If you’re under 50 years old as a participant in developed markets, you haven’t experienced much in the way of inflation. If you’re under 60, you likely haven’t experienced high, disruptive inflation.
The selloff across global developed market government bonds over the past two weeks—against a backdrop of spiraling energy prices, queues at gasoline pumps and logistics bottlenecks—is prompting many to dust off the old inflation playbooks.
Temporary price spikes in food, energy and other markets over the past 20 or 30 years have all passed without sparking a general rise in inflation. We think this time is different, for four reasons.
Energy Prices—Reversing a 120-Year Trend?
First, as everyone seems to be noting at the moment while natural gas prices hit double their levels from a year ago, the transition to a low-carbon economy means that energy costs for industry and consumers are likely to rise structurally for the first time ever. For example, apart from a pop in the late 1970s, real U.S. gasoline prices fell steadily until the turn of this century. The fracking boom kept a lid on things through the 2010s, but the urgency of climate change likely spells a definitive end to what has been a 120-year downward trend.
That adjustment need not be disruptive. In our view, if governments broadly tax carbon, incentivize renewables and allow free markets to do their work, the transition to moderately higher costs can be smooth. If they are more prescriptive and proscriptive over what we make and use, however, market signals may be dampened, making price volatility the new normal. It’s worth remembering that defeating high inflation in the 1980s was not only about hiking rates, but also rolling back control, regulation and intervention in global energy markets.
Second, China is no longer exporting disinflation to the rest of the world.
In May, the country’s latest census data revealed that its population is aging, barely growing and as urbanized as it is ever likely to be. In short, its labor force is not expanding. That is why its recent announcements on social and business regulation are able to prioritize things like equality, good health, the environment, autarky and the automation of the economy over jobs-generating growth. To us, it appears that China will no longer be the low-cost workshop to the world, but the high-tech workshop for itself.
Third, in our view, the major central banks are now as politicized as they have been for 30 or 40 years—earlier this year we posed the question about their independence. This is not just about the huge interventions they made in markets during the Great Financial Crisis and the COVID-19 pandemic. It’s also about changes to their mandates, both implicit and explicit, which appear to prioritize social goals, such as the financing of sustainable infrastructure, full employment, greater equality and fiscal liberality, over the goal of price stability.
Finally, while the majority of pandemic-related supply chain disruptions are likely “transitory,” as central bank leaders keep on assuring us, that does not mean there will be no longer-term impact.
Many management teams that we speak to about physical-goods logistics, semiconductors and raw materials prices tell us that their supply chain problems are likely to persist well into the summer of 2022—and the dates seem to get pushed back every time we meet.
These problems are costly: shipping a 40-foot container from Asia to the U.S. costs around $20,000, versus $2,000 pre-pandemic; the cost of raw materials in a vehicle have increased by around $2,000 in the past year, with tire materials doubling in price; the semiconductor shortage has led IHS Markit to cut its global 2021 light-vehicle production growth estimate again in September, which was 14% in December and 12% in May, to less than 2%.
The point is not that these experiences will last forever, but that they are painful enough for management to take action to prevent them from happening again, by reorganizing supply chains to be more localized and more diversified. Survey after survey is finding that robustness and visibility now matter more than efficiency gains—and that is how we see a transitory spike in prices evolving into a structural, marginal increase in costs.
Admirable, Necessary—But Different
We regard these new priorities—more robust supply chains, a more sustainable Chinese economy, weaning ourselves off of carbon, social equality—are admirable and necessary. But they are different from the governing priorities of the past 40 years, and therefore investors need to think deeply about how to adapt to them.
At the moment, many businesses have contracts that allow them to pass rising costs down the supply chain. Moreover, pent-up demand and trillions of excess dollars on household and corporate balance sheets are part of today’s inflation dynamic, which means that a lot of those higher costs can be passed onto the end consumer. But if inflation ends up higher and stickier than we have become used to over recent decades, and central banks are slow to act, we expect demand patterns to change and contracts to be renegotiated.
That will affect the bottom lines and the creditworthiness of many companies. It also implies higher bond yields—a view we have been articulating for some time. As we have been saying through the course of this year, even in the absence of major price spikes, we expect inflation to be a topic of investor conversation throughout the new cycle and beyond. We believe market participants coming of age today could find themselves defined as the inflation generation.
In Case You Missed It
- U.S. Durable Goods Orders: +1.8% month-over-month in August (excluding transportation, durable goods orders increased 0.2%)
- S&P Case-Shiller Home Price Index: July home prices increased 1.5% month-over-month and increased 19.9% year-over-year (NSA); +1.5% month-over-month (SA)
- U.S. Consumer Confidence: -5.9 to 109.3 in September
- China Purchasing Managers’ Index: -0.5 to 49.6 in September
- U.S. 2Q2021 GDP (Final): +6.7% quarter-over-quarter annualized rate
- U.S. Initial Jobless Claims: +362,000 for the week ending September 25
- U.S. Personal Income & Outlays: Personal spending increased 0.8%, income increased 0.2%, and the savings rate decreased to 9.4% in August
- ISM Manufacturing Index: +1.2 to 61.1 in September
What to Watch For
- Tuesday, October 5:
- ISM Non-Manufacturing Index
- Thursday, October 7:
- U.S. Initial Jobless Claims
- Friday, October 8:
- U.S. Employment Report
– Andrew White, Investment Strategy Group