In June 2020 we gave a non-consensus view that inflation definitely ‘had a future.’ Now that inflation has begun to rise, we ask whether inflation has indeed found its feet. We conclude that inflation a little above 2% over the long term is a natural part of global economic healing; not only from COVID-shutdowns, but also healing that was still not complete following the 2008 financial crisis. We have positioned our fully managed customer portfolios accordingly, with inflation hedges in equities, gold and an under-exposure to rising bond yields. We do not anticipate a disruptive period of high inflation but do expect some temporary higher readings this year due to the low 2020 base-effects.
Doctor’s orders: a healthy dose of inflation
Low and steady inflation is a sign of a healthy economy, with most central banks targeting consumer inflation around 2% annually. Stable inflation helps ensure all stakeholders in a modern economy continue to benefit from an efficient allocation of resources:
- Savers get a reasonable interest rate on deposit accounts.
- Borrowers are not overly incentivised to take on more debt (high inflation can encourage indebtedness – especially in the housing market).
- Companies retain some flexibility with prices, safeguarding profitability.
- Workers don’t suffer significant real income loss from high inflation, mitigating the need for larger wage claims on employers.
- Productivity gains can offset low inflation so that unit labour cost increases are even lower.
- Steady prices and stable employee-employer industrial relations provide a positive environment for companies to consider new investment – further benefitting future productivity and real income.
- A degree of inflation is an acceptable price to pay to minimize unemployment. (See Chart 3).
- Central banks – and government policy in general – retain a flexibility to respond to unforeseen events.
Policy makers prescribed economic CPR
The 2020 economic paralysis was induced by forced shutdowns and restricted mobility. To recover from this state, the economic patient needed some serious policy resuscitation; it was duly administered. The amount of money circulating in the US economy grew by over 25% during the crisis thanks to fiscal handouts and assistance programs. Chart 1 shows how this compared starkly with the 2008/9 crisis. The green line shows the impact of central bank action; the black line shows how much policy measures seeped into the wider economy through commercial bank lending. The chart illustrates that, while this did not occur in the earlier crisis, the added fiscal measures this time around have led to economy-wide benefits – as illustrated by expanding money supply.
Chart 1: Quantitative Easing impacting money supply this time around
Money base (M0) is the total of currency in circulation and money held by Federal bank reserves. Money supply (M2) includes deposits in bank current and savings accounts, and so reflects broader bank balance sheets – including whether or not banks are expanding their lending. %oya = percentage over year ago (year on year change). 2ma = 2 month average
The patient is responding but needs to take things easy
As Chart 2 shows, US inflation is spiking above the 2% target. The patient is showing vital signs again. No doubt the UK will follow suit, but it’s important not to get carried away with talk of high inflation. As has already been explained, inflation of just over 2% is a healthy level. And the International Monetary Fund agrees with the central banks of the US and UK that the medium-term outlook is for inflation around this healthy level (Chart 3). So, although the short-term readings may spike higher, these should not persist.
Chart 2: US and UK inflation
%oya = percentage over year ago (year on year change)
Chart 3: US and UK official annual inflation forecasts
FOMC US PCE = Federal Open Market Committee US Personal Consumption Expenditure; CPI = Consumer Price Index. BoE = Bank of England; IMF = International Monetary Fund
Goods price inflation awakening from its slumber.
The price of goods, not services, is the main driver of current trends (Chart 4). The shut-down had its most brutal impact on manufacturing and commodity prices. Bottlenecks have resulted from an uneven reopening of manufacturing capacity and that has awoken goods-price-inflation from its slumber. Chart 5 provides a further level of drill-down of this, showing that durable goods are leading the charge. The black line in the top panel of Chart 5 shows durable goods inflation is positive for the first time in 25 years. And although a small part of the CPI basket (11%), the fact that this segment is adding to (not subtracting from) inflation is an important part of the medium-term prognosis for inflation.
Chart 4: Goods vs services prices
%oya = percentage over year ago (year on year change); 3ma = 3 month average
Chart 5: Goods prices
%oya = percentage over year ago (year on year change)
Medium term prognosis: no crisis but inflation has found its feet
There are several medium-term forces acting on prices:
- Fiscal policy has become more proactive in all countries. Since fiscal policy has a more direct and timely impact on economic demand than monetary policy, the new policy mix should be more inflationary. Since the 2008 crisis, the focus of policy has been the restoration of health to the banking system through extra-ordinary monetary policy. Since COVID-shutdowns we are seeing extra-ordinary policy of a fiscal variety.
- Monetary policy continues to focus on bringing inflation up to the long-term targets of just over 2%.
- Global supply chains are shifting. The undeniable economic and political rivalry between the United States and China has changed the global landscape for generations to come. Although Nutmeg believes self-interest will drive both great powers to accommodate each other, global trade supply chains will need to adjust, and this may very well involve higher inflation.
- Commodity prices will be key to the outlook, but with fossil-fuels at the end of their product-life-cycle, petrol prices are unlikely to impact future inflation as they have done since the 1970’s. Furthermore, enhanced environmental awareness and recycling behaviour means a net-reduction on raw commodity demand.
- Services prices are 63% of the inflation basket (Chart 4). The key here is wages growth (Chart 6) and technological development. Wage growth has been on a long-term downward trend on improved labour-mobility and technology, and this looks set to continue, despite the geopolitical tension that is now a permanent feature of the global economy.
- Goods prices will likely add more to inflation if durable goods inflation remains positive. With the hiatus in global supply chains, this is probably more likely than not.
- Companies have pricing power – with pent-up household demand, savings accumulated during the shutdown, and labour markets protected by government fiscal policy, consumer demand is set to swell as economies open. That will give companies some licence to pass-on higher costs and widen profit margins.
Chart 6: Services prices and wages growth
%oya = percentage over year ago (year on year change); PCE= Personal Consumption Expenditure implicit price deflator; ECI = Employment Cost Index
How is Nutmeg positioned with respect to inflation?
We don’t think there is too much room for complacency on inflation into the medium term, nor do we think we are back into a 1970’s-style inflation environment.
Our investment strategy takes this into account with a small overweight exposure to equities and overweight in technology stocks. Equities provide a hedge against inflation if companies have the pricing power to protect their profit margins, which we believe to be the case. Government bonds are more problematic when inflation rises, as the value of their fixed coupons is undermined. So, we diminish them in our portfolios in favour of gold, which usually acts as an inflation hedge. As usual, the investment team keeps a close watch on this and all aspects of investment risk on behalf of our clients, making strategic adjustments as required to our managed portfolios.
Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.