Inflation is the topic of the day at the moment and it certainly dominated the recent Asset Allocation meeting here in Goodbody. The arrival of inflationary pressures has not surprised us. We did expect to see this as the Western Economies re-opened and we lapped the low point of the recession in 2020. The catalyst for the discussion was the last non-Farm Payrolls, which were weak, and what was behind that weakness. Along with that is the broadening out in supply chain pressures which adds to inflationary problems but also could cause some loss in economic activity. A surprisingly high inflation figure in the US topped it off. Looking into some of these issues we feel that we are travelling through the ‘eye of the inflation storm’ and that come the middle of the year we will see some of these pressures begin to abate.
How can a weak employment report be inflationary?
A weak employment report came at a time when we are hearing from some industries in the US, in particular the re-opening leisure and hospitality industries, that they could not fill vacancies. This has led to the concerns that there will have to be a step-up in wages to overcome this labour shortage. This could be true but there are also some short-term issues that could be affecting this. People are still receiving support payments in the US so they could be more inclined to delay returning to work until these are switched off, which is happening now. Secondly, some people could be fearful about their health and waiting until vaccinations have broadened out before returning to work and forego income until then. Thirdly the childcare system is not back to full effectiveness which again would depress the numbers that can go back to work. All of these issues are most relevant to the lower paid jobs market which is where the shortages are being cited.
More supply chain issues?
This speculation about a potential labour shortage came at a time when we are hearing about delays in delivery and difficulty in getting a broad range of products. Could it be symptomatic of a broad problem that the global economy faces and impact on the recovery? Again, we would stress that this was always going to be the most difficult time for these issues. The efficiency of transport systems across the globe is well below par due to sick leave as a result of the pandemic and the impact of distancing protocols on work practices. Logistic systems were already strained. Add to that the re-opening of the economy which leads to a spike in demand for all manner of goods from cleaning products to workwear and it is not surprising we are hearing about broader product shortages. It is not going to go away instantly but the ramp up in vaccinations, we hope, will bring down the sickness rate and allow a move towards more efficient work practices.
Could it impact on growth rates?
It could lead to some slowing in the monthly growth rate but that would be very temporary and just leave longer backlogs which will be filled in later months. Currently there is no reason to believe that will have any lasting effect on the recovery we are going through. Where you are seeing some impact is in the motor industry. The shortages in semi-conductor supply is impacting on their production plans for this year but outside of that we do not see any lasting impacts.
The semi-conductor shortage is a demand problem. One of the results of the pandemic was a large spike in demand for all types of IT hardware and the semi-conductor industry was not ready for that. It takes some time to react to the extra demand, but we should be seeing signs of it in the second half of the year. Adding to that was the speculation in cryptocurrencies. ‘Mining’ for these ‘currencies’ is a reasonable source of demand for semi-conductors, in particular at the high end. A drop in speculation here will help the supply/demand balance for semi-conductors.
But the CPI figure from the US confirmed inflation is here?
We would not think so reading this figure. Yes, the month-on-month figure was extremely high, 0.9%, but there were some quirky impacts and the effect of re-opening. Of the 0.9% increase month on month, 0.38% came from 2nd hand car and truck prices because supply of new vehicles is limited due the semi-conductor shortage. Lodging & transport added another 0.2% reflecting the opening up of air travel and hotel industries. These are unlikely to persist and stripping them out leaves us with an inflation rate that is unlikely to bother the Fed.
How are we reacting to this?
As we pointed out at the start, we did expect re-opening to lead to a spike in inflation and that there would be some supply issues as a result of it. You cannot read too much into one month’s set of figures, but we are not complacent about the messages they may contain. We have our portfolios positioned for a higher growth and a higher inflation rate; over-weight equities with relatively low exposure to fixed income and see nothing in these developments to alter that mix. We increased our exposure to the US fixed income markets and reduced our holdings in the euro area. We have just had an inflation scare in the US and a response in the fixed income market (actually quite modest) but it gives another good entry point to an asset which can provide a positive return. Inflation favours early cyclicals and low-quality. In principle this would put you off moving to mid-cycle exposure. For us, it reduces the urgency of making that move but we must always be aware of what is priced-in. Inflation may be higher but could already be more than priced into the sectors that benefit from it.