Prices in the United States are rising, and not just a little bit. The annual inflation rate for April 2021 was 4.2%. Analysts and investors held their breath, because it was clear that it would be a high figure. The key question now is: is it a temporary inflation spike, or have we entered into a longer period of rising inflation? Will the central banks react as controlled as they suggest? And can you, as an investor, learn to live with inflation?
- Inflation figures in the US came in (even) higher than expected.Besides the one-offs, there are also some long-lasting effects that increase prices.Europe doesn’t have to worry about inflation going through the roof.
- The ECB will maintain its low interest rate policy and the Fed faces a difficult balancing act.
- As an investor, there are certainly opportunities to capitalize on today, even with higher inflation.
It Was Written in the Stars
You don't have to have a crystal ball to predict that inflation would pick up in the spring, as the US economy is slowly closing, the vaccination campaign is in full swing, and millions of Americans are eager to spend their money again. The lockdown forced them into a savings mode from which they are more than happy to pry away from.
In fact, escalating consumption is creating bottlenecks in the supply chain, especially in sectors such as transport, components and raw materials. Companies didn’t dare to replenish their stocks too quickly during the pandemic. But with the economy taking off so quickly, it's all hands on deck with the purchasing directors. This creates scarcity, increasing a demand to buy. The empty rack syndrome puts pressure on prices.
The weak basis for comparison also plays a role. By April 2020, price levels had bottomed out. Due to the sudden economic standstill, commodities tumbled rapidly downwards, with the oil price even briefly trading below zero. With such a low basis for comparison, you automatically arrive at a sharper increase year on year.
These three factors – avid consumers, scarce goods and a weak basis for comparison – explain the inflation surge today. We haven't seen a headline inflation rate of more than 4% in twelve years, and for core inflation (excluding food and energy, just under 3% in April 2021) we have to go back even longer. But will the price increase also remain in the longer term?
Keep an Eye on US Wages
There are elements that indicate this isn’t necessarily a temporary inflation spike. The flexible monetary policy of the central banks play an important role here. For years, the ECB and the Federal Reserve have been pumping money into the economies by keeping interest rates low. Until before the pandemic, many economists scratched their heads about this: how is it possible that the quasi-free money policy had hardly any influence on the inflation figures? Their disbelief often resulted in a call to governments: if they too were to dig into their pockets with spectacular investment plans, those inflation figures would have to rise.
The coronavirus served the confused economists at their beck and call. Governments worldwide announced spectacular aid packages, from helicopter money and American Rescue Plans to Recovery Plans and Green New Deals. The budget deficits in the US and Europe went through the ceiling. Sure enough: the economies did push inflation upwards. When you consider what bazookas are in return, that 4.2% doesn't even seem that exaggerated.
In addition to monetary policy, the trend towards de-globalization (a lesson from the pandemic, and a strategy for a global climate plan) could also exert a longer-lasting upward impact on prices, as could an ongoing scarcity of raw materials and materials.
But the pawn in the long-term inflation story is wages. In the US, price increases are not automatically passed on in wages, but they are not completely immune to it because the American labor market is a lot more dynamic and flexible than the European one (let alone the Belgian one). During the pandemic, employment collapsed like a pudding. But once the economy is back on track, employment figures will undoubtedly follow – even if recent employment figures have been a bit of a disappointment. If it turns out that labor becomes scarcer, we will have to keep a close eye on wages.
Inflation Fears in Europe Are Premature
Europe will not escape an increase in inflation, albeit it’s coming a little later because the economic boom in Europe is somewhat slower than in the United States. But there are even more important differences, including that the European economy is a lot more rigid than the American one. The budget deficit is significant, but less spectacular than in the US because the aid packages weren’t as substantial. Unemployment in Europe has not plunged as deeply as in the US. This will result in an expected growth rate of 4.3% in 2021, much more modest than that of the US (6.9%). So for the time being, we don't have to worry about European inflation going through the roof. A return to normal is a more accurate representation of the facts.
Are the Central Banks Keeping Cool?
Will central bankers switch sides as inflation rises? We see little or no reason for the ECB to do so. As described in the previous section, the economic recovery in the old continent is fragile and premature, and inflation will at most return to normal levels. The ECB will keep its interest rates low to give the economy all the oxygen it needs.
In America, the situation is more difficult to estimate. Analysts are wary of the Federal Reserve's targets. On one hand, they want to do everything they can to keep the economy on track for the foreseeable future. On the other hand, they would of course intervene if inflation derailed in the longer term. Were we to find ourselves in that situation, an early rate hike by the Fed might not even be so badly received, as it would prevent further escalation. The tension between the short-term and longer-term goals will determine whether Fed Chair Powel can muster the restraint to leave rates unchanged until 2023-2024. It seems for the time being that he would rather be one step too late, rather than one step too early.
Living With Inflation as An Investor
A world with price increases above 2% will take some getting used to for an investor. Growth stocks are taking a hard hit as investors discount future cash flows at higher interest rates, causing the current value of these stocks to be adjusted negatively.
However, as an investor, you need not despair. After all, there are plenty of opportunities to achieve returns, even in an environment of accelerating inflation.
For example, Econopolis opts for inflation-linked bonds in its bond portfolio. Within the equity portfolio, the financial sector traditionally thrives when interest rates rise, with insurance being preferred over banks. Cyclical sectors (such as construction, raw materials, industry) are responding to the economic recovery, although Econopolis is not abandoning the ESG criteria (Ecology, Social responsibility and Governance). Finally, Econopolis believes that many sectors can simply pass on the price increases of raw materials to the end consumer, so that companies, in for example, the luxury industry, can take full advantage of the increasing demand.
US inflation is rising faster than expected. Evidence points to this being a temporary uptick, although there are also factors with a longer-lasting impact at play. We need to keep a close eye on the evolution of wages in the US. Things may not be going so well in Europe, because the recovery is a lot more fragile. For that reason, we don’t expect any change in the ECB's interest rate policy. The Fed faces a more difficult balancing act: it must juggle between maintaining growth, on the one hand, and not derailing inflation, on the other. Fortunately, as an investor, there are plenty of ways to capitalize on today's opportunities, even if inflation rises above 2%.
Macro-economist and founder of Econopolis