Inflation chatter has dominated the financial headlines we monitor recently. We have seen many economists suggest rapid inflation is inevitable as easing COVID-related restrictions allow more businesses to reopen, especially with America’s government reportedly pursuing a multitrillion-dollar infrastructure spending plan. This week, we have come across commentary arguing we are seeing the initial signs of this, which we think makes it worth a look at what generally is—and isn’t—inflation. Mind you, we don’t think rising inflation is inherently a risk for equities, which have actually done quite well during such spells in the past.[i] Our research indicates trouble generally stems from when central banks commit a monetary policy mistake—for example, being too late to attempt to rein in prices by raising short-term interest rates and then over correcting. However, monetary policy decisions are human decisions, which we think defy prediction. Still, having a better understanding of the supposedly inflationary news today can help investors seeking long-term growth keep a level head when making portfolio decisions, so off we go.
First off, what is inflation, really?
Glad you asked. Inflation, as defined by every economics textbook we have encountered, is a general rise in prices across the entire economy. Inflation measures use broad baskets of goods and services in hopes of capturing broad trends accurately. These include government agencies’ gauges, such as the Office for National Statistics’ (ONS) Consumer Price Index (CPI) in the UK, Eurostat’s Harmonised Index of Consumer Prices (HICP) and the Bureau of Labor Statistics’ CPI in America. Private-sector measures exist, too, with one example being the Massachusetts Institute of Technology’s (MIT) Billion Prices Project. At any time, our research shows some items in these inflation baskets will rise whilst others will fall, but those outliers tend to cancel each other out and let the broader price trend emerge.
What causes inflation?
There are various schools of thought, and this is really a topic for a book. We generally subscribe to Nobel prizewinning American economist Milton Friedman’s pithy view: Inflation is a monetary phenomenon—too much money chasing too few goods and services. Some central banks have inflation targets to guide how they set monetary policy—for example, the Bank of England (BoE) targets 2% annual inflation. To achieve this goal, central bankers will use tools, including adjusting interest rates, with the goal of keeping money supply and velocity (the rate at which money changes hands) growing fast enough to fuel economic expansion, but not too fast, lest the economy overheat. That is jargon for too much money sloshing around with no productive use and thus pushing prices higher.
Do high oil prices fuel inflation?[ii]
Energy is a component of most inflation indexes, so yes, it contributes to inflation. But oil prices, like food prices, are frequently subject to market forces that have less to do with monetary drivers, so many statistical agencies also have core inflation measures that exclude these more volatile categories. The theory there is to give a clearer look at trends that big swings in commodities might be hiding.
We have seen some commentators argue energy prices can bleed into other consumer goods and services by driving up businesses’ costs, forcing them to pass these costs onto consumers. This is possible on a case-by-case basis, but corporations that consume a lot of oil generally account for this situation by using futures contracts to keep costs stable. (The thinking is similar to companies that import parts and labor and hedge for currency swings.) Companies also don’t pass every cost on to consumers—sometimes they elect to keep prices low to attract demand. When plunging oil prices pulled UK CPI below zero in 2015, core CPI remained positive.[iii] Same goes for when rising energy prices temporarily lifted headline UK CPI in 2011 and the mid-2000s.[iv] Core CPI rose less.
I read a lot about semiconductor shortages driving up prices—not just for computer chips, but in the consumer goods made with them, like cars. Is that inflation? It sounds like an example of too few goods.
This gets into some interesting nuances, because yes, supply shortages contribute to higher prices. If a semiconductor shortage leads to shortages of cars, consumer electronics and the multitude of smart products using chips, that could drive those prices higher. But we are hesitant to call this inflation. We doubt it is something central banks could address with interest rate hikes, for example. Plus, as ubiquitous as these goods are in everyday life, they aren’t an outsized chunk of the inflation basket.[v] As mentioned earlier, we think the breadth of that basket helps even out niche, supply-driven developments like this.
Supply disruptions’ impact on prices is usually temporary. According to industry analysts we follow as well as our own research, today’s semiconductor supply shortage stems partly from production taking a hit during the pandemic. Rising demand has also played a role, but this imbalance probably isn’t permanent. Higher prices are a signal. They tell producers it is time to invest in new production. Semiconductor companies have apparently received the message, with a major one announcing plans to build new foundries (the industry term for chip manufacturing facilities) this week.[vi] Those construction projects take time to complete, so this isn’t an instant fix, but overall we see this as market forces working the way they are supposed to.
What about shipping costs? And that big tanker that got stuck in the Suez Canal? That can’t be good for prices.
We think this is another temporary factor, and the market seems to agree.[vii] Equity markets have seen through numerous shipping disruptions in recent years, from work stoppages at West Coast ports in the US to Brexit and the pandemic. All have caused backlogs of container ships (or, in Brexit’s case, lorries), much as we are seeing around the Suez Canal right now. But companies and the shipping industry adapted, and as the stranded ships eventually docked, longshoremen unloaded them at rapid speed and everything got where it needed to go. When shipping costs rise, companies do what they need to adapt. One widely followed shipping cost index, the Baltic Dry, has hit much higher levels than where it presently sits, without whacking global trade or causing a recession.[viii] When world trade did fall a few years ago, the global economy still grew and global equities’ bull market continued.[ix] And—you guessed it—inflation didn’t surge.
[i] Source: FactSet, as of 26/3/2021. Statement based on MSCI UK Investible Market Index total return in GBP and S&P 500 Index total return in USD as well as the US and UK Consumer Price Indexes. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[ii] Pun intended, of course.
[iii] Source: FactSet, as of 26/3/2021. Statement based on UK’s CPI and CPI excluding energy and seasonal food Indexes.
[v] Source: ONS, as of 26/3/2021.
[vi] “Intel is spending $20 billion to build two new chip plants in Arizona,” Kif Leswing, CNBC, 23/3/2021.
[vii] Source: FactSet, as of 26/3/2021. Statement based on Brent Crude oil prices and the MSCI World Index return with net dividends, 19/3/2021 – 26/3/2021.
[viii] Source: FactSet, as of 26/3/2021.
[ix] Source: FactSet, as of 26/3/2021. Statement based on world trade volumes as tracked by the CPB Netherlands Bureau for Economic Policy Analysis, October 2018 – December 2018.
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