Inflation is now running at the highest level in decades. The challenge for investors is working out whether this is a temporary spike – or a more persistent phenomenon.
Recent economic data shows that inflation continues to rise. Earlier this month, the US Consumer Price Index, a widely-tracked measure of average living costs, showed that prices rose 5.3% in the year to June, close to the highest level in 30 years. Inflation was only higher in the summer of 2008, when the oil price briefly hit $150 per barrel (compared to around $70 per barrel today). Excluding energy, which can skew inflation data, prices are rising at an annualised rate of 4.5% – the highest since the early 1990’s. Investors are once again questioning whether this year’s spike in inflation really will prove to be “transitory,” as claimed by many central bankers.
Looking in more detail at the numbers, a number of factors suggest that inflation will ultimately remain contained - even if data continues to be higher than anticipated in the near term.
We are continuing to see significant “base effects” as a result of the pandemic. Prices fell last year in response to the global recession – so a recovery back to more normal levels looks like high inflation over a 12-month period. This is most obvious within the energy market, where year-on-year inflation has been running at around 25% for the past three months. Data from the White House’s Council of Economic Advisors shows that prices in industries worst hit by the pandemic have now recovered strongly, but remain a little below 2019 levels. Base effects should therefore start to wash through in the second half of the year, removing one source of inflationary pressure.
We are also seeing supply-side constraints in certain industries including new and used cars and trucks, car and truck rentals, hotels and airlines. These sectors are struggling to meet elevated demand as economies re-open. Used car and truck prices rose 10.5% in June (or 45.2% on a year-on-year basis), the largest increase since January 1953 when the government started tracking the series. Overall, these industries account for just 12% of core (excluding food and energy prices) inflation – but were responsible for almost two-thirds of June’s CPI increase.
If you are booking travel this summer, you might be in for an unpleasant surprise if your plans involve renting a car. In response to reduced travel last year, many car rental companies sold off large parts of their fleets, with both Hertz and Avis selling over 200,000 cars last year. As a result, they are now struggling to meet returning demand, with the cost of renting a car in the US increasing by 88% since this time last year.
Supply-side inflationary pressure could persist for a while longer but it should eventually normalise. We have seen such an adjustment play out in the lumber market. The price rose by close to 130% in the five months to May, as supply struggled to meet strong demand from housing construction; it has since fallen by almost two-thirds from the peak as supply has picked up.
There are, however, a number of factors which could result in further inflationary pressure and even suggest that it has the potential to prove more persistent. If, as the Fed project, we see continued strong growth in consumer spending as the economy fully re-opens, businesses will have the opportunity to raise product prices and inflation will persist. Saving rates remain elevated and pent-up demand, following close to 18 months of restrictions, has not yet been exhausted. As supply constraints ease, strong demand could become the key driver of higher prices.
One area which is likely to be of increasing focus is shelter, which makes up around a third of core inflation. Rising house prices means that shelter costs are likely to rise: lower affordability means many individuals will be forced to rent rather than buy. If we see shelter inflation (currently at 2.6% year-on-year) start to pick up more meaningfully, this will have implications for core measures of inflation.
Finally, an important issue for the inflation trend remains wage expectations. While unemployment rates have declined significantly from 2020 levels, they remain elevated in comparison to pre-pandemic averages and there is still some slack in the labour market. Despite this, in many industries, labour supply remains relatively constrained with workers increasingly looking for higher pay in order to start a new job. This is at least in part a result of generous fiscal support packages at both a state and a federal level. Once these end, it is likely we will see more workers returning to the labour force. This suggests that in the short term wage inflation shouldn’t be too much of a concern, but as labour market starts to tighten in 2022 we could see wages contributing to higher core inflation.
At this stage, there is no decisive evidence to determine whether inflation is transitory or persistent. We expect that some of the pressures from base effects and supply side constraints will start to fade. However, there is a risk that strong demand, rising rental costs and gradually rising wage inflation could continue to drive CPI data higher.
The question for investors is how to position in this environment.
Gradually rising inflation, when accompanied by improving economic growth and a positive earnings outlook, should not necessarily be cause for concern. Historically, equity markets have tended to deliver solid returns ahead of inflation in this environment, particularly more economically-sensitive sectors such as energy and basic materials.
We continue to be constructive on the growth and earnings outlook and remain overweight equity.
Sharp rises in inflation expectations do however pose a challenge to diversification and have resulted in the correlation between US equity market and Treasury returns rising to 20-year highs in the second quarter. Within our defensive holdings, we therefore have a preference for both gold and US TIPS which historically have performed well in periods of unexpected inflation. We feel they offer relatively attractive hedges against the potential for continued inflationary pressure.
Data sourced from Refinitiv. Forecasts included are not guaranteed and should not be relied upon.
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