Inflation: How Worried Should We Be?
Chris Watling, Longview Economics
Inflation has become a deeply contentious, and indeed critical, issue for markets in recent months. In particular, the approaches to forecasting inflation, and the opinions about to how it will evolve, are sharply divided.
On one side of the debate, some argue that inflation is already out of control. For the past three months, US core CPI readings have printed at +0.9%; +0.7%; and +0.7% (m-o-m, i.e. in April, May & June). They were all significantly above expectations, they are the highest readings since the mid-1980s and, according to the ‘inflationistas’, inflation should persistently surprise to the upside in the second half of the year.
In particular, they highlight the monetisation of the fiscal deficit; the recent surge in money supply (to its highest since WWII); the significant rise in oil and other commodity prices; as well as the production bottlenecks associated with the pandemic.
On the other side of the debate, where the consensus currently sits, is the Fed’s argument that high inflation is ‘transitory’, and that CPI prints will soon revert back to lower/more normal levels. So far, the bond market appears to agree – with 10 year Treasury yields trending down despite the upside inflation surprise over recent months. Naturally, though, and as the cartoon suggests, the more that CPI surprises to the upside, the more the Fed’s inflation view loses credibility.
The key question, therefore, is: Who is correct? Will inflation fade? Or will it keep surprising to the upside over the second half of the year (and potentially beyond)? Furthermore, if it does, which asset classes will outperform? And, how quickly would the Fed then change its current policy stance (i.e. and move away from its intention to let the economy run hot)? All of those questions are now in sharp focus and currently sit at the heart of many key asset allocation decisions.
On balance, though, two key reasons suggest that strong inflation readings will fade in the near term. In particular:
1. Recent inflation spikes have been distorted by ‘one off’ factors, mainly associated with the re-opening of the US economy. They therefore overstate the broader inflation backdrop. In particular, core inflation has been pushed higher by a sharp rise in the price of used cars and trucks. Over the past 3 months those prices have risen by +9.6% m-o-m in April; +6.5% m-o-m in May; and then +10.8% m-o-m in June, see fig 1 below. While their weighting in the index is small (sub 4%), higher car and truck prices, alone, have accounted for about 42% of increase in core inflation in the past three months. That impact is unlikely to be sustained, given that it relates to a temporary shortage of microchips (as well as other related supply issues). Some other individual prices have also been strong, including airline fares; motor vehicle insurance; and recreation. On the whole, though, most price increases have been within the usual range of increases. As such, the breadth of the increase in core CPI has been narrow.
Fig 1: CPI subcomponents (motor vehicle insurance vs. used cars & trucks), M-o-M %
Fig 2: Median inflation vs. core CPI (M-o-M %), shown with US recession bands
Looking overseas, it’s also clear that while inflation has picked up, it’s not nearly as dramatic as the monthly gains in the US. In the UK, for instance, core CPI is still below 2018 levels (Y-o-Y). Over in the Eurozone, whilst core CPI spiked sharply in January, it’s now back at the bottom of its range of the past 5 years. While, finally, in Australia, similar trends are playing out with a relatively modest bounce in core inflation (i.e. back to pre-pandemic levels). Overall therefore, the most dramatic inflation pick-up is focussed on the US.
2. Despite one of the deepest recessions on record, the supply side capacity of the US, and indeed, global economy has grown in this pandemic. In particular, the global corporate sector has been significantly supported by unprecedented levels of policy largesse. That’s evident on two fronts: First, in the US according to the ‘American Bankruptcies Association’, total bankruptcies have fallen in this crisis to their lowest level since 2006 (see fig 3). Equally in France and Germany the combined number of bankruptcies fell by 40% last year (from end 2019 levels). Second, there has been a sharp increase in new business applications. Reflecting those two factors, we estimate that US net new business creation, for example, equates to 120k companies in the past 5 quarters (Q1 ’20 – Q1 ’21 inclusive). Of interest, a significant proportion of those new businesses were created in March (i.e. on the re-opening of the economy) in sectors such as ‘accommodation and food services’ and ‘other services’, thereby illustrating the dynamism of the supply side of the US economy.
