Should we worry about inflation and markets?
This appeared on the Netwealth website under mine and Iain Barnes’s names on 20th May, 2021
In recent months, we've highlighted the inevitability that inflation would rise and likely be volatile for some time. Now we are reiterating the message that we need to take this inflation risk seriously, but at the same time, we should not panic.
We can start by focusing on three questions: What's happening? Is this rise in inflation transitory or permanent? And what are the implications for policy?
A year ago, the UK economy was collapsing. Last April, inflation fell on the month by 0.2%. In contrast, this year’s April data, just released, shows that inflation rose 0.6% on the month, thus contributing to a significant year-on-year change. That saw the rate of inflation rise to 1.5% from 0.7% in the year to March. One needs to be aware that year-on-year comparisons in data will show large changes, not just for inflation, but across the whole economy.
Earlier this year we talked about “rebound, reflation and inflation”. These aspects are important in terms of understanding the price pressures we are now seeing. The rebound relates to the fact that there is a lot of pent-up demand in the economy and as we come out of lockdown, spending could rebound strongly.
However, supply chains across the economy have clearly been impacted. So, the combination of that pent-up demand and supply bottlenecks is inevitably going to result in some pricing pressures.
These pressures won’t be equally distributed. Some parts of the economy will see inflationary pressures come more to the fore and indeed, that's seen in the latest data with household services. Other areas, in contrast, like the creative sector, and for the moment, tourism, are seeing low prices.
On top of that rebound, we are also seeing the consequence of the reflationary policy, with considerable policy initiatives having taken place over the last year and more easing in the pipeline. That policy easing was inevitable and indeed understandable over the last year, so the rebound plus reflation is now leading to some inflationary pressures.
Setting the tone for markets
Recently we talked about how one of the key drivers for markets was the inevitability of a pickup of inflation in the US, expecting a rise to 3.9% in April and 4.5% in May. The last month's figures in the US show that in April, the market expected year-on-year inflation to go to 3.6%. It actually went to 4.2%.
We'll have to wait and see whether the inflation pick up in April continued in May – it likely did. But the key message was that inflationary pressures were feeding throughout the US. This is against the backdrop where monetary growth, in particular, surged last year, which has led to some greater focus on inflationary pressures.
This will set the tone for the markets.
In the UK the picture is similar to the US. As you can see on the right of the chart below, in March, year-on-year inflation was 0.7%. In April, it’s up to 1.5%.
Source: Bloomberg, ONS.
We think UK inflation, like US inflation, will hit a high in the next few months – and the pressing question, of course, is whether this is transitory or permanent. Markets were initially buying into what central banks, led by the US, are saying: that this is a transitory, short-lived pickup. Now, people are not so sure.
For instance, what will happen to oil prices and will other inflationary pressures start to hit us hard? The recovery globally is likely to see not just other commodity prices firm up, but quite possibly, oil prices, too. This creates a more uncertain environment, but the first key message is this: as we've outlined previously, we're seeing a pickup of inflation, some of this is transitory – a key question is, though, whether there will be any longer lasting impact.
Transitory or permanent?
The last prolonged period of sustained inflation in the Western world was in the 1970s and there was a combination of reasons for that – in particular, a succession of oil price shocks. On top of that, the whole environment in the seventies was very different. There was plenty of fiscal easing, but monetary policy very much accommodated the pickup of inflation.
It was a different era, but some people are now saying there are shades of the 70s again. And that's true, but only in a partial way.
In the late 80s to early 90s only a minority of economists thought that we were moving to a period of sustained low inflation. The relevance of that for now, is this: it took a long time for the market consensus, to actually buy into the idea that we were moving from high to low inflation.
The point is that if we are now moving from a low to high inflation environment the markets and economists, unfortunately, are not likely to be ahead of the curve. They are likely to take time to adjust, partially due to a status quo bias. Of course, the reality is that we don't know what will happen.
Even though we're only talking really about inflation now, the reality is that we have seen significant inflation of a kind in recent years. Post the 2008 Global Financial Crisis we saw unconventional monetary policies, as interest rates were pushed low and central banks started to print money.
We have seen asset price inflation in terms of house prices and financial market prices. That has been a direct consequence of monetary policy, and it has fed inequality.
Factors that have kept inflation low
The question now, though, is more broad based. What will happen to inflation across the whole economy, not just here in the UK, but in the Western world? Let’s examine some of the factors that have helped to keep inflation low. These are structural factors that have contributed to the low inflation environment that we've seen, and include: power, globalisation, technology, and financialisation.
Power – is about the ability of firms to be able to raise profit margins, and was also about the relationship between workers and managers in the inflationary 70s, when the unions, in the Western world, were particularly powerful. The wage share, though, has fallen significantly over subsequent decades so the power issue is a particularly important one – and it may start to be changing if one looks at the politics in the West.
Globalisation – in the wake of the pandemic, it's quite possible that supply chains will change. There is more talk of de-globalisation and if that were to take hold, then there will be more inflationary pressures creeping through. But overall, even though there will likely be some shift as a result of this pandemic, we still think that globalisation will see people sourcing goods and buying their services globally.
Technology – is adding to competitive pressures. Now, of course, for many an iPhone is incredibly expensive but there are a lot more capabilities on those phones, so in terms of value for money, the idea is that they're better. It's sometimes difficult to quantify because quality is changing as well as prices. But the bottom line is that technology, like globalisation, has exerted a big influence on keeping prices low.
