Arguably the biggest debate at the moment is between the inflation hawks who think we’re about to suffer a nasty bout of inflationary surges and the transitory camp who think ‘it’ll all pass’. I’m in the latter camp although I’m not especially dogmatic about it and think that it could all go badly wrong quite quickly.
The debate forces us to look at fragmentary and dynamic pieces of evidence. Take breakeven rates for instance. The US inflation breakeven rate curve has risen materially and is near flat up to seven years. Moreover, the inflation breakeven curve up to seven years has shifted up in almost parallel fashion so far in 2021. This indicates that the rise in inflation may not prove as transitory as anticipated by policymakers.
Another useful bit of evidence is to look at how much news – and online chatter – there is about inflation. On that score SocGen have been using their own proprietary SG Inflation Newsflow (SGINI) and SG Economic Newsflow indicators to assess the potential trajectory of inflation and growth and share our views on portfolio construction.
These measures currently signal that:
- “US inflation newsflow is rising again but remains well below the Jan 2021 peak. Having fallen constantly since Feb 2021, the US indicator has started to rise again.
- “Inflation newsflow is far more intense in Europe, especially the UK. Currently, the inflation z-score is most dislocated in the UK. The US z-score is also above average, and it appears that inflation newsflow is heading higher.
- “Energy is not the only driver of inflation Though an important component, energy is not the only driver of inflation. “
Bloomberg columnist and Substack blogger Noah Smith is also interesting on this subject. Rightly he suggests in a blog last week that we focus on the measures of inflation themselves.
“ ….while measures like core CPI and median CPI are better for determining how much excess demand their is in the economy, total CPI — including food and energy — actually represents the prices that consumers are paying. When total CPI goes up and workers aren’t able to negotiate raises to match it, it might lead to a permanent decrease in their buying power. Sure, energy prices are volatile, but if wages have trouble rising in response to inflation, that’s a one-way ratchet that erodes purchasing power. In fact, surveys show that it’s precisely fear of this effect that makes people hate inflation so much. And though real wages ticked up in the past two months, they’re still significantly down from the start of the year”.
The killer stat for me though is this :
“Research suggests that a country experiences between 2 and 12 years of sustained above-average inflation before it explodes into hyperinflation. So we still have time to let prices moderate. But if it’s 2023 and prices are still rising at a 5% clip, it will be time to defenestrate our friends on Team Transitory.”
Smith expects the Fed, act considerably earlier than 2023.
“Americans may mostly not remember the 1970s, but the Fed’s institutional memory is quite long. The central bank values its credibility as the country’s shield against inflation very highly, and sporadic progressive attacks on Jerome Powell aren’t going to change that anytime soon. Now that inflation has come in above target for much of the year, I expect the Fed to start tapering its asset purchases soon. Inflation may or may not be a real threat, but the Fed is very used to treating it as one.”
What next for UK consumers ?
Analysts at Morgan Stanley in Europe have been trying to work out what all these inflationary pressures mean for the poor old UK consumer. Their message? Don’t panic quite yet ! Keep calm and carry on.
The MS analysts recognise that there’s some obvious signs of distress they still “expect overall consumption to grow, backed by high wage growth and pandemic savings.
“….Plenty of buffers: We are more constructive. Inflation is rising, but so are wages. And while real disposable income growth flatlines on our forecasts in 4Q21-1Q22, we see this as a short-lived hit, and expect a return to real pay growth later in 2022. More broadly, we think that high pandemic savings will support consumption. We see a tough winter for low income households with high energy costs, but we expect some support to be announced for them in the October 27 budget.”
And what of the investment implications?
- “we think the Bank will wait for more information on the labour market after furlough before acting, delaying liftoff to 2022.”
- Favour the FTSE100. “ The FTSE250 has underperformed FTSE100 by 7% over the last month, which has only previously happened in recessions or around the Brexit
However, at 16.4x N12M PE the FTSE250 remains expensive versus history and is not yet tactically oversold. We continue to prefer the FTSE100 given low valuations (12.1 N12M PE) and its exposure to the global Value rally”
Commodities, equities and the dollar
Last but no means least, sticking with the inflation theme, I liked the chart below from Stuart Kirk, Global Head of Research & Responsible Investments at HSBC. It shows that relationship between the S&P 500 and global commodities is “pretty significant. Indeed, the current five-year correlation is about 90 per cent, based on Bloomberg data, the highest in 70-odd years. Versus global indices is similar”.
Kirk also reminds is that the dollar plays a crucial role in the commodity complex, reminding us that it “ based on a negative historic correlation of 60 per cent, to be bullish on the greenback and commodity prices. “
One has to choose : bullish on commodities OR the dollar. But not both. I’d bet more on commodities, than the dollar.