There is a lot of inflation data out this week, and as you might have seen, it doesn’t appear good. A measure of American prices used by the US Federal Reserve accelerated to 6.4% y/y in February, a multi-decade high.[i] Meanwhile, preliminary March numbers in the eurozone suggest more pain is in store: the French Consumer Price Index (CPI, a government-produced index tracking prices of commonly consumed goods and services) sped to 5.1% y/y, and Germany’s jumped to an eye-popping 7.2%.[ii] The full eurozone’s hit a record-high 7.5%.[iii] Last week, Britain reported February CPI rose 5.5% y/y, up from 4.9% in January.[iv] We think another uptick seems likely when March data hit. We think it is fair to say the extended surge of fast inflation is a hardship for many and painful for all. Yet for stocks, painful often isn’t part of the calculus, in our experience. Rather, we think the key question for investors to ask is this: Are the ongoing disruptions forcing prices higher big enough to offset all the underappreciated positive drivers out there? We don’t think so.
Now, please note: Inflation is an increasingly partisan issue in many parts of the world. We favour no party nor any politician. Our comments on inflation are limited to the economics in question, viewed through a market-orientated lens. With that out of the way, we suspect it is worth noting inflation probably will peak higher—and stay elevated for longer—than we thought likely last summer. We think there is a simple reason for this: Russian President Vladimir Putin’s invasion of Ukraine, which rippled through oil, natural gas and other commodity markets, as well as complicating shipping routes.[v] We have all felt this at the petrol pump and when paying our electricity bills.[vi] Soon, fertiliser shortages may show up in food prices. So, too, might the potential shortages of wheat. Oil is also a feedstock for plastics and many consumer goods, making expensive oil likely to drive up costs for a wide range of products.[vii]
This is all happening at a time when we think the forces that our research shows drove prices higher throughout 2021 should be starting to wane. Last spring and summer—which might feel like an eternity ago—prices jumped off a depressed base as businesses reopened from lockdowns.[viii] Many businesses seemingly weren’t prepared for reopenings’ sudden demand influx, sending prices higher throughout travel and leisure.[ix] Motor vehicle prices also surged, especially in the US, where rental company activity appeared to be skewing the market.[x] Based on our analysis of the data, those fast increases, with 2020’s lockdown-deflated prices as the denominator in the year-over-year calculation, were primarily responsible for inflation as 2021 progressed, with supply chain issues adding dislocations later in the year.
Yet these factors were poised to fade, in our view. The aforementioned effect of depressed prices skewing the base downward would have left the maths later this spring, raising the denominator. Logistical pressures appeared to be easing. In our view, it all pointed to prices rising more slowly off a higher base—making 2021’s faster inflation a one-off headache that we think would have eventually worked its way through the system. But then Putin invaded, replacing those fading inflationary forces with new supply-side price spikes. If oil and petrol prices hover around recent highs, we think that points to inflation staying elevated for longer, simply due to inflation maths, even if other prices are benign. We don’t mean to alarm you, but we think it is important to be realistic.
That is the bad news. The good news? We think there are a lot of positive forces to offset these headwinds. They don’t appear to be getting much attention, but in our experience, good news rarely does when stocks are in a correction (sharp, sentiment-fuelled drop of -10% to -20%). As we detailed earlier this week, Purchasing Managers’ Indexes (PMIs), monthly surveys of business activity, show European economies are still growing despite the fallout from Putin’s war.[xi] The EU is the most exposed major region, since it is dependent on Russian gas and most at risk of shortages and rationing.[xii] Yet even as surging oil drove French and German inflation higher, PMIs registered expansion.[xiii] Why? Because the demand boost from COVID restrictions finally ending seemingly counterbalanced it. Several US states are experiencing a similar reopening wave, along with Japan.[xiv] Not coincidentally, The Conference Board’s US Leading Economic Index (LEI)—a measure of future economic conditions—is on a long upswing.[xv] So is eurozone LEI.[xvi]
Global yield curves (the graphical representations of issuers’ interest rates across the spectrum of maturities) are steepening.[xvii] Yes, steepening! In the US, the gap between 3-month and 10-year yields, which is the portion of the curve that we think most translates to banks’ lending profit margins, is at its widest point since 2017—a great year for the US economy.[xviii] Eurozone nations’ curves have also overall steepened in the past few months.[xix] In our view, it all points to more capital fuelling more investment and growth. We think high prices incentivise investment even more, as we are seeing in America’s oil industry right now.[xx] Tech hardware and industrial equipment are also big beneficiaries, attracting huge Q4 investment in America.[xxi] The UK experienced a similar tailwind, with strong growth in business investment in transportation and storage, as well as information and communication equipment in Q4.[xxii]
Paying higher prices for petrol and food in the interim may be unpleasant for as long as they persist, likely a function of how long the war’s disruptions linger. But note: Stocks did fantastic in 2021 despite inflation accelerating throughout the year.[xxiii] We don’t think that is all that unusual, as our research shows inflation isn’t inherently negative for stocks. So take a deep breath and remember stocks have seen this movie before, and we think continued economic growth is likely to help them weather the ongoing inflation storm.
[i] Source: FactSet, as of 31/3/2022. Personal Consumption Expenditures price index, year-over-year growth, February 2022.
[iii] Source: FactSet, as of 1/4/2022.
[iv] Source: Office for National Statistics, as of 31/3/2022.
[v] “How the Russia-Ukraine War Is Worsening Shipping Snarls and Pushing Up Freight Rates,” Weizhen Tan, CNBC, 11/3/2022.
[vi] “Why Are Energy Bills So High?,” Lora Jones, BBC News, 1/4/2022.
[vii] “Russia-Ukraine War Driving Up Feedstock Costs Triggers Petrochemical Crisis in Asia,” Wanda Wang, Ramthan Hussain, Zhi Xuan Ho, S&P Global, 14/3/2022.
[viii] Source: FactSet, as of 1/4/2022. Statement based on US, UK and eurozone CPI, April 2021 – August 2021.
[xi] Source: S&P Global, as of 1/4/2022.
[xii] Source: Directorate-General for Energy for the EU, as of 1/4/2022.
[xiii] Source: S&P Global, as of 1/4/2022.
[xiv] “Japan to Fully Lift COVID-19 Restrictions as Infections Slow,” Mari Yamagucki, Associated Press, 16/3/2022, and “State Action on Coronavirus (COVID-19),” National Conference of State Legislatures, 1/4/2022.
[xv] Source: The Conference Board, as of 31/3/2022.
[xvii] Source: FactSet, as of 1/4/2022. Statement based on benchmark 3-month and 10-year government interest rates in the US, UK, Germany, France and Japan.
[xviii] Source: FactSet, as of 31/3/2022.
[xx] “Drilling Productivity Report,” Energy Information Administration, 14/3/2022.
[xxi] Source: US Bureau of Economic Analysis, as of 1/4/2022.
[xxii] Source: Office for National Statistics, as of 1/4/2022.
[xxiii] Source: FactSet, as of 1/4/2022. Statement based on MSCI World Index return with net dividends in GBP, 31/12/2020 – 31/12/2021.
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