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Revisiting the great inflation debate

By: Izak Odendaal and Dave Mohr, Investment Strategists at Old Mutual Wealth

It’s a new year but the global inflation debate continues to rage. Few things are as important for longer-term market behaviour as inflation; so this is important stuff, but also difficult since the big inflation shifts of the past 60 years (first up, then down, then way down) were largely unexpected.

Back to basics

To recap the basics: Inflation is typically measured as the year-on-year change in the broad price level. This means prices a year ago matter as much for the official inflation rate as prices today. It’s a technical view that can cause distortions in unusual times, particularly when there is food and fuel price volatility. For instance, the oil price slumped early in 2020, but has rebound since then.

Global year-on-year fuel inflation is about to shoot up even if prices (in rand and dollar terms) are still at pre-pandemic levels. Investors and policymakers should therefore consider underlying inflation trends when thinking about the impact on the economy and markets.

In much of the developed world, the underlying inflation trend has been persistently low. This means the overall price level increased, but very slowly. Some prices, particularly manufactured goods, actually fell. To combat inflation that persistently undershot their targets, major central banks kept interest rates historically low even before the Covid-19 pandemic.

When Covid-19 hit, global demand slumped, particularly for items related to travel and leisure. This put downward pressure on most prices. Demand for some items rose (such as toilet paper, inexplicably) but not enough to offset the overall lower demand. This highlights another reason for focus on broad underlying trends: the prices of individual items move around, sometimes in different directions.

Too much money?

As global demand eventually normalises, so should pricing. The concern many have is that the extraordinary monetary and fiscal policy response – the trillions of dollars authorities threw at the problem – will start circulating in the economy once herd immunity is achieved. All this money will chase the available goods and services, potentially pushing up prices.

In addition, there is a concern that there has been damage on the supply side too. For instance, if social distancing requirements mean a factory cannot operate at full capacity. However, such bottlenecks are likely to be temporary. After all, if vaccines lead to increased consumer activity, they should lead to more people being able to work too.

There are two additional fears. Firstly, that massive increases in government debt will lead to inflation. Secondly, that commodity prices have increased quite robustly.

Sceptical

So why are we sceptical of the runaway inflation story?  For a start, although modestly higher inflation is likely, that’s not the same as runaway inflation or even hyperinflation, as some have argued. Given price declines in several categories early in 2020, the first half of 2021 could well see headline inflation rates jumping. But this would be temporary.

Similarly, we know the massive monetary and fiscal stimulus has largely ended up inside in the banking system, instead of circulating in the economy. If people were to spend all that money, it could lead to increased price pressures, but for inflation to rise year after year, these fiscal and monetary injections would have to be sustained even once economies regain full employment. A policy error of that magnitude is very unlikely. (Already we saw the European Central Bank musing last week that it might not need to use the full amount allocated to its pandemic quantitative easing programme.) Moreover, part of the reason why savings rates increased so dramatically is the massive uncertainty, which is unlikely to fade overnight.

Turning Japanese

As for the surge in government debt levels, Japan’s experience would argue that debt is deflationary. Japan has the most indebted government relative to national income of any country, but it also has the most persistently low inflation rate. Neither loose fiscal or monetary policy (Japan pioneered quantitative easing a decade before the US) has dislodged inflation from a seemingly permanent weak trend. An entire generation of Japanese have grown up with the experience that prices rarely go up and often decline. 

Commodities

In terms of commodities, these have clearly shot up over the past year and that is good news for South Africa. However, higher prices of iron ore, copper and palladium are not likely to have a big impact on consumer prices, since most of us don’t buy them in any great quantity. Firstly, that is because we spend more money on services than goods these days, and secondly because even goods prices reflect much more than the underlying raw material. For instance, steel and other raw materials only account for about half of a car’s price, with labour, design and marketing costs together with taxes accounting for the rest. And producers and retailers can only pass on those raw material cost increases to the extent that consumers can absorb them. 

During the 2002 to 2008 commodity super-cycle, consumer prices trotted higher but never galloped. This was despite the commodity surge coinciding with a global housing bubble and massive credit growth. US inflation averaged 2.7% over this period, briefly peaking at 5.6% when oil was at $150 per barrel. That is far from runaway inflation.

