The Inflation Question

The world’s economy is reviving and many countries – notably in developed markets – have put the Covid-19 pandemic on the backfoot thanks to co-ordinated vaccination campaigns and strict lockdown measures. So with worldwide economies starting to reopen, why have global markets been experiencing regular bouts of turbulence this year?

Having long been dormant, the threat of inflation has reawakened and is unnerving investors. But is this emergence of inflation just a transitory effect from last year’s extreme lockdown measures or should investors prepare themselves for higher prices over the long term?

Inflation’s rising
So far this century, inflation has been an issue that investors have not really needed to consider, remaining stubbornly low despite long-term accommodative monetary policy providing plentiful stimulus. Yet data is now showing signs of a sharp pick-up in inflation. The latest reading of US consumer prices showed a 4.2% rise in April from last year’s levels – the sharpest rise since September 20081.

While policy makers have strived to reassure markets that short-term rises in inflation are not a cause for concern, other influential voices are challenging this view. US Treasury Secretary, and former Federal Reserve (Fed) chair, Janet Yellen was forced to back track after recently raising the need for higher US interest rates. While former Treasury Secretary Larry Summers and former IMF Chief Economist Olivier Blanchard have both accused the Biden administration of stoking inflation through excessive fiscal stimulus.

Amid such mixed messaging, is there a definitive answer to the inflation question?

Inflation is a temporary issue…
For many, the rationale behind the rise in inflation is straight forward and shouldn’t raise alarm bells. Much of the recent rise in prices can be attributed to base effects – that is the unwinding of the slump in prices, particularly commodities, that accompanied the first lockdowns in March 2020 and depressed headline inflation figures at that time.

As lockdowns ease and in-person services sectors reopen, prices of lockdown-sensitive goods and services are starting to stabilise. Moreover, using last summer’s reopening as a guide, the prices of airfares, car rentals and entertainment are expected to rise again in coming months.

Demand for goods is expected to increase as well, based on a mix of improving consumer confidence and sharply higher disposable income for many households – the pandemic is expected to have generated $1.6tn of excess household savings in the US alone2. This glut of disposable money has been amplified by President Biden’s latest stimulus, which issued $1,400 cheques to many American households.

Supply bottlenecks are another driver of ‘short-term’ inflation. Again, the pandemic severely disrupted supply chains last year which has driven down inventories across many areas and regions and users have been unable to restock. The clearest example of this is in the shortage of semiconductors. Surprisingly, this not only impacts the production of technology goods but has also slowed the production of domestic appliances and new vehicles which also incorporate semiconductors. And any shortage in products helps drive up the price of these items.

Finally, labour market shortages may lead employers to offer bonuses or higher wages to tempt reluctant qualified workers back into jobs. The combined forces of higher wages and disposable income are expected to have an inflationary impact on housing costs, particularly in the rental market where evidence is already suggesting newly negotiated contracts are being struck at higher rents.

Many economists, including the Fed, believe these factors are temporary and that inflation will return to target levels, as happened after the Great Financial Crisis (GFC).

… Or an inflationary regime change has commenced
A second school of thought, and one that we at BNP Paribas Asset Management subscribe to, argues that beyond the base effects and temporary bottlenecks, there are cyclical and structural reasons to suggest that a major regime shift to persistently higher inflation is underway.

Firstly, global supply chains are being reconfigured. Globalisation has historically been a deflationary force, but the Trump-era sparked a rise in protectionism that was then exacerbated by the pandemic-inspired disruption of supply chains. Now both nations and businesses are increasingly diversifying, reorganising and reshoring vulnerable supply chains, focusing on medical goods, vaccines, microchips, as well as advanced technologies like artificial intelligence and battery development that have national security importance requiring a degree of domestic self-sufficiency and protection. A reduction in globalisation, which is also being driven by rising tariffs on trade and restrictions on technology transfers, is expected to curb competition and spark inflation.

Secondly, the monetary and fiscal policy response to the pandemic, led by the US, was unprecedented in its scale, coordination and ambition and is also another potential cause of longer-term inflation. The pandemic lockdowns presented a very different economic shock to what happened during the GFC and should allow for a much faster recovery. For many, including the aforementioned Larry Summers and Olivier Blanchard, the sheer size of fiscal intervention poses a clear risk of overheating economies, driving unemployment down and stoking wage inflation.

Finally, many believe the low inflation climate of the last 20 years is a consequence of domestic and global demographic pressures, where a modest growth in working age populations has been supported by net immigration. Looking ahead, most developed economies are commencing a demographic reversal where ageing populations will be a greater burden on pension and healthcare systems, while also reducing global savings rates. Combined with tighter restrictions on immigration and a slowing pace of labour force growth, the impact of this is expected to drive up real wages and inflation, although on the plus side inequality should be reduced.

Demographic changes in China are a good example of these potential inflationary influences. Over the last 30 years, China’s economic expansion has greatly benefited from a 30% increase in its working age population, as well as an unprecedented domestic migration of workers from the countryside to its cities. But this demographic shift is about to reverse course. As China’s working age falls, wages are expected to rise as its population switches from being net producers to net consumers, creating more competition for productive workers.

Imminent central bank intervention?
Ultimately, only time will tell whether the current rise in inflation will prove to be temporary or persistent. But if one thing is certain, this lack of clarity will create ongoing turbulence for global markets as upcoming data is forensically analysed for any definitive signals.

Investors should therefore brace themselves for frequent tests of their nerves. Uncertainty lies at the heart of this era of Great Instability, but volatile times also create significant investment opportunities and sell-offs can and should be viewed as buying opportunities for prudent investors.

At BNP Paribas Asset Management, we want to help investors navigate through these times of uncertainty and equip them with the knowledge to make better-informed investment decisions. We investigate before we invest and look at things from different angles, because in a world of change you need to have an open and curious mind to find the best opportunities.

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