High inflation – is it here to stay?

Sam Slator 25/11/21 in Strategy

Inflation figures around the world have continued to climb in recent months. While many believed price rises would be transitory, they are proving to be stickier than expected.

US annual inflation jumped to 6.2% in October – a 31 year high – while we hit a ten year high here in the UK when the consumer price index came in at 4.2%.

The Bank of England’s new economist, Huw Pill, has even said he would “not be shocked” to see UK inflation reach 5% or above in the coming months*.

This has led to increased expectations that the Bank of England will raise interest rates in December, just weeks after it shocked markets by keeping borrowing costs on hold.

But as Ian Lance, fund manager at RWC pointed out: “The central banks are walking a tightrope. Given the huge amount of leverage in the system, they know that even a small rise in interest rates runs the danger of tipping the global economy back into recession.”

At a dinner hosted by FundCalibre last week, three Elite Rated managers gave their views on the inflation dilemma.

“Inflation is less transitory than people first thought and it’s true that energy and materials have hit a level they were last at in the 1970s when there was demand destruction,” commented Jeremy Podger, manager of Fidelity Global Special Situations.

“But the labour market is improving, so the conditions for stagflation – when there is high inflation and high unemployment – are not there today.

“Then there is the question of the Federal Reserve (Fed) raising interest rates. Nothing hurts equities more than unexpected tightening. But the Fed and markets seem to be on the same page, and we are unlikely to see any negative surprises.”

“Is there any point in raising interest rates, though?” asked Jim Leaviss, manager of M&G Global Macro Bond. “The Bank of England probably will next month, but it’s not going to increase the availability of container ships, which is part of the inflationary cause today.”

The Bank of England – which has a target of 2% inflation – has admitted as much itself, saying higher borrowing costs can do nothing to influence energy prices. But some of its policymakers are concerned that high inflation could harm its credibility in the eyes of the public.

“Oil prices need to go up to about $200 (per barrel) in the next year for energy inflation to stay where it is today – which I don’t think will happen,” continued Jim. “The worry though is that 80% of the inflation ‘components’ in the US are above 2% today, so it is broad-based. 40% of US inflation is also from rent, which operates on a long lag to house prices which have gone up a lot.”

“Yes, house prices are up some 16% year-on-year in the US and the rental market is following,” agreed Jeremy. “At the moment the 10-year inflation expectations in the US are for 2.6%. “If it goes over 3% there is the danger the Fed gets too far behind the curve, and we have to worry about more aggressive rate rises. That situation would be bad for equities.

“It’s different for different countries though,” he continued. “Japan for example, has had many phases of currency depreciation and stimulus, but nothing has helped inflation as there is a deflationary mindset. The Labour market expects wages not to go up. “The US is more subject to market forces, but even here, most wage growth has so far been driven by lower paid workers. Professional and qualified workers haven’t seen it yet.

“Europe is somewhere in between and there is no sign yet of pressure in the labour market even though there are some shortages in certain sectors. And the UK is difficult to fathom. We don’t have the collective bargaining power we had 30 years ago, so I think real wages are likely to be under pressure for a while.”

“If wages don’t rise by the same amount, that could dampen inflation though,” said Jim.“Traditionally, manufacturing has always dampened inflation by threatening to move to countries where there are lower wages. Today, working from home means that any worker – white collar too – can do a job from anywhere. So, wage pressures should be ameliorated.”

“China is also a deflationary force on the world as it is a source of vast quantities of things at lower prices and exports have gone through the roof again,” added Rob Brewis, co-manager of Aubrey Global Emerging Markets Opportunities. “India is also about to become a much bigger manufacturing force. Globalisation is not dead.” he added.

This is a view shared by Dickie Hodges, manager of Nomura Global Dynamic Bond, who said in his last fund update: “With the Chinese economy slowing and the US consumer being impacted by higher prices, both sides have a vested interest in reducing Chinese export tariffs – we expect negotiations to resume, be fruitful, and the good news to lift risk markets as a whole in the short term, with emerging markets the greatest beneficiaries.”

Dickie also believes that the Fed could be making a policy error if it raises rates into a slowing economy. “The supply chain impairment should come to an end in Q1 next year,” he said. “I expect inflation to roll over in the second quarter of 2022.”

“Today, the risk is that US consumer confidence has collapsed and, when it falls as much as it has, it can be an indicator of recession next year,” concluded Jim. “The yield curve has also flattened, although it’s not yet inverted, which is another recessionary sign.

“Maybe central banks should be targeting the unemployment rate instead, which is five times more powerful than the inflation rate when it comes to measuring the degree of economic distress felt by everyday people.”

*Source: Financial Times, 21 October 2021

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