Peter Little | Fund Manager | Anchor Capital | mail me |
Major central banks have combined with structural trends (slowing developed market population growth, globalisation, and technological innovation) to almost eradicate developed market inflation volatility over the past 50 years or so.
Now a wall of fiscal and monetary stimulus is being thrown at markets to offset the dire economic consequences of the COVID-19 pandemic, many investors are concerned about the potential inflationary impact of disrupted supply chains, combining with excess liquidity, and a faster-than-expected economic recovery.
The return of meaningful inflation would force central banks to tighten monetary policy, effectively removing key tailwinds for equity markets.
What are expectations for inflation?
A recent survey of investment managers by the Bank of America (BofA) suggests that there is strong consensus amongst professional investors that inflation is likely to trend higher.
Figure 1: Inflation expectations
Source: Bank of America Global Fund Manager survey
The key questions for us are not whether inflation will increase but by how much, and for how long high inflation could persist.
We examined the forces most likely to impact prices, and whether these forces are likely to be transitory or persistent. We also considered the components of the inflation basket that would have the most material impact on overall inflation.
We focus on US inflation, since the US dollar’s status as reserve currency tends to result in US rates having the most significant impact on global funding markets. The US is also a good proxy for what is happening in major developed markets and offers very granular data for analysis.
Factors that will drive inflation higher
Below are the factors that the bears are suggesting will drive inflation higher.
Disrupted production causing a supply shock
The pandemic shut down mining and manufacturing operations around the world, raising concerns that supply bottlenecks could result in inflation.
The Bureau for Economic Policy Analysis in the Netherlands publishes an index of global industrial production, which suggested that in the first four months of 2020 there was a 12.5% contraction in global industrial production.
However, data available to the end of October 2020 suggests that the recovery in industrial output has been as swift, with output only 2% below pre-pandemic levels six months after it troughed at the end of April 2020.
We expect supply disruptions will be transitory and will not cause enough persistent goods inflation to prompt the Fed to act.
Excess saving causing a demand shock
The CARES Act, signed into legislation by former US President Donald Trump in March, was a $2.3 trillion relief package, of which roughly half went to households and small businesses. The package included extended unemployment benefits and cheques mailed directly to eligible individuals.
The US National Bureau of Economic Research, using household survey data from Nielsen Homescan Panel, estimated that almost 30% of the stimulus was saved by households.
This, along with an inability to spend on some activities that were restricted because of lockdown measures, and a general increase in more conservative consumer behaviour in the face of economic uncertainty, led to a fivefold increase in US personal savings (from $1.2 trillion to $6.4 trillion) in the first four months of 2020.
This had subsided by the most recent reading at the end of November 2020, when US households held approximately $1 trillion of excess savings – the equivalent of about 7% of what American households spent on consumption in 2019.
Figure 2: US households accumulated c. $1 trillion of excess savings in 2020
Source: Bloomberg, Anchor
It has been speculated that, as Americans become comfortable that the economy is going to normalise along with the vaccine rollout, these excess savings will fuel consumption and put pressure on prices.
We are reasonably certain that this will be a once-off demand shock, which will fade as soon as savings normalise.
The US economy is recovering quicker than expected, meaning a sooner-than-expected end to fiscal and monetary stimulus
Some market commentators believe that the US economic recovery will happen faster and will force the Fed to start tightening monetary policy sooner than it would have hoped.
However, we calculate that the projected path of US economic growth should still leave it about 10% behind where economists thought it would get to by the end of 2021, based on pre-pandemic forecasts. This should still leave the US economy with plenty of slack before it overheats.
Which components of the inflation can impact the outcome?
Five categories within the US core inflation basket represent two-thirds of core US consumer spending: health care (including pharma), housing (excluding utilities), financial services (including insurance), food services and recreational goods and services.
Health care
Health care (including pharma) accounts for almost one-quarter of the core consumer spending basket. It is hard to imagine an environment where a Democratic Party-led government allows the cost of healthcare to increase meaningfully over the next few years.
Housing
Housing inflation has been running at around twice the level of overall core PCE inflation for most of the past 20 years.
We expect it will continue running comfortably above 2% as consumer balance sheets remain healthy, funding conditions remain decent, and historically low home-ownership rates support demand.
Pandemic base-effects may cause a spike in housing inflation during 2021, although, with an already above-average run-rate, we doubt whether housing inflation can deliver much persistent incremental inflation impetus. This category, however, seems the one most likely to deliver an inflation shock if animal spirits return to the US housing market.
Financial services
The biggest part of the financial services inflation basket is the implicit ‘cost’ bank clients incur depositing funds in banks (calculated as the income banks earn on placing deposits with the Fed less the interest that gets paid to bank customers) and the ‘cost’ borrowers incur by paying interest to banks that is higher than the funding cost of those loans.
Ironically, this theoretical calculation is sensitive to Fed policy changes, so inflation coming though this channel is likely to be ignored by central bankers, due to its overly technical characteristics and its feedback loop from actual Fed policy.
Food services
The food services category is roughly evenly split between full-service dining and limited-service dining (which encapsulates fast-food restaurants and take-out).
While full-service dining was hit hard by lockdown restrictions, fast-food and take-out services have thrived. Full-service dining may experience some transitory inflation spikes of a supply nature as many businesses, which have been forced to shut, face delays in getting back up and running to meet normalising demand.
However, fast-food restaurants and, in particular food delivery, are in the midst of a technology-induced transformation. As the major food-delivery apps and services compete for market share, we expect discounting will keep a lid on inflation.
Recreational goods
Recreational goods and services account for c. 9% of US core consumer spending and have been experiencing vastly different price dynamics over the past two decades.
Around 40% of the recreational goods category is the purchase of TVs and personal computers, where pricing has been significantly impacted by globalisation and technological innovation.
It could be impacted by a reversal of globalisation and a slowing of technological innovation, but computers and TVs represent only a combined 2% of the core consumer basket.
Recreational services have experienced above-average inflation for most of the past couple of decades, with TV services making up a quarter of the spending in this category.
As streaming services look to displace cable and satellite services, we expect price wars will contribute to deflation in this key category for the foreseeable future. We believe that this category will shift from a marginal support to a marginal drag on inflation for the next couple of years.
In conclusion
We expect US inflation will creep higher in 2021, although we think much of it will be transitory.
Despite higher inflation, we think that for the foreseeable future it will not be high or persistent enough to disrupt the Fed’s easy monetary policy stance to the extent that it would materially derail markets.