Fig 3: US bankruptcy fillings (total, number)
In the near term, therefore, inflationary pressures are likely to fade somewhat (i.e. in the second half of the year).
Beyond that, though, there are a number of reasons why the medium term inflation landscape is changing (from one of low inflation, to one of growing inflationary pressure). Those reasons are multiple and include:
(i) the policy response to the pandemic (i.e. helicopter money and a significant increase in money supply);
(ii) a relatively strong demographic profile in the US (especially given the growth rate of the Millennials); and
(iii) linked to (ii), the case for a sustained, multi-year uptrend in money velocity (i.e. driven by that stronger demographic profile). Of note, inflation is not just driven by large/growing levels of money supply, but also by the speed at which that money moves around the system (i.e. money velocity). Both those two key (monetary) ingredients for higher inflation are therefore currently in place.
As such, and while many of the major drivers of (currently) high inflation should fade in the second half of this year, there are longer term inflationary forces which are likely to start firing/materialising, potentially as early as next year.
In addition, and somewhat related to those three factors noted above, housing is increasingly becoming an inflationary force in the US economy, and a key risk to our view that inflation fades in 2H 2021. In particular, with current annual US house price growth of 15% y-o-y, shelter inflation is beginning to turn higher (rising sharply in June, by 0.5% m-o-m). Usually, as the chart below shows, strong house prices eventually feed through into stronger shelter inflation. Given shelter’s large weighting in the CPI index (i.e. of ~30%), it’s possible that, while ‘one-off’ inflation factors may fade later this year, other factors begin to pick up the reins.
Fig 4: Case-Shiller Home Prices (Y-o-Y %, advanced 12m) vs. shelter inflation (Y-o-Y %)
If that assessment is correct, then the key question becomes: Where can investors hide? Or indeed profit from higher inflation?
From a simple/top level perspective, the answer hinges on the inflation regime. In particular, will the inflation uptrend be relatively gradual/tame (as it was, for example, in the second half of the 1980s)? OR, will it be pernicious (as it was, for example, in the 1970s)?
If it’s pernicious, real returns in bonds, equities, and credit will be poor. That was the case in all three major inflation spikes from the late 1960s to early 1980s. In those (and similar) environments, business costs tend to rise faster than prices (i.e. profit margins are squeezed) while nominal bond yields, unsurprisingly, trend persistently higher. In contrast, TIPS* and hard assets (e.g. real estate and commodities) perform well. The real terms performance of gold, for example, was particularly strong during both inflation spikes of the 1970s (fig 5).
In reality, though, a pernicious inflation regime is unlikely at this juncture. Instead, the rise in inflation will probably be gradual, at least initially. While bonds would still perform poorly as yields rise, certain parts of the global equity market should perform well (e.g. the cyclical and value oriented indices – fig 6). The growth areas of the market, though, which are valued on long term discount rates, would come under pressure as those rates move higher (as they did, for example, in Q1 this year).
Fig 5: Gold price (real terms) vs. core CPI inflation (Y-o-Y %)
*I.e. Treasury Inflation Protected Securities.
Key commodities, including gold, should perform well in both inflation regimes (whether gradual/tame, or more pernicious). Indeed, according to research by Draaisma, Funnell, Harvey, and van Hemert**, commodities have delivered the strongest returns during the eight major phases of high/rising inflation, that they have identified and studied since the 1940s. On average, commodities, in aggregate, deliver real annualised returns of 14% in those phases. In ‘normal/low’ inflation environments, in contrast, average annualised commodity price returns are in low single digits.
In five of those eight inflation regimes, though, average real returns from equities were negative (-7% on average). For bonds, average real returns were negative in six of those eight inflation regimes (with an average return of -5%).
Given the long term outlook for inflation, therefore, the risk reward favours tilting strategic portfolios towards greater commodity exposure and greater exposure to cyclical and value parts of the equity market over coming quarters and years.
**See their April 2021 paper “The Best Strategies for Inflationary Times”, available on the SSRN (Social Science Research Network).