Financialisation – is a factor often overlooked, but this trend (of a country’s financial sector growing faster relative to its economy) has very much been a driving force in terms of companies, although in some respects the emphasis has been too much on the short term.
These structural factors combined, however, have kept investors happy, have kept price pressures down and costs in check – and resulted in a low inflation environment in recent decades. Some of these factors will continue to drive the outlook, although, at the margins, one or two of them will change.
The upshot of all of this is that we think we will be moving to a higher, but still relatively low inflation environment.
Of course, the key might be what happens on the policy side. Fiscal policy has been the shock absorber alongside monetary policy in the pandemic, but it was against the backdrop where debt levels were already high.
We were hit by the 2008 Global Financial Crisis and now by this pandemic, where a high level of debt to GDP creates a problem. This forces governments to try and grow their way out of the problem. But also in terms of the inflation debate, it's led to the issue about how this is financed. In this pandemic we've seen the Bank of England here in the UK and the US Federal Reserve in the US buying more of that government debt.
But even as optimism about the growth outlook has picked up, the Bank of England has continued to decide to print money as inflationary pressures have risen. If the economy is recovering and inflation is rising, perhaps they shouldn't be doing this.
It's up to central banks and governments to take policy action to stop stimulative policies from continuing and to curb inflationary pressures. There are lots of structural factors that will keep inflation in check – those longer-term drivers will cap the rise in inflation. But a lot does depend on the policy stance ahead, both in the US (which dictates market sentiment around the world) and in the UK.
Real outcomes of inflation
We should also focus on some aspects of the inflationary environment and think about how some of the inflationary pressures we’ve mentioned are visible in both the real economy and also in markets.
Below, for example, we can see how the improvement in demand and some of the strains in supply chains at the moment are starting to be felt very visibly.
Source: Bloomberg, with Netwealth calculations.
The cost of shipping is heavily influenced by the cost of raw materials, and the impact here is illustrated by a broad look at commodity markets. Witness the robust increases across the board below – in energy, precious metals and agriculture. We are happy to say that we have captured some of this strong price growth since we decided to invest in commodities for the Netwealth portfolios in March.
Source: Bloomberg, with Netwealth calculations. Commodity returns shown to 17th May 2021 in US dollars.
Of course, we cannot deny the speculative impact on commodity prices, and that's one of the reasons why we don't hold strategic positions in commodity investments over time. We feel that, at the moment, they're the best placed asset class to respond to some of the inflationary pressures we have already mentioned.
Other factors to consider
Chinese activity has had a strong impact on inflation over the past 20 years, and we are actually seeing some signs of activity rolling over in China now. Chinese activity has been a strong leading indicator of commodity prices in the past, so that's something we need to be wary of as we hold this asset class.
Moving across the Pacific to the US and a recent National Federation of Independent Business survey of small businesses shows that the jobs market is quite tight now. In fact, going back over the past 20 years, it's one of the toughest environments for hiring people now. Clearly that's indicative of underlying inflationary pressure within the job market.
The survey also revealed that poor sales are no longer seen as a problem for business, a dramatic reversal from this time last year. A key question, therefore, is how sustained pressure within the US jobs market will be.
To understand how expectations for sustained inflationary pressure is being priced, we look at the inflation swaps markets. This is suggesting that the market is looking for slightly higher prices than has been the case in recent years.
Particularly in the US you can see the grey line is starting to move upwards and the eurozone is ticking up as well. The UK line, however, was sustained by sterling weakness through the course of last year and also, the swaps market reflects a slightly different underlying index: RPI rather than the traditional CPI, which tends to be a little bit more elevated. So you can see the UK position is a little bit more stable at higher levels, so far.
Nevertheless, we do need to think about whether this is an episodal change in the environment for inflation. If it is not, then some inflationary protection assets such as inflation-protected government bonds could be looking a little expensive.
Equity market resilience
Inflationary pressure has a more direct relevance to fixed income assets. As we've mentioned previously, there are parts of the bond market which are already reflecting some of that pressure. We're still happy holding some areas of fixed income within portfolios, but it's an area that we reduced in March.
Equity market performance has been pretty stable over the past couple of months. Returns haven't been too dramatic, although some areas like Japanese equities have been underperforming.
So, what's behind the equity market resilience? The table below shows the outcome from the recent earnings season in the US and Europe. We took a very favourable position on the US equity market earlier in the year, and indeed, the earnings season here did deliver strongly.
Source: Bloomberg, JPMorgan with Netwealth calculations.
So, in the US, we saw strong sales and earnings growth in the first quarter of the year. Just as important, however, is the percentage of companies who are beating elevated aggregate analyst expectations.
We need to be a little bit careful looking at these numbers because the investor relations teams tend to manage expectations very well for the market, but these numbers are much higher than is normally the case. In Europe, we’ve seen some very strong performance as well.
Now, the challenge that the market faces, which we have mentioned previously, is one of valuation.
High expectations of future performance are built into asset prices, particularly in the US. So, to the right of the table above, the cyclically adjusted P/E Ratio – at 30 times – is a lot higher than other markets, and also compared to US history. For now, we're happy that this earnings growth will be sustained within the US, but it's something that we are monitoring extremely carefully.
As we always mention, to people who are thinking about investing with us and to our clients on an ongoing basis, is that you should still expect to see periodic bouts of volatility in the future.
We think that these valuation levels will continue to dampen future returns within the market over the longer term. That's why our expectations are reasonably modest in terms of how we think markets will perform.