Investments | 19 September 2022
the great inflation balancing act
With inflation reaching record levels on both sides of the Atlantic, Coutts Asset Management’s Head of Asset Allocation Lilian Chovin takes a deep dive into what it means for investors.
HOW DID WE GET HERE?
To understand the outlook for inflation, it’s important to understand the drivers, which include government policy, shifts in consumption patterns, and labour market changes. The pandemic has had profound impacts on the global economy, and some will be persistent. In this article we will focus primarily on the US. And while the specifics of different regions vary, the main drivers and developments are very similar in most western economies.
Firstly, authorities’ response to the pandemic has had a significant inflationary impact. Governments in most developed countries either backstopped private sector wages via furlough schemes, or in the case of the US, boosted unemployment benefits to protect consumers. And meanwhile, low interest rates and quantitative easing have increased asset prices.
Secondly, the pandemic saw an unprecedented shift in consumer spending from services to goods. This put additional pressure on goods supply chains, which were also severely strained by the pandemic due to shutdowns and a spike in shipping costs, resulting in rising prices.
US Price Trend
Labour markets are tighter (low unemployment) than they have been for some time, as participation fell dramatically during the pandemic and they are yet to fully recover. We would expect recent improvements in US labour force participation to continue. However, some of the drivers of these tight labour markets may be more structural in nature. A disproportionate percentage of people who have stopped working are those in older age groups. This may be linked to health concerns, but also because rising asset prices will have benefitted those with retirement savings and home equity, therefore potentially encouraging them to take early retirement.
Unless we see a major escalation of events in Ukraine, the impact of rising food and energy prices on inflation is likely to recede in the second half of 2022. The recent fall of many commodity prices also supports this. However, there will be some economic costs associated with the ongoing transition to a green economy (partly encouraged by the move away from dependence on Russian hydrocarbons). These may be manifested in higher and more volatile inflation. For example, if a greater proportion of our energy is reliant on the weather, this will result in more volatile energy prices.
Rising prices for all type of goods was a main inflation driver during the pandemic but this has lessened recently. We would expect goods inflation to decline dramatically this year. Bank of England research shows that goods inflation is over twice as volatile, but less than half as persistent, as services inflation.
Given the tightness of labour markets, wage growth poses a bigger inflation risk than it has done over the past two decades. We need to consider the impact on inflation, and the likelihood of it persisting. Coutts Asset Management’s own research has found that the low inflation of the past two decades can be attributed to a weakened relationship between wages and prices. Rising inflation 40 years ago was in part due to a wage-price spiral – rising costs led to rising wages that then created and encouraged further rising costs. Though onshoring of manufacturing and rising geopolitical tension may see the relationship between wages and prices strengthen, we do not expect a return to those previous wage-price spirals.
We would expect the demand for labour to ease gradually over the next year. This will be driven by a modest rise in labour force participation, slowing economic growth and the potential for lower labour intensity, as businesses adjust to the post-Covid normal. Importantly, membership of labour unions has fallen significantly in both the UK and the US, reducing the bargaining power of workers, and the capacity for wage-price spirals.
Energy and food price inflation is having a direct impact on the spending of consumers, thereby limiting their ability to help sustain economic growth. This makes it difficult for governments and central banks to address the problem – it’s a fine line between taming inflation and choking off growth.
INFLATION RISES TO RECORD LEVELS
Central banks can try to address rising inflation by making financial conditions tighter (for example by raising interest rates). This causes demand for goods and services to slow and inflation to ease as a result. However, it’s more difficult for central banks to bring inflation down when it’s the result of supply shortages, as we’re seeing currently.
High inflation can be a risk for an economy. It contributes to a fall in real incomes (income adjusted for inflation) meaning people are less likely to spend. A second risk lies in the response inflation can warrant from central banks. Central banks risk slowing economic growth too much and tipping the economy into recession.
In the UK, as a result of the current bout of inflation, we expect to see the largest fall in real incomes in over 30 years. Given private consumption in the UK accounts for over 60 per cent of GDP, this is challenging for economic growth.
REAL POST-TAX LABOUR INCOME CALENDAR YEAR GROWTH
Source: Bank of England
In addition to the current drop in real-income illustrated above, we’re also seeing evidence of this economic challenge in consumer confidence surveys, which have been deteriorating in the UK since last summer.
Another risk of higher prices is that inflation expectations become unanchored, as we saw in the 1970s and 1980s. This is challenging for central banks as it can cause high inflation to become self-fulfilling – if workers expect inflation to be high, they’ll demand higher wage to maintain their purchasing power. Businesses then try to pass this increased cost onto consumers, leading to a wage-price spiral.
The current environment is also challenging because of the delay between raising interest rates and the impact it has on inflation – which could be as much as 18 months. This lag means central banks are reluctant to raise interest rates to correct demand-driven inflation, as they would expect the economy to respond by increasing supply.
The VIEW From coutts asset management
Current inflation pressures have led to a significant shift in the stance of central banks. Expectations for central bank rate hikes this year are very high, with the Bank of England rate expected to approach 2.6% by the end of the year – the highest level since 2008.
However, the negative impact it will have on consumer demand will also likely accelerate the speed at which inflation comes down once it has peaked. A return to normal for the current, large imbalance between the demand for goods and services, should continue as the world moves past the pandemic.
The labour market, though still tight, is also showing signs of improvement, while US and UK wage inflation has eased in recent months. Importantly for the US central bank the Federal Reserve (the Fed), consumer inflation expectations have not become de-anchored, and market expectations for US inflation over the next 10 years are now below the level they started the year at, despite a large rise when the Russia/Ukraine situation shifted expectations higher.
So, while inflation is likely to settle at higher levels than we have become accustomed to in the last decade, we don’t expect current levels, which are inconsistent with healthy economic growth, to be sustained. Four consecutive months of actual US CPI topping estimates highlight how difficult it is to predict inflation over the short term. Nevertheless, we continue to believe inflation is in the process of peaking, something that should become more evident in the coming months as the lower demand resulting from the economic slowdown dominates supply driven issues.
So far this year, bonds have been far more sensitive to inflation than economic growth. They will ultimately stabilise when data shows that the peak of the inflation pressures is behind us. Therefore, the outlook for the next few months is very dependent on upcoming inflation data, in particular evidence that price rises are starting to decline. While central bankers will not soften their language immediately, when they do, it will help to stabilise markets and in particular fixed income assets in our portfolios.
The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. Past performance should not be taken as a guide to future performance. You should continue to hold cash for your short-term needs.