Everybody’s talking about inflation

Those hoping for a more sedate political and market environment regrettably found that 2022 has started in turbulent fashion. At the forefront of investors’ minds remains the implications of surging inflation, and thus the pace at which central banks will look to tighten monetary policy in an effort to avoid further economic overheating. Both factors have the potential to weigh on economic growth at a time when government support for the economy has reduced.

What’s happening in the US?

Turning to the US first, the Federal Reserve’s preferred inflation measure of Personal Consumption Expenditure (PCE) rose 4.9% over the year to end of December (excluding food and energy). For core PCE to be hitting the Fed’s target, the more widely followed Consumer Price Index should be at 2.3%. Currently it is 7%, but as the very high price increases of last summer eventually drop out of the numbers, there is hope that we may be close to the high water mark. The good news is that the market believes the Fed will get inflation under control eventually. Using inflation linked bond yields as a barometer, the market expects inflation to average 2% for five years starting in five years’ time – arguably almost too low but basically where they should want it to be, within an appropriate margin of error.

What’s happening in the UK?

In the UK, inflation is also the main narrative on all news streams with this prompting the Bank of England to move interest rates to 0.5% and warn about the need for moderation. Central to the UK inflation push are energy prices, be that for transport or heating.

So, inflation is the main point of concern, why are economists and longer term focused investors so sanguine about the situation?  The central case is that there have been unusual supply circumstances – be those constraints on the ability to supply due to COVID or be that business responses to the lockdown demand changes – and that these should normalise.  The catalyst for normalisation takes two forms which we will call price incentive and spending habit normalisation. 

Price incentive

Price incentive is worth focussing on first as this captures commodities like oil and gas. What has happened to the oil and gas sector – and has rippled elsewhere, is that there has been no incentive to invest in new capacity for some time. 

For oil and gas, new investment faded in 2018 as the oil price peaked at just under $80 and spent most of the next few years on the backfoot with ESG and energy transition considerations an accelerating influence on investment, not to mention the initial COVID related drop in demand.  But the recent jump in oil to c$100 per barrel is likely to prompt investment in improving supply.

Most of the large multi-national oil companies have a cashflow breakeven in the region of $55 and many national operators will be below that level. Similar trends can be seen in semiconductors where TSMC and Intel have added new capacity incentivised by shortages and high prices (that had a knock-on impact on a range of retail areas, not least cars). So, at a simple level, increased supply should at least start to limit price increases, making year on year comparisons moderate, and in time might put downward pressure on some of these commodities.

Spending habit normalisation

Spending habit normalisation is also likely to be helpful.  In a supply constrained world, the only way to secure product was to 'pay up' and in lock down many consumers saw savings build as their typical spending on holidays and commuting was added to their bank account.  This created a perfect storm – why not pay up, after all I need or deserve this in the circumstances I face! As restrictions ease and Omicron hints at the severity of illness reducing, greater confidence in returning to more normal living and therefore spending habits seems likely, aided in no small way by some of the ripples of inflation that the lockdown period caused.

In conclusion

2022 seems set to be a year of transition. This will be uncertain at points and therefore volatility seems likely to continue but, in time, it should start to fade as some of those inflationary pressures fade too. Periods like this can be unnerving but they serve as a reminder why, in investment terms, we ask people to take a long-term approach supported by well-planned financial circumstances.

Written and prepared for Crowe Financial Planning UK Limited by John Moore (Senior Investment Manager at Brewin Dolphin).