Inflation continues to dominate the global investment agenda. Investors have become inflation worriers, mainly because persistently high inflation is forcing central banks to become inflation warriors.
Another reason for the focus on inflation is simply because developed economies have not seen anything like this in decades and responding to such high inflation falls outside the experience of most consumers, investors and indeed policymakers. In emerging markets like South Africa, it is a slightly different story. Inflation rates of 5% to 6% are not particularly unusual here. What is unusual is to have US inflation higher than South Africa’s as is currently the case.
One part of the inflation story is obviously the oil price. Much like other commodity prices, oil benefited from demand rebounding faster than supply (partly because supply is artificially constrained by OPEC quotas). More recently, Russia’s aggressive stance towards Ukraine and the risk of a war in the region have seen oil prices jump almost a third in the past three months. We don’t know where this is headed because no-one knows exactly what Russian President Putin’s end-goal is. Markets don’t like uncertainty, and the longer it persists, the longer the oil price can stay elevated while equity prices remain under pressure. In contrast, a resolution of the stand-off could see investors breathe out and oil prices decline.
Chart 1: Brent Crude oil price
Source: Refinitiv Datastream
Oil price increases feed directly into inflation statistics, but this is not inflation in the true sense. Yes, it increases the cost of living for consumers as well as the cost of doing business, but whether higher fuel prices cause inflation depends on whether businesses can pass on costs to consumers, and whether consumers can absorb those increases without reducing spending. In other words, rising oil prices in a strong economy with rising inflation (like the early 1970s) is a very different proposition than rising oil prices in a weak economy.
It is therefore important to understand the underlying economic picture.
Covid-19 was a shock to the global economy unlike anything previously experienced. Millions of people were forced to stay at home or did so voluntarily. Spending patterns, particularly in rich countries, shifted dramatically away from face-to-face services to goods. A well-worn example is that people cancelled gym memberships and bought home exercise equipment instead.
The other element to this story is monetary and particularly fiscal stimulus. Governments in rich countries were quick to lock down their economies in the face of the new virus, but they were also quick to provide financial support to workers and businesses. In poorer countries like South Africa, support was obviously on a much smaller scale. In the richest country of them all, the US, the support was historically large. Trillions of dollars were injected into the US economy through two large fiscal packages signed off by President Trump in 2020 and President Biden in early 2021. For the first time ever, total US household income increased during a recession. In other words, households had more money to spend, but fewer things to spend on. Some of this money was therefore saved, but a large portion was channelled into spending on goods which jumped well above pre-pandemic trends while spending in services languished below pre-pandemic trends.
Chart 2: US household income and spending
Source: Refinitiv Datastream
Goods are physical items that take up space. They need to be produced, transported and distributed. They often have long and complex supply chains. These were always prone to disruption, something that was not necessarily well understood before Covid. The lockdowns and quarantines provided disruption in spades and at every stage of the supply chain. This continues to this day, especially in China where a zero-Covid policy remains in force.
The final ingredient is labour shortages. Right at the start of the pandemic, we said that behaviour will change in profound but unexpected ways. One of these unexpected changes is that large numbers of people have reassessed their relationship with work and have dropped out of the labour force, especially in the US where there are more job openings than unemployed people. Only time will tell if they will be lured back by higher wages and better working conditions.
The US experience matters greatly for the rest of the world since the US Federal Reserve’s policies impact financial markets in every corner of the globe.
The Fed has traditionally viewed inflation through the lens of the labour market. In other words, it believed that low unemployment tends to push up wages and ultimately consumer prices, a relationship known to economists as the Phillips Curve. The Phillips Curve relationship largely broke down over the last two decades due to global labour competition and technological change. If current labour shortages persist and lead to continuously rising wages, which in turn put upward pressure on prices, central banks are likely to get very nervous and interest rate increases could accelerate faster than currently priced in. At the extreme, interest rate increases aimed at cooling the economy can lead to a recession, an outcome neither the market nor central bankers want, but can still happen.
It also matters whether people believe the price increases will be once off or persistent. If the latter, those beliefs become self-fulfilling. Central banks also therefore place great importance on this notion of stable “inflation expectations”.
So far, the evidence is encouraging. Surveys in the US show that expected inflation over the next year has predictably shot up, but expectations of what inflation will be over the next five years have not moved up nearly as much.
Chart 3: Consumer inflation expectations over 1 and 5 years
Source: University of Michigan and Bureau for Economic Research
A similar picture emerges in South Africa. This is one of the reasons the interest rate cycle here should be mild compared to other countries with the Reserve Bank insisting that it is on a gradual hiking path.
Consumer inflation was 5.7% in January, with large contributions from fuel inflation (32% year-on-year) and food inflation (6%). Core inflation, excluding volatile food and fuel prices, was somewhat higher at 3.5%, but still indicates a lack of demand-pull inflation by historical South African standards. Since interest rate increases impact demand and not supply, this is important for monetary policy.
Hiking rates will do little to generate electricity, boost production or unclog logistical logjams. Rate increases work almost entirely through cooling demand and by reiterating in the mind of the public that central banks take inflation seriously. In other words, they have a symbolic as well as practical role.
It helps that the rand has been remarkably well behaved considering global angst and in fact briefly broke below R15 to the dollar last week even as the Ukraine crisis appeared to be escalating. While the impact of the exchange rate on inflation has diminished over time, it still features in the SARB’s thinking and therefore it will take some comfort that the prospect of a US rate hiking cycle has not put downward pressure on the local currency. The 5% year-to-date appreciation of the rand against the dollar somewhat blunts the pain of a 18% increase in global oil prices.
Investing in a time of inflation
Though cash returns will rise with policy interest rates, US, UK or European money market returns are very unlikely to beat inflation in their home markets in the next year or so. They are unattractive to a South African investor unless you believe the rand is a one-way bet lower, which it never is. The same is true for bond yields in those markets. They remain low even after recent increases, and therefore offer negligible prospects for interest income.
South African bonds have yields that are well above current and prospective inflation rates. Local money market rates are rising with the repo rate, but it also seems unlikely that money market returns will handsomely beat inflation as was the case pre-Covid. Each successive interest rate cycle since 1990 has had a lower peak and trough, and this cycle is unlikely to be different.
Equities remain the best long-term inflation hedge since companies capture inflation in their earnings (one person’s inflation is another’s income growth).
However, in the short term, the relationship is more complicated and prone to changes in investor sentiment. As rates rise, investors typically reduce how much they are prepared to pay for each dollar’s worth of expected earnings, called a derating in finance jargon. The further out in the future those earnings are, the more rising rates hurt and therefore growth stocks – technology shares in particular – have taken the biggest beating this year after a long stretch of outperformance. Indeed, global growth shares have suffered their biggest underperformance against value shares in a 12-month period since the bursting of the dotcom bubble in 2000 (chart 4). This is a good argument for diversification within equity portfolios as opposed to just loading up on what has worked well in the recent past.
Chart 4: MSCI All Country World Growth vs Value indices, $
Source: Refinitiv Datastream
The backdrop of strong global economic growth should continue to support company earnings. The question is whether this will be overwhelmed by investors’ anxiety over higher interest rates. So far in 2022, this is the case in the tech-heavy US equity market, but not in South Africa’s. Though there are sector and country nuances, broadly speaking the big risk to equity markets is when rising interest rates result in a recession and earnings slump. We are not there.
Humble and nimble
It is clearly an uncertain time. In a recent press conference Fed Chair Jerome Powell spoke about the need to be “humble but a bit nimble”. Nimble, because policymakers might have to respond quickly as the situation evolves. This might mean stepping back after a few rate hikes to assess the impact. Or it might mean increasing the pace of rate hikes. Humble, because not even the mighty Fed knows with certainty how things will play out over the next year or three. This is always true, mind you, but it is particularly true in today’s Covid-distorted world.
The same is true for investors. Humility is crucial since investments are not about certainty, but rather about getting the odds on your side. Humility means constantly asking what am I missing? And what if I’m wrong? Getting the odds on your side is much easier if you are nimble (it is easier to sell a portfolio of stocks than a portfolio of rental beach houses for instance). But nimbleness shouldn’t be confused with the urge to act, even when headlines are scary and markets volatile as they are now. The best way of getting the odds in your favour is to be correctly positioned for your investment time horizon and end goal, and then sticking to your investment strategy. Remember the level of uncertainly and upsetting news flow exactly two years ago and also how costly it would have been to miss out on the rally that followed the initial price declines.