The spectre of inflation has come back, rising to highs not seen in well over a decade in the US, Germany, the UK, and across other developed and emerging market economies – and there are no signs of a major reversal in the headline inflation trend as the year-end approaches
Why has inflation been going up?
The coronavirus pandemic and the intermittent closures of economies across the world resulted in a surge of demand for energy and goods once these economies started to re-open. Although central banks initially called it ‘transitory’, inflation is proving far stickier as raw material shortages, labour shortages, high shipping costs, and supply bottlenecks continue.
However, the inflation situation does vary by country and region. Price pressures have been growing rapidly across the globe, causing all sorts of problems for consumers and producers alike – especially in Europe and America. Across the Eurozone, inflation started to surge higher from around the middle of the year and raced to multi-year highs in the ensuing months to reach an annual rate of 4.9% in November.
In the US, inflation was at 6.2% in October. Federal Reserve Chairman Jerome Powell indicated at the end of November that tapering QE could speed up in the next few months.
In the US the Fed’s first-rate rise is looking more likely to take place in June 2022, while in the UK the Bank of England is closely monitoring wages and productivity to better understand if it is more of a demand or supply problem (as monetary policy has little effect on supply problems).
In the Eurozone, with its higher levels of structural unemployment, there is a slightly different approach. European Central Bank (ECB) President Lagarde has repeatedly stated that the ECB continues to expect inflation to dissipate in 2022 as demand and supply mismatches are resolved and energy prices fall, with inflation returning to the 2% target rate in the medium term. The ECB has been insistent it will not raise rates any time soon.
However, this belief doesn’t seem to be the case across all of Europe. According to Croatian central bank governor Boris Vujčić, inflation now eclipses concerns over public finances as the biggest risk to Croatia’s hopes of adopting the euro in 2023 and the Croatian central bank (HNB) sees inflation accelerating to 2.3%, driven by imported energy and food costs it deems largely beyond its control.
Inflation has now become a political issue. Central banks around the world are coming under increasing criticisms by investors, consumers and, sometimes, e.g., in Turkey, by the government itself.
The main concern now is the pace at which central banks move: moving too quickly may weaken consumer spending, lower capital investment and weaken economies that are still recovering from the pandemic. Moving too slowly may result in a sudden rush to get ahead of the curve, forcing a slowdown in the economy if supply doesn’t catch up, ultimately leading to a degree of stagflation.
Consumers and producers want a clear policy path; central banks are failing to control inflation expectations. Firms, already suffering labour shortages either due to skills mismatches or for country specific structural reasons, will boost wages and prices in expectation that their competitors will also do so, increasing the stickiness of this inflation.
How are investors protecting against inflation?
Judging by how cryptocurrencies managed to make solid gains and repeatedly broke to new record highs, we think that investors, especially the younger generation, have been seeking protection from inflation by holding Bitcoin, Ether and other popular coins.
Even meme coins have at times been preferred over fiat currencies. Stock markets continued to hit record highs despite benchmark yields increasing. Gold, the traditional bulwark against inflation, has surprised to the downside, with gold futures down from January highs.
Going forward, a lot will also depend on which scenarios play out.
Scenario 1: The Omicron variant, although with a higher transmission rate than its Delta predecessor, proves to be a milder form of the virus. Covid infection and death rates drop in the US, Europe and large parts of Asia following a booster programme and new legislation on vaccination requirements.
Emerging markets in Latin America, South East Asia and Africa have greater vaccine uptake as supplies increase due to overseas development assistance. The containment of Covid allows economies to stay open, fuelling increasing demand for services and raising labour supply.
Existing supply constraints will start to lessen, leading to inflation lowering by the end of 2022 to near target as the rebalancing of demand, the effects of US economic stimulus on global demand eases, shipping rates fall, and a recovery in goods and labour supply accelerates. However, there is still a divergence in central bank policy: the US accelerates its taper programme and starts raising rates towards the end of Q2 2022.
The dollar gains against the Euro and GBP. Investors should stay clear of long-term bonds and consider Emerging markets for best yields. Europe diverges and doesn’t raise rates or remove its taper programme. European stock markets recover ground with non-cyclicals outperforming. In the US energy, cyclicals, financials and tech stocks fall.
Scenario 2: The Omicron variant results in higher hospitalisation and death rates leading to Q1 and Q2 global growth rates slowing as economies start to close back down. This means a fall in consumer confidence, a drop-in demand, a continuance of supply shortages and labour shortages, and inflation will likely remain above target until 2Q 2023.
The Fed may continue its taper but not raise rates. Depending on the effectiveness of vaccines, the US government may seek to re-employ fiscal stimulus with additional stimulus coming from the infrastructure bill and the build back better bill. Liquidity remains high; expect US stock market indices to remain high with cyclicals and basic materials performing well.
In Europe the ECB, wary of growing threats to euro-area stability, extends its Pandemic Emergency Purchase Programme. In the UK rates remain low despite surging inflation from supply constraints, labour shortages, rising wages. Trade imbalances increase and debt levels rise as GDP growth falters. The UK is most likely to face a stagflation situation. The Euro and GBP weaken against the Dollar.
Regardless of which scenario comes closest to what actually happens, investors need to adjust their portfolio holdings of equities, bonds, commodities, crypto derivatives and other alternatives to maximise returns as regional central banks, like Goldilocks in testing the bears’ beds, seek to find which policy path is really neither ‘too hard or too soft’ but ‘just right’ for their unique labour, trade balance, and debt levels.
If Covid remains contained, we believe that consumer and business spending are both likely to stabilise towards the second half of 2022. A growing number of countries have ended their furlough schemes and have or are about to raise taxes. Supply chain bottlenecks may continue to dissipate as more labour becomes available and port congestion improves.
Finally, we have seen several key commodity prices weaken in recent months and weeks, including crude oil and natural gas, after rising sharply previously.
Therefore, if we do not see a resurgence in high mortality or hospitalisations from Covid variants over the next few months, input prices for producers should start to fall, boosting margins and leading to increased price competition. This in turn should lead to lower consumer inflation and stock market performance.
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Text Anthony Lukač