Inflation is a critically important question for equity markets right now given it is resurgent and may have a potential impact on interest rates and asset prices.
As we increasingly move out of lockdown elements of demand that have been absent in the economy are resurgent – meeting significant supply chain disruptions as a result of Covid and the complexity of global supply chains. This is creating inflationary pressures in the near term.
Why does it matter?
If this near-term inflation is transitory, as markets currently seem to be anticipating and central banks are definitely signalling, then these pressures should abate. As such, we can expect lower interest rates for longer and limited damage to the ‘real’ (inflation adjusted) value of many investments.
If it’s something more structural, then interest rates may have to go up, bond yields are likely to rise and this is probably a negative for most asset prices from houses, to bonds, to equities.
Also, the types of stocks that we would expect to do best in these two different environments are very different, so it matters what is in your portfolio. Long duration assets are generally far more sensitive (negatively) to any rise in bond yields and interest rates.
What are we seeing?
At a company specific level, we are seeing a lot of evidence of inflationary bottlenecks:
- Amazon put up wages, with the average warehouse worker in the US seeing a $2 an hour pay rise (to $23 per hour) versus pre-pandemic
- Automobile manufacturers are cutting production because they can’t get semiconductor chips
- Copper prices recently hit an all-time high, US steel prices are at historic highs, meanwhile lumber is up 40% in the last few months – it’s hard to actually get supplies, driving costs up for businesses and producers
Having said all that, there are powerful deflationary forces out there that have shaped much of the last decade, reducing any upward price pressure for goods and services: debt acting as a drag on future demand growth, détente (globalisation) bringing in cheaper labour and manufacturing into the world economy, digital disruption allowing technology to deliver more for less, and of course demographics – aging populations with lower population growth lead to weaker end demand (versus the average of the last 20-30 years).
A big question for investors is how transitory these pressures are and how they impact mindsets in the real economy.
In our view, it is too early to tell how transitory these pressures are, but here are our thoughts as a team:
- We will be looking into Q2 results and commentary from management on these topics: wages, input costs and demand-supply dynamics to see what is happening in the real world
- Our base case is that this is transitory, but it may take 12-24 months to work through the post-Covid disruption
- We expect stock, industry and geographical specific differences and variations, so we won’t be treating this topic with a single brush stroke. Rather looking to understand the nuances of where inflationary bottlenecks exist that may impact stocks, industries, or the market
The only way is up?
For the time being, it’s hard to get your hands on a new graphics card, a second-hand car, a builder, paving slabs, holiday flights, a cottage in Cornwall, or a restaurant chef… Whilst an inconvenience in the near term, how transitory these issues are (and their respective impact on the economy and mindsets around inflation) remains a key focus of investors right now.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.