Inflation is at a 40-year high.
Inflation has risen in many parts of the world. Here in Singapore, headline inflation was at a high of 4% in January 2022. In the United States, inflation rose to a 40-year high of 7.5% in January 2022, causing a sell-off in markets on the back of growing concern that the Federal Reserve would tighten monetary policies more aggressively to fight inflation.
So, is inflation going to remain persistently high?
The answer to that question depends on the time frame that we are looking at. If we are looking at 2022 till year end, inflation is unlikely to stay at current elevated level. We believe that it would peak sometime this year due to the reversal of 2 drivers of inflation. They are:
- High energy prices
- Supply chain disruptions from Covid-19
Inflation is likely to peak off this year
Higher demand for oil from the resumption of global travel and a colder winter last year led to higher global oil prices. Geopolitical events like the conflict in Ukraine could lead to a short term spike in oil prices. However, we think in the longer term, oil prices would settle at the $80 per barrel level as the OPEC+ (Organization of the Petroleum Exporting Countries) nations have sufficient capacity to meet global demand. It is also in the interests of oil producers to avoid excessively high oil prices globally as it would accelerate investments into Shale and alternative energy. As such, despite short term swings in energy prices, we do not expect energy prices to be a significant driver of inflation this year.
We are all familiar with the supply chain disruptions brought about by Covid-19. A consumption shift from services to goods and excessive orders by manufacturers to ensure adequate inventories could have exacerbated the situation. However, these factors could reverse quickly with the resumption of normal production as Covid-19 restrictions eases.
Longer term inflation is likely to settle above pre-Covid-19 levels
We expect inflation to peak this year but settle at levels higher than pre-pandemic levels for the following reasons:
- China is becoming less able to drive prices of goods lower, and
- Price reduction by new disruptive/technology companies has slowed
The theory is that globalization has contributed to low inflation globally as multinational companies have been able to cut prices by shifting to lower cost destinations. The supply disruptions during Covid-19 made many countries realize the importance of self-sufficiency and localization of production. This has led to a reverse of globalization which would lead to higher longer term inflation.
China has driven prices lower globally due to its scale and low wages. However, wages in China have risen in recent years from an aging and shrinking workforce. As such, China could no longer drive prices lower as their cost of production rises.
The rise of many technology companies in recent years, like platform retailers, digital payment platforms and food delivery companies, have driven prices lower as they disrupt traditional competitors. In some instances, such costs reductions are done by subsidizing clients to pursue growth. However, price cuts have started to slow as these companies have reached critical mass in terms of market share and they have started focusing on profitability instead.
The implications of a gradual shift from a low to high inflationary environment could mean:
- More hawkish monetary policies by central governments to control inflation
- Past winning investment strategies focused on bonds and growth stocks may no longer work
Central banks generally raise interest rates when inflation runs high. Some market participants believe that long term inflation could remain elevated post-Covid-19 and that central banks would need to raise rates to much higher levels which would be a structural headwind for bond investments. Higher interest rates would also mean valuations of growth companies decline as future value gets discounted at a higher rate.
It is currently too early to tell with much certainty how high long inflation would settle at as current data is skewed by the impact of Covid-19 and current geopolitical events. We would revisit this topic again when there is more clarity. The objective of this article now is simply to reflect our thoughts on this topic and not make actual recommendations.
How should we invest if inflation stays elevated?
The basic principle is to pick companies that are able to i) pass on the increase in cost to their clients and ii) avoid companies with high leverage. Such an environment would also be negative for fixed income investments.
Real estate is seen to be a good hedge to inflation as landlords generally can pass through the cost increase by hiking rents. While the financial sector would benefit when central banks raise rates. E.g. Banks enjoy better lending spreads and insurers benefit from higher investment income.
A higher inflation with higher interest rates would be negative for companies that cannot pass through the cost increase and suffer from lower profit margins. Companies with high debt would also suffer from higher interest costs. Such an environment would also be negative for fixed income instruments like bonds.
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