces, while still present, are a less powerful backdrop than we’ve become accustomed to. Meanwhile, there is the incremental risk from emerging inflationary trends.

Inflationary structural trends – are they here to stay?

Covid has changed voter tolerances, which in turn affects policy. This then has an impact on the economic backdrop and, ultimately, inflation risk.

We believe the true impact of the pandemic goes beyond headline fiscal payments, which are only as inflationary as the next cheque/infrastructure project, and more towards a change in what people truly care about and will vote for.

The post-Covid regime shift is happening to address the issues of Inequality and Climate Change. The vulnerability exacerbated by the health crisis is creating tolerance of big government. Unlike after the GFC, when the response to a financial crisis was fiscal austerity, today the electorate want fiscal dominance.  The newly created EU recovery fund, worth €750 billion, is such an example.

Figure 2. Grants and loans from the EU recovery fund (in 2018 prices)

These, we believe, are inflationary forces. Big government is historically a poor allocator of resources compared to the private sector – it curtails supply (the British auto industry in the 1970s is a good example of this).Addressing inequality at a micro level means a greater share of stakeholder profits going to wages rather than to shareholders and management. This would direct resources to lower income earners who have a greater propensity to spend and therefore drive demand.

Inequality at a macro level means infrastructure projects and providing incentives to invest, thereby driving full employment and reducing social scarcity. Full employment as a policy is inflationary.   

The climate agenda is a wrapper to digest the fiscal shift but it is also inflationary in its own right. Net neutrality requires capital investment: we need to build turbines, solar parks and transmission networks, which creates demand for physical assets.

Figure 3. A rise in green investment demand worth nearly 1% of GDP

However, we also need to build the infrastructure with renewable commodities meaning cement needs to be ‘green’ and steel needs to be low carbon. Some commodity producers will invest and take advantage, but others, previously running for cash, will be forced to close and hence we will finally see capacity come out of the market.

Consumers will be affected too with tolerance for higher prices (especially if wages are increasing) for greener products and replacement demand driven by policy – think replacing vehicles for hybrid or electric alternatives as internal combustion engine (ICE) cars are being banned from urban areas. This is inflationary.

Environmental policy is affecting capital availability already. Financial regulation means asset allocators need to disclose environmental data with the fastest growing asset class being ESG compliant funds.

These fund flows impact corporate capital allocation with environmental projects getting cheaper funding than brown projects. There simply isn’t cheap money available for coal, new oil or other environmentally challenging industries and, hence, over time, there will be a squeeze of supply. We know we are approaching peak oil at some point, however, what happens if peak supply comes first: prices rise – inflationary.

We believe there are some incremental inflationary forces at play, absorbing output gaps. These, combined with the perhaps abating ‘structurally’ deflationary forces will lead to net inflation, but on the condition of monetary complicity.

Monetarists believe money growth is key and MV=PT (or Money Supply times Velocity of money (rate of exchange)) is equal to Prices times Transactions. What does seem to be true is that without money growth, there’s no inflation. Simply because without new money, increased demand growth from, say, Government crowds out private sector demand and so net there’s no growth.

Importantly then, post-Covid, we have both fiscal dominance and monetary accommodation. Post-pandemic, broad money growth has been far greater than following the GFC and we also have a banking system that’s fully functional, i.e. neither deleveraging nor working out bad loans.

Monetary policy makers are shifting their mandate to remain accommodative for longer with targets of full employment and average “synchronised” inflation. This allows developed market central banks to stay ‘behind the curve’, meaning they do not feel the need to address the current inflation scenario.

There’s also consensus that central banks want fiscal cooperation in support of their tired monetary bazookas and will manage the interest costs through yield curve controls if required.

As per the Fischer equation, MV=PT, with ‘V’, the velocity of money, as the balancing item. The ‘V’ is probably best understood as how much the money in the economy changes hands. It has fallen over many years and fell more drastically post Covid as the saving rate has increased. However, we believe ‘V’ will increase as economies unlock, the savings rate falls and inequality falls (lower incomes have a lower propensity to save).

With abundant liquidity meaning banks will be able to lend (even as savings are reduced), central banks printing money and velocity increasing, then prices will rise: inflation.

Transitory inflation is just a distraction – cyclical stocks and Europe set to benefit

We believe that arguing about the short-term transitory inflation numbers misses the key point.  Yes, short-term inflation is spiking because of bottle necks. However, asset prices are based on mid-term inflation forecasts, not crisis-related data. Therefore, it’s mid-term inflation we need to think about.

It’s our strong belief that mid-term inflation will be sustained at above central bank targets, albeit not rampant. Indeed, inflation-linked bonds are signalling as much. Yet, the ongoing polarisation of the equity market with preference for long duration and growth equities would suggest something different.

In our view, from a top-down perspective, the types of companies that could benefit from nominal growth are the short duration equities and these are the cheapest parts of the market. We believe they are cheap hedges to the mid-term inflation risk that we have argued for above.

In addition, from a bottom-up perspective, it’s the same sectors and companies that will be a direct beneficiary of the political shifts we’ve mentioned. The environmental agenda is pro-investment; it’s pro-cyclicality. 

Companies in industries exposed to construction materials, utilities, automotive OEMs and even banks through volume growth, all might benefit. These are also where currently the most compelling valuations are.

Likewise, the impact from more re-balancing of stakeholder profit shares and fairer taxes with bigger government are less onerous on European companies. This is simply because they have been operating under a more egalitarian environment for longer than other global regions.

Generally, equities are owned with the aim of protecting you from inflation. However, many portfolios that have outperformed over the last decade, and more, have been ones that have benefited primarily from a lack of inflation – so one composed of bonds and long-duration/growth equities.

As we move into a new regime of inflation for the reasons argued, in our view, this type of portfolio is unlikely to do so well. On the contrary, our valuation discipline has resulted in our fund ranges being exposed to short duration or cyclical stocks, which we believe are well positioned in the more inflationary backdrop we have outlined.

Please continue to check back for more updates.

Andrew Lloyd DipPFS

01/07/2021