State Of The World

The final Global Fund Managers’ survey, carried out by Bank of America at the end of 2020, indicated global inflation expectations among fund managers was at an all-time high. The last time inflation expectations were close to this level (in 2004), US core inflation, which strips out volatile prices like oil and food, rose towards 2.5% over the following two years.

 

 

State Of The World

The final Global Fund Managers’ survey, carried out by Bank of America at the end of 2020, indicated global inflation expectations among fund managers was at an all-time high. The last time inflation expectations were close to this level (in 2004), US core inflation, which strips out volatile prices like oil and food, rose towards 2.5% over the following two years.

Whilst most of Europe and parts of the US remain in lockdown, it might seem fanciful to focus on inflation and worrying about it rising from current levels, as people are stuck at home and not able to go anywhere or do anything. By way of example, retail sales in the UK show consumers did not spend heavily in December. However, the situation in the US looks different. Handily, UBS (a Swiss bank) lay out the upside and downside factors for US inflation:

Upside Factors:

Downside Factors:

Perhaps the reason for having greater conviction over rising inflation in the US is due to the fiscal stimulus that was applied to the economy under the Trump administration, and that being proposed by the Biden one. At the end of last year, the US Government enacted a fiscal easing package that was 4.2% of Gross Domestic Product (GDP), whilst the new administration has plans to implement an additional fiscal support program worth 8.8% of GDP. The total of the two packages is in excess of 13% of GDP, and comes in the form of direct and immediate increases in spending, or funds effectively mailed directly to households.

The essential point is that the current and impending fiscal stimulus is far larger than the current output gap, which is calculated as actual GDP versus potential real GDP. The obvious implication is that once the vaccination program is sufficiently advanced for the economy to fully reopen, the US will rapidly find itself with the most positive output gap on record, perhaps to the order of over 10% of potential GDP. To put this into context, the largest output gap previously recorded by the US economy was 5.5% of potential GDP in 1966, a point that marked the start of the late 60’s lift-off for inflation.

In addition, excess household saving enforced by the pandemic could be as high as $2.2trillion. The accumulated excess saving position, equivalent to between 7.8% and 10.4% of GDP, is a function of the way the pandemic enforced reduced consumption in the services sector of the economy. As this part of the economy reopens following a successful vaccination program, we should expect these excess savings to be deployed into consumption.

At this point, it is worth highlighting current global supply constraints, most notably in shipping goods across the World. The last months of 2020 saw a slew of stories covering the shortage of empty containers and congestion at ports, which at the start of this year has led to a tripling of the price of moving a container from China to the US. Acknowledging that shipping costs are a notoriously volatile economic indicator this rise, if sustained, raises the spectre of so-called “cost-push inflation” for advanced economies. Empty containers were left in Europe and the US in the Spring of last year, but now ports cannot handle the volume of trade going through them.

Elsewhere, the Financial Times reports that increases in costs are not limited to shipping – “Car manufacturers have similarly been caught short by an unexpected surge in demand at the end of last year and bottlenecks in semiconductor supplies have forced factory closures. Liquid natural gas prices reached a record earlier this month (January), partly due to a cold snap. Other commodity prices too, are surging; metals prices have risen rapidly because of mine closures in Africa and South America and rising Chinese industrial production. Wheat, soya bean, rice, and corn prices are higher too: shipping costs, weather and COVID-related stockpiling have all played their part.”

Critically, we need to be alert to the risks of this rise in prices proving “transitory”. The fall in oil last April led to a collapse in headline inflation levels, but the recovery since will mean that in late Spring inflation will suddenly spike up again on a year-on-year basis, as the low inflation months from a year ago drop out. The judgment that needs to be made is whether or not this inflation will become entrenched or even rise further in the US. The most recent business cycle saw unemployment drop to 3.6% in 2019, but inflation did nothing. A detailed explanation of this would involve regression models, plugging in the lagged output gap and unemployment rate, whereas the simple reason why inflation never rose is that the US economy failed to grow above its long run potential.

Despite the possibility that inflation might cause a shock to the upside, consensus economic opinion views this as a highly improbable event. Similarly, no Central Bank official has voiced any concerns about inflation being a problem. The risk to focus on is that if US consumers begin to believe that higher inflation will become embedded in the economy, the Federal Reserve (Fed) will not be able to raise interest rates to fight it.

The reason for this is obvious – it will have an immediate and deleterious impact on Government financing. As interest rates are increased, then the burden of serving the national debt increases as a percentage of GDP. Imagine if US interest rates had to rise to 5% to quell inflation. In such a scenario, the US Government budget deficit would increase immediately by more than 3% of GDP, due to increased debt servicing costs. To wit, even in a situation where the US sees a bout of fairly mild inflation, then the Fed may find itself in a difficult position. If it raises interest rates, this could hamper the Government’s attempts to reduce inequality and deliver on a green agenda, both of which are currently supported by the majority of the electorate. In the past, the Fed has acknowledged the economic costs of slaying inflation and exploited its independence to do it, but further back in time it has acquiesced in supporting Government borrowing by holding interest rates down, which triggered a period of high inflation.

We cannot know what the outcome for inflation will be at this time, but with the vaccine roll-out speed improving, in line with President Biden’s pledge of vaccinating 100million Americans in 100 days, it seems reasonable to assume that the US economy will reopen gradually from Spring. At which point, we expect a significant amount of pent-up consumer demand to be unleashed and for that impact to feed through to inflation, as a result of the aforementioned supply constraints, that then leads to another leg up in the Consumer Price Index.

Portfolio positioning wise, we think it is sensible to take account of this by being exposed to sectors of the service economy that will do best post-lockdown, as the recovery kicks in. This rationale also applies to being exposed to cyclical stocks and smaller companies. Moreover, in light of the above commentary, we are positioned in assets that should benefit from a rising inflationary backdrop like commodities, inflation-linked US Government bonds and gold. If US equity markets come to the conclusion that any period of inflation is likely to be sustained, then it would herald a change in sector leadership away from technology winners to financials and so-called value stocks. As a result, we would contend having a more diversified portfolio of equities, during what might be an inflection point on something as consequential as inflation, is prudent.