Chart 1: US consumer inflation, %

Source: Refinitiv Datastream

Food for thought

This period also saw sustained increases in food prices. Food prices again spiked after the Global Financial Crisis and both episodes caused social upheaval. In particular, high grain prices are believed to have provided the tinder to the logs of decades-long political repression that ignited the Arab Spring uprisings a decade ago.

The past few months have also seen global food prices rising. Food price cycles are mostly weather-related, but shifts in demand can play a role, as can government policies. Russia banned wheat exports in 2010 after a major drought, and this contributed to the price spikes ahead of the Arab Spring uprisings. This time round, a Russian export tax coming into effect in February has again contributed to global price volatility, as have dry conditions in other major growing regions.

Chart 2: Global food price inflation

Source: United Nations Food and Agriculture Organisation

Since most people buy food almost daily, changes in prices are very noticeable and one of the main reasons why many people feel official inflation data underestimates true price changes. While food prices can be volatile in the short term, they only add noise to inflation numbers over the long term and don’t drive the big trends. (Except in the poorest countries, where food can be up to half the consumer inflation basket, compared to 15% in South Africa and 8% in the UK. As a general rule, the poorer you are as a group or individual, the greater portion of your income you spend on food.) Food price increases should not be confused with overall inflation.

Finally, technology continues to be a disinflationary force. Think of how much is saved by doing business meetings on Zoom or Teams instead of flying around.  These kinds of technology also continue to broaden the global labour pool, keeping a lid on wages.

To summarise, what should worry us is not higher inflation for a year or even two, but rather sustained rising inflation. In other words, if 2% inflation becomes 4% the next year and 6% the following year as was the case in stagflationary 1970s. That in turn raises inflation expectations. People who expect prices to always rise rapidly tend to change their behaviour, making the price changes become self-fulfilling. Today inflation expectations are still well anchored.

Low inflation to stick around

What about locally? Consumer inflation dipped to 3.1% in December from 3.2% the prior month. This does not mean all items increased by 3.1% over 12 months. Some items rose more, some less. Food prices increased by 6.1% from a year ago. While South Africa is self-sufficient in many food items, global price trends are always felt here. However, ample rainfall and expected large harvests mean food inflation is unlikely to hit double digits this year, and should average around 5% to 6%.

Core inflation, which excludes volatile food and fuel prices, was steady at 3.2% in December.

Stats SA noted that inflation averaged 3.3% in 2020, the lowest since 2004 and second lowest since 1969. Inflation averaged only 1.4% in 2004, but that was due to a massive 40% appreciation of the rand over the prior two years. Low inflation in 2020 occurred despite a weaker rand, reflecting an economy with weak demand but also greater flexibility. Would we have managed to work and shop from home in 2004? Not likely.

Chart 3: South Africa’s long-term consumer inflation trend

Source: Stats SA

Rates unchanged

Against this backdrop, the Reserve Bank’s Monetary Policy Committee kept interest rates unchanged last week as widely expected.

The SARB’s forecasts point to muted price pressures over the medium term, with inflation expected to average 4% this year and 4.5% in 2022.

The SARB expects the final economic growth number for 2020 to be a bit better at -7.1%, but this still represents the deepest contraction on record. Growth of 3.5% is forecast for 2021, slowing to 2.5% in 2022.

While central banks in developed countries are in the game of raising inflation these days, our own Reserve Bank is not yet ready to declare victory on containing inflation. It wants inflation expectations to decline deeper into the 3% to 6% range. It also keeps a wary eye on the possibility that a fiscal crisis could result in a rand blow-out. If investors lose faith in government bonds, the rand could sell off heavily and put upward pressure on inflation. However, the MPC also acknowledges that the rand has less influence on inflation than in the past.

The MPC’s accompanying statement suggests no further cuts. Substantial further rand gains or progress on fiscal consolidation could still result in another tweak lower. Two out of the five MPC members voted for a cut, but it is safe to say that most cuts are behind us.