The great debate among economists and financial analysts right now is – Inflation: transitory or not? Looking at the news and markets lately one could be mistaken for thinking the debate is over with the negative being the victors. Inflation, it would seem, is here to stay.
We take a contrary view or rather believe it is too early to tell if the inflation pressure we are seeing currently will persist to the same extent next year. In our view, the transitory forces are still being played out. In terms of recovering from the COVID-induced dislocation, we are not there yet.
The biggest demand surge since World War II
When we are thinking about whether inflation will be transitory or not we need to think about what is causing the pressure in the first place. It seems there are two main drivers:
1) the surge in consumer goods demand as lockdown restrictions are eased, and
2) the shortage in energy.
There are of course second round price pressures that are feeding through into other prices like commodities and wages.
Most of the price pressure in the US and Australia are being driven by the surge in consumer demand – spending the COVID stimulus packages. As the chart below shows, consumers in the US and Australia have been among the largest responders to the stimulus of any other country in the world.
This is not too surprising given the fiscal stimulus packages in the US and Australia were among the largest in the world. In Europe consumers are more conservative. The price pressure we are seeing there is mostly coming from higher energy prices.
Chart 1: The biggest stimulus drives the biggest surge in goods demand
In our view the transitory argument for inflation cannot be discounted yet. It is still valid because the drivers of that inflation are themselves transitory and are in fact still transitioning. The consumer spending growth we are seeing in Australia and the US currently, at six to seven times the historical average, is not sustainable. Within consumption, the rampant spending on goods versus services will also correct as lockdown restrictions ease and we spend on services, like travel and tourism again.
The biggest supply collapse the world has ever seen
Balanced against the biggest demand surge since World War II, caused by the COVID reopening, was the biggest supply collapse the world has ever seen, caused by the COVID lockdowns. Supply and demand have been taken to such opposite extremes it is no wonder we are seeing pressure on the supply chain and production bottlenecks.
The largest manufacturers of the world – China, the US, Japan and Germany – have been scrambling to meet the demand (chart 2). Industrial production has surged. At one point in Germany it was growing at 80%! Growth has since declined across the board but, with the exception of China, it is still above average rates.
The 12% growth in US consumer spending is as meaningless as the 13% unemployment rate we saw last year.
Both of these events, on the supply and demand side, have been far outside the range of previous experience, and therefore impossible to capture in economic models. Unless we believe something fundamental to the economy has changed in the past 20 months, these data points are spurious and have little informational content.
That is not to say the 12% growth in US consumer spending is as meaningless as the 13% unemployment rate we saw in the US last year but extrapolating these growth rates into the future should be treated with some caution.
Chart 2: The big-4 manufacturers responsible for almost 60% global production
The labour market is still dislocated
Nobody can predict with confidence when supply and demand will come back into balance and the timing will differ for different markets. In the meantime, the imbalance has spilled over into other markets such as commodities and latterly the labour market.
We can see the spill-over of excess demand into commodities in chart 3. Two points are worth making here. First, the upward pressure in prices across all groups, with the exception of natural gas, began in June last year. Agriculture, it seems, has already started to plateau and in fact some commodities within agriculture have begun to correct down. Corn for example is down by 30% since peaking in July, soybeans are down by 26% since peaking in May and cotton is down 6%. Wheat and sugar are still rising. The important point to note, however, is that market mechanisms have not been permanently paralysed or changed by COVID.
The second point to note is that all of the subsectors are still well within historical norms. Indeed, the most sensitive subindex to economic growth is energy. This subindex is made up of crude oil, heating oil, unleaded gasoline and natural gas. It has the highest beta to US consumption of any of the subsectors. And yet it is still well down from its highs in 2012-14. A time, incidentally, when US inflation was tracking between 1 and 2%.
Chart 3: Bloomberg sub-indexes for commodities
The last market to adjust will be the labour market. The slow correction in the labour supply in the US is possibly due to the type of COVID policy response provided to workers. In Australia our policy response for the job market was to ensure people remained connected to their job (via JobKeeper) so the search time for a new one was reduced on reopening.
The connection between workers and jobs wasn’t maintained in the US policy response. Workers were separated from their job in lockdown and were paid an additional unemployment benefit. Now coming out of lockdown those workers need to re-establish that connection with an employer. This will take time, particularly given there are lingering Delta concerns. A comfortable savings account also means there is no urgency. Importantly, however, the pandemic did not permanently shrink the labour force. The employment rate for workers in the 25-54 age bracket, that is currently 2.4% below pre-pandemic levels, will rise back easing labour supply issues and therefore wage cost pressures.
What are the investment implications?
Markets have a tendency to adjust. Some markets adjust faster than others. Some markets may even over-adjust and instead of talking about inflation next year we could be talking about deflation again.
Supporting the case for deflation is the trend that received the largest turbo boost during the pandemic – technology. There are few if any industries that are not being disrupted by technology – from the most traditional like agriculture to the most labour intensive like hospitality. Technology is helping to address some of the biggest labour shortage issues that these industries are dealing with currently. Hotels are experimenting with fully contactless experiences with digital check-in and check-out, mobile keys, a digital concierge service, branded room service via “ghost kitchens”, and robotic room service delivery. In agriculture, agri-bots and harvesting machines are replacing migrant fruit pickers who have been locked out due to border closures. The investment in these technologies means there is no going back. What will then happen when borders re-open and migrant workers return?
We are not dismissing the immediate threat of inflation. Our portfolios are positioned to benefit from a rising inflation environment with allocations to global real estate, property and infrastructure and an underweight to fixed income. Our view is simply that it is too early to say that the inflation pressure we are seeing will not ease in the first half of 2022. This therefore means we are unlikely to see an as aggressive rate hike cycle from the central banks that markets currently imply.