ON MY TRAVELS the vexed subject of inflationary risk splits professional investors more than any other subject.
In one camp lies the inflation sceptics who argue how can there be inflation when there has been such a global demand shock? We remain in a world of relatively free global movement and innovation driving down prices and while there may be a stimulus-induced rebound the scale of destruction will likely mean a continuing world of low inflation rates and possibly low growth.
Global free trade and the advance of Asia greatly increases inexpensive productive capacity driving down cost. Moreover, the examples of Japan and more recently the West in general, in terms of substantial central bank balance sheet expansion, has not been inflationary. Why should it be now?
The alternative perspective focuses on a concern that the scale of the stimulus, fiscal and monetary, particularly in the US, will over-cook growth at a time when supply chains have been stretched due to Covid-19 leading to potential shortages. Moreover, commodity prices are re-bounding strongly as is global growth. This, they argue, will feed through to price rises which central banks will find very difficult to control given the current starting monetary position.
Although the argument is fierce and there is no clear historical precedent, given the extraordinary circumstances of lockdown and central bank policy action, I am in the camp that sees selective but growing inflationary risk.
The risk appears greatest in the US and to a lesser extent the UK, while I suspect inflationary pressures in the Eurozone are likely to remain more muted. I thus do not believe its impact will be internationally uniform.
To an extent, in my view, official inflation data globally has not picked up asymmetric trends. As a headline inflation has been subdued for well over a decade but this hides what have been divergent trends. Many basic products have not risen in price. A trip to Aldi or Primark would bear witness to that. However, over the last decade other, perhaps more rarefied products and services, have been appreciating much more rapidly.
I view the global inflationary risks to be moderately but firmly on the upside with substantial inflation risk in certain categories. This perfect storm is based on five key variables below:
- a) The impact of fiscal policy;
- b) The monetary response;
- c) The impact of woke economics;
- d) The savings ratio and pent-up demand; and,
- e) Selective supply shocks.
Both Biden and Sunak have thrown money at the Covid-19 problem essentially deficit financing. The stimulus, in the US, is equivalent to over 40 per cent GDP over the next five years and I suspect the UK equivalent will end up being a similar magnitude. This makes Roosevelt’s New Deal look like chicken feed and Corbyn’s plans more than a tad tame.
The monetary response is similarly unprecedented particularly in the UK and Eurozone where real yields remain strongly negative. The unpalatable truth is that almost all the current fiscal deficit (some £350bn in 2020 in the UK, or almost 2x the entire income tax revenues) is indirectly funded by Quantitative Easing (QE) by the UK Central Bank (which is effectively magic money tree creation).
The scale of QE and, in my view, the inability to safely end it creating what I have described as a treadmill effect, simply means should inflation start to take hold the policy leavers to alleviate it will be limited.
If politicians have shown their colours on one thing over the last decade it has been to throw endless amounts of sugar at a problem. Therefore, I see it as highly unlikely the policy choice would be to choke-off growth and inflationary risk with higher interest rates. How thus would a central bank tame rising prices?
On top of that, with ‘nought’ to spend one’s money on – as holidays in Italy, France and Spain are, to use the modern parlance, cancelled – the savings ratio has exploded. Britain has gone from a nation of spenders to one of savers. On some estimates £125bn has been squirreled away – a substantial sum equivalent to around 5 per cent GDP.
Further, perhaps more critically, forced factory and service closure has impacted the supply chain. Capacity has been taken out, factory closures are causing shortages and bottlenecks are occurring. This seems a particular problem in aspects of building materials, electrical goods, automotive and technology products.
While I absolutely do not see a return to 1970’s style inflation I do expect price rises to accelerate with significant risks in certain lines. This is asymmetric inflation, not universal price rises.
On the face of it we have lived in a very low inflationary environment for at least two decades both in the UK and globally. However, in my view, headline inflation masks highly divergent trends.
Inflation at Aldi may have been negligible over the last decade, possibly even negative, but inflation, prior to lockdown, at top hotels, cultural venues, private educational establishments and the like, was not. Similarly, a bottle of Hardy’s wine might still be purchased for £4.59 but a bottle of fine Burgundy has gone up almost five-fold in a decade.
With foreign travel all but impossible, social distancing and forced capacity constraints the price of a picturesque Dorset holiday cottage has literally tripled. Even more obscure locations are in hot demand. Lockdown has changed tastes and options with some side inflationary effects. It may be some of these trends are embedded.
The substantial wealth effect globally has resulted in certain rarefied goods and services significantly out-performing. We suspect this asymmetric inflation will continue with lower end product pricing remaining subdued either as product is re-engineered to fit a price point or through continuing global competition. Inflationary pressure for fine wine, art, trips to the theatre, exclusive holiday location, and the like is likely to continue apace.
In my view the key determinant is potential supply constraint (there is only one Venice or a limit to the amount of fine Burgundy that can be produced), rarity, large element of craft, local labour or intellectual value added, and exclusivity and inevitably fashion and taste.
Thus, while I believe the fiscal and monetary response will lead to a pick-up in inflation, particularly in the US and UK, continuing growth in global capacity and productivity should cap substantial price rises. Thus, for most things inflation may remain fairly modest but for the rarefied this may not be the case and in some cases substantial price appreciation should be anticipated.
Next up woke economics – a further risk to choice, prices and liberty.