We often get asked our view on inflation, especially given the powerful conflicting forces driving economies at present. This week we aim to put a framework around the discussion.
Clearly, the current economic shock is hugely deflationary and financial markets see that. The US recently published falling consumer prices month on month, with food price increases being offset by falling energy prices, even underlying ex food and energy, CPI saw a fall. Chinese producer prices are also falling, no doubt reflecting reduced export and domestic demand. The same will, no doubt, be true when figures are released elsewhere.
Beneath these headlines however, there might be a very different picture. These inflation indices are constructed by weighting different consumption items. Obviously, during the lockdown consumption patterns have changed dramatically. No-one has been eating out while more food has been eaten at home, less petrol was consumed and there has been no travel to hotels. In practice, households are consuming more things that are going up in price and little of what is falling in price.
If inflation is meant to evidence how ‘well off’ people are for the same wage, it probably isn’t doing a good job in the near term. Clearly, households have saved a huge amount by not being able to go out and spend, but the things they have been buying are getting more expensive.
In the longer term, once consumers are able to spend again, the outlook becomes even less clear. There is clearly likely to be a demand shock, given the number of jobs that have been lost. Depending on how long industries take to recover this would be deflationary. At the same time, there has also been a supply shock, firstly during the lockdown as nothing has been made, with factories and services businesses on lockdown. Longer term, supply chains have been disrupted to a degree we do not yet have visibility of, but anecdotal evidence suggests that production will take time to get back to previous levels.
The balance of these two competing factors is hard to fathom. It is easy to suggest that free money from governments, with no production to support it, is inflationary. Everybody spending and nobody making anything is obviously inflationary. The reality is, however, much more complex. We have lower energy costs; changing medium term consumer preferences; disrupted supply chains; mass unemployment; distressed businesses discounting products, all working in different directions. Another factor is likely to be the productivity impact of what, no doubt, will be new health and safety measures. These will inevitably lead to reduced productivity and increased business costs, which would be inflationary if demand remains the same.
Much longer term, we might take the view that government spending of the type currently underway is inflationary, but this hasn’t been tested in the post–QE era. We cannot, yet, say for sure that the income support schemes will remain for the long term. In the short term the Governments are paying over 15% of the work force not to produce anything and supporting business owners to stay closed. This is evidently an inflationary force, other things being equal.
Overall, as ever, we won’t be making any strong predictions, simply considering how things pan out over time. At present things are clearly very deflationary, but the outlook, post a return to work, is much less clear. Many of the changes to consumer and business behaviours will clearly be costly and therefore the assumption would be inflation increases over time but until there is evidence of this we won’t be acting aggressively.
When looking for hedges, in the case that inflation returns, we like to consider assets that have merits in the current environment as well as in a potentially inflationary future. This leads us to gold and infrastructure. Gold benefits from the current volatile environment, acting well when there is financial or political uncertainty, in addition to being a good inflation hedge. Infrastructure companies, such as utilities, are attractive because of their revenue stability in the currently difficult economic conditions, but these holdings will really come into their own if and when inflation returns.
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