The Little Inflation with the Big Bite
Peter Warburton - 26 April 2018
We contend that global inflation will continue its upward trajectory for at least one more year, come what may. The last inflationary flurry was in 2010-11 in the context of dramatic increases in energy and commodity prices. It failed to gain much traction then due to the significant under-utilisation of real resources in the wake of the GFC. Today, the outlook for global inflation is shaped by the interaction of the reckless extension of easy credit policies with supply bottlenecks.
The “Little Inflation” that took hold in late 2015, after the oil and commodity price collapse was exhausted, is slowly gathering strength. It is a global inflationary process that has 5 strands. First, the transmission of inflationary pressure along global supply chains from EM producers to DM consumers. Second, despite some significant and ongoing headwinds, clear signs of wage acceleration are visible in US, Japan and UK. As we discuss in our latest Global Inflation Perspective, unit labour cost inflation has risen at roughly half the pace of general inflation over the past 2 years, but the prospect is for wage growth to catch up some of this lost ground in 2018-19.
Third, there is an unmistakeable drift towards deliberate fiscal relaxation, led by US, Canada and Germany in the advanced economies, in China and numerous emerging countries. After a decade of fiscal moderation and penny-pinching, the political pressures for fiscal relaxation are intensifying. Fourth, the prices of industrial commodities, particularly metals, have responded quite predictably to a positive phase of the global goods inventory and trade cycles. Industrial production growth, at 4 per cent annually, is the strongest reading since 2011, and the tight inventory position has restored producer purchasing power, evidenced by producer price inflation. The imposition of US tariffs on steel and aluminium is expected to have a further constricting effect on supply, not only for these metals, but also for copper, nickel and tin.
Fifth, food and energy price inflation is a wild card. We don’t subscribe to the view that core CPI is all that matters. In poorer countries, primary product inflation carries a large weight in the index and is very influential in the formation of consumer inflation expectations. Food and energy inflation can also be a leading indicator of generalised pricing pressures. The firming of crude oil prices in 2018 may soon be capped by an output response, but the market is more finely balanced than a couple of years ago, when inventories were abundant. Our inflationary thesis does not depend upon a chunky contribution from food and energy, but we may have one anyway.
Who cares about a Little Inflation, even one that looks to be growing a little larger? Every investor should care, because the prevailing attitude to the return of (any) inflation is a mixture of incredulity and complacency. Even modestly rising inflation is unanticipated inflation.
Whereas inflation is like Kryptonite to conventional fixed income investments – robbing them of strength and performance – the effects of inflation on equity investments are insidious and furtive. Inflation sets traps for equity investors. According to one well-regarded US study (figure 1), the average, forward-looking, P/E ratio actually rises during the transition from sub-1 per cent core CPI to the 2-3 per cent range. The return of a Little Inflation (from its virtual absence) represents an improvement in corporate pricing power and a probable earnings boost. However, the transition from a 2-3 per cent core CPI range to a 3-4 per cent range is typically associated with a 25 per cent de-rating of equities.
Perhaps, we have become so conditioned by 1-3 per cent central bank target inflation ranges that interest rate consequences are only taken seriously once inflation breaches 3 per cent. There is every likelihood that this will happen, both for global inflation and for US inflation, within the next 12 months. This is the Little Inflation with the Big Bite.
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