Stories drive short-term market sentiment and stock prices. That is the reality. And there is no bigger narrative today than “surging” inflation in the US, the world’s largest economy — especially after the inflation rate in April 2021 came in at 4.2%, the fastest clip since 2008.
It is fodder for lively debate: whether we are on the path to sustained higher inflation that would force central banks to tighten monetary policies sooner than expected. We too have written fairly extensively on this subject. In fact, we had predicted that inflation would pick up steam, as articulated in our column back in February (“A bull or bear market for 2021?”, Issue 971, Feb 15). All right, we are out by two months, as we expected back then that inflation would cause market jitters in July instead of May.
We suspect the inflation rate in May could be even higher than in April. This is due, primarily, to very low comparables in 2020, when the inflation rate dropped to just 0.1% (see Chart 1).
We think the worst of the increases will start to taper off towards the end of 3Q2021 and into 2022, when the low base effect fades. By then, excitement over the reopening of the economy and the rush to spend all those excess savings would have played themselves out while supply constraints are gradually rectified.
A case in point: The strongest price gains in April’s inflation rate breakdown were for used cars and trucks, where demand far outstripped supply, as production of new vehicles was severely hampered by chip shortages. Elsewhere, strong price increases were also recorded for things such as airline tickets — in this case, because there are limited flights available.
These issues of supply and logistical constraints will be resolved — though some will take longer than others. For instance, fares will decline as travel normalises — airlines can restart routes and boost capacity very quickly.
Another example: Lumber prices have rallied strongly over the past year, boosted by robust demand for home construction and renovations — and also supply chain disruptions, including sawmill shutdowns and a lack of rail cars and trucks. But prices may have peaked as mills ramp up output. Prices may not fall back to pre-crisis levels immediately, but abnormal profits typically cannot be sustained for long (see Chart 2).
This is what happens, in every industry when selling prices rise well above production costs — it attracts new players while existing players also expand capacity output, with the result being increased supply and lowering of prices. Closer to home, this scenario is already unfolding rapidly in the glove sector.
Similarly, global shipping rates too appear to have peaked and will continue to decline as pandemic-related port congestion and delays in container turnaround get sorted out over the coming months (see Chart 3). Orders for new vessels too have picked up, though there will be a lag of two to three years to delivery.
The same goes for production capacity for semiconductors, which will rise but not immediately, owing to a longer lead time. Countries including the US and South Korea have allocated huge amounts to set up manufacturing and R&D facilities over the next few years. The European Union is aiming to double chip production to 20% of global market output by 2030. Meanwhile, major foundries such as Taiwan Semiconductor Manufacturing Co are planning to spend record amounts on capex to boost production capacity.
In the meantime, rising prices suggest that businesses are able to pass on higher costs to consumers, who can absorb the increases thanks to excess savings and healthy cashflow-balance sheets. This is good for profits, part of which will be reinvested to create new capacity and jobs — and sustain growth. US companies, flush with cash, are also resuming share buybacks and paying out dividends at record pace after cutting back in 2020.
Elsewhere, at least 16 (mostly Republican-led) states in the US are reportedly opting out of federal unemployment benefit programmes (which will end in September) in response to anecdotal evidence of labour shortages. So far, the most acute shortages appear in the lower-paying jobs like restaurants and retail sales. It has been widely reported that companies such as McDonald’s, Chipotle Mexican Grill, Amazon.com and Target are offering signing bonuses and raising minimum wages to attract workers.
As we have written before, wage inflation tends to be sticky — therefore, more entrenched — but higher minimum wages may not necessarily be a bad thing. Lower-income households have a higher propensity to spend, which will translate into future consumer spending and economic growth. It could help narrow the growing income inequality, which is a hot political issue.
In other words, the answer to rising prices and inflation rate does not have to be all about higher interest rates. Price inflation as a result of supply constraints would be much better resolved with time, new investments and increased productive capacities.
Markets are driven by stories but central banks will likely be far more circumspect. We believe there is a very high bar for central banks to reverse course on monetary policies just yet — and risk damaging the recovery, especially with unemployment rates so high. Frankly, owing to the magnitude of the distortions, it is hard to get a real reading on underlying inflationary pressures.
Central banks will also seek to keep interest rates low for as long as possible — to sustain public debts at record-high levels and ensure growth to achieve full employment. As such, we have seen and will continue to see real interest rates falling or going negative, for now.
In any case, some inflation must be expected, simply because economies are in recovery mode. Are the massive relief and stimulus measures excessive? Probably. But the fact is, it would be an even larger concern if the unfolding economic recovery — aided by massive stimulus — does not boost short-term inflation. Deflation is scarier — and dare we say, far more destructive — than moderate inflation. The European Central Bank and Bank of Japan spent years fighting deflationary expectations.
Additionally, while vaccinations are progressing rapidly in major developed nations, poorer emerging countries are still lagging far behind. Indeed, we are witnessing renewed movement restrictions in many countries. The market may be a little too optimistic about seeing the back of this pandemic. This is not the time to pull the plug on accommodative policies.
If the short-term price growth does not taper off — even after supply issues are resolved — then higher prices will start getting built into inflationary expectations. And that will trigger a series of cascading events that could turn into a vicious cycle, with deep negative impact on interest rates, public debt, economic growth and capital markets.
We do not dismiss this risk, which is further elevated given the current high valuations for stocks. Hiking interest rates will remove some of the liquidity that has been one of the key drivers in the market rally. As long as this uncertainty over inflation and the interest rate persists, there will quite likely be heightened volatility in the markets. We will write more on this subject next week. Our view is that even this elevated high valuations risk is now self-corrected by the market, thus diminishing the concern.
But even more so, we do not want to overplay the inflation risk. We remain convinced the secular trends — globalisation (though slowing given rising protectionism and nationalism), demographics and, most importantly, technology and innovation — that have driven global inflation lower (see Chart 4) over the past two decades are intact. Longer-term trends such as digital transformation — and its benefits — will continue to unfold.
The Global Portfolio closed 2.7% lower for the week ended May 19. The top losers were Builders FirstSource (-14.7%), The Walt Disney Co (-8.2%) and Home Depot (-7.8%). On the other hand, Geely Automobile Holdings (+1.8%) and ViacomCBS (+1.1%) recouped some lost ground. We disposed of all our holdings in Ericsson, netting a return of 14.3%, and reinvested proceeds into Bursa Malaysia-listed Awanbiru Technology. The portfolio remains fully invested. Total portfolio returns now stand at 51% since inception. We are still outperforming the MSCI World Net Return index, which is up 47.1% over the same period.
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