We have recently changed our outlook on inflation as we see key medium-term price pressures becoming more than transitory. In this viewpoint, we outline why we are moving away from the lowflation school of thought due to the pandemic, an acceleration in sustainability-driven investment and de-globalisation trends. Going forward, we see a slow and sustained tussle between such medium-term drivers and longer-term secular drivers of disinflation or deflation.
As structural doves for many years, we had been strong proponents of the ‘lowflation’ school of thought. Our view was based on several factors pinning down global growth along with inflation for the long term. These factors included: globally higher debt levels; ageing demographics in developed markets as well as China; rapid technological adoption; ample labour slack globally; structurally low utilisation rates across many industries; and austerity-like fiscal measures accepted as doctrine by governments.
In this scenario, wage growth remained low and the vicious cycle of lowflation continued. Consequently, neutral1 and terminal2 rates for US Treasuries were also materially lower than the hawkish projections of the Federal Reserve over the past decade.
As we entered this year, our view was no different and we believed in more of the same: any increase in inflation would be transient, largely led by a short-term reopening boom, a surge in pent-up demand and temporary supply chain bottlenecks.
Firms are telling us that supply chain bottlenecks could last years in some sectors.
It’s a simple story, however, speaking to the companies we invest in gives us a different picture from the ground up. Firms are telling us that supply chain bottlenecks could last years in some sectors. Input costs – in the form of transportation, logistics, materials and labour costs – are rising, and they do not appear temporary.
On the other hand, many of these firms themselves are increasing prices and expanding their operating margins to make up for lost ground, encouraged by low competition and tight industry-wide utilisation rates.
We now believe it is only fair to acknowledge that some price pressures are beyond transitory. Several medium-term trends are leading to longer lasting price pressures, in our opinion, and these trends look set to engrain inflation beyond the short-term effects of economic reopening and excess market liquidity.
In no order of priority the trends are:
- China reducing its largest export: deflation. Over the past two decades since China’s entry into the World Trade Organisation, the country has effectively exported deflation to the developed West. Excessive stimulus in response to the global financial crisis in 2008 left China with high system-wide debt, excess utilisation rates, and a political will to pursue supply-side reforms in its sprawling, state-owned-enterprise sectors. We expect the reduction in deflation exporting means that factory-gate prices will increase, excessive exports at highly competitive prices will be reduced and more pricing discipline will set in globally. This pressure will only be exacerbated by the fact that China is a net importer of commodities and various raw materials.
- Structural demand for base metals setting in. We believe accelerated investment in sustainable infrastructure after the pandemic will endure, with strong commitments now set by major powers such as the US, China and the Eurozone. Electrification of transportation fleets, build out of parallel and replacement energy generating systems, enhancement of telecommunication systems and other needs will require a significant amount of base metals for an industry that has notoriously long lead times for new supply development. It takes up to 15 years to find and develop a world-class iron ore mine, whilst significant new copper discoveries are becoming scarcer.
- Sustained oil prices. Oil prices have now found life above USD70 per barrel. The key drivers are again the acceleration of sustainability-driven investment and the Covid-19 crisis, both of which are likely to lead to the US losing its price-setter status. The US, with its ability to quickly ramp up non-conventional shale production and an unlimited availability of domestic hydrocarbon, has now seen its oil majors come under intense shareholder scrutiny to maximize return on equity, whilst being pressured by environmentalists to transition towards cleaner fuel.
The net effect is that US production has already dropped from pole position to below that of Saudi Arabia and Russia – it is likely that OPEC regains price-setter control, in our view. Additionally, with the cautious investments in capital expenditure and the depleting ability of various poorer OPEC member states to support production3, there is a case where supply growth is being tapered much faster than demand growth over the next 3 to 5 years.
- Excess global savings being gradually released. Global excess savings vs pre Covid-19 levels are now an estimated USD 5.4 trillion, and will likely be spent in the services sector rather than the goods sector over the medium term. Unlike the 2008 crisis, this recovery is expected to be a globally synchronised one, which could further prolong supply bottlenecks and eliminate their temporary nature.
- Longer-term restrictions on labour movement. Fractured movement of labour in Asia and developing countries owing to the pandemic as well as recent protectionist government policies could mean that wage pressures in various domestic markets take hold, translating into higher costs for services and goods. This is largely a partial reversal of the globalisation trend seen over the past few decades. An environment where labour is favoured over capital would certainly lead a shift from lowflation to inflation, in our view.
- Greater willingness to experiment with fiscally expansive programs. Globally, governments opened up their coffers to battle the pandemic, and even emerging markets increased their debt by 10% to 15%, representing unprecedented amounts in such a short time. Unlike emerging economies with natural fiscal limitations, developed economies are recognising their heightened ability to push the fiscal envelope much more than was previously accepted. The US could continue down this path in the coming years4, no longer to pursue a Covid-19 recovery, but to arm itself to compete against China for dominance in technology, intelligence and geo-political importance. In turn, current expansionary borrowing could become entrenched, and mark a shift away from monetary policy being the sole stimulus over the past decade.
- Corporates changing behaviour to increase prices boldly. Firms globally across many sectors appear armed with a new boldness to increase prices at the expense of investing in capital expenditure. Many firms, which have survived this crisis, are unwilling to invest in large incremental fixed costs, owing to what they perceive to be long-term economic uncertainty. Such collective behaviour is likely to lead to tighter utilisation rates, and greater pricing power for industry leaders. For example, in the US, steel plants are simply not willing to invest in new large facilities currently, despite impending federal infrastructure spending.
- Greater housing demand. In many places globally and particularly in the US, current demographics point to sustained housing demand in the wake of the pandemic, and as more millennial households enter prime homebuilding age and start families. Opposing such demand is the baby-boomer generation no longer downsizing as before, leading to a structural imbalance that was not anticipated. Strong price increases in real estate are thus being witnessed across Asia, the UK and the US: this trend likely has further to run as housing supply also remains tight from homeowners who are refinancing at low rates and staying put in their homes for longer.
Inflation tug of war: where to go?
The case for inflation in the short-term, spurred by a synchronised global reopening, a world flush with liquidity, and supply bottlenecks, is now well known and accepted – even by the Fed. We, however, are left with the above medium-term drivers that will likely continue to keep price pressures high, versus the longer-term secular drivers of disinflation or deflation. This tug of war will continue and only unravel slowly, as markets in the short-term remain flooded with central bank induced liquidity.
Meanwhile, investors face difficult issues: the extent of price pressures and the central bank response, the potential of a policy misstep by the Fed, the timing of US monetary policy normalisation, and anticipating correlation shifts between bond and equity markets.
Historically, higher inflation has led to lower real asset returns, and we believe this will again be the case. Given the tricky outlook, we think investors are likely to be better off investing in the growth and income segments of the market whilst being prudent on duration positioning and reducing exposure to crowded and overvalued segments, given the impending reduction in market liquidity in the coming months.
1The neutral rate is the Fed funds rate at which the economy neither expands nor contracts, all else being equal. 2The terminal rate is the peak Fed funds rate that marks the tightest level of the monetary cycle.3 For example, Angola with its fiscal pressures at the sovereign level, has little ability to invest in not only production increase but also to maintain its own production levels over time.4 Fiscal expansionary policies will also be dependent on the US midterm elections at end-2022. Greater Democratic control of the Congress would allow such policies to be enacted with greater ease.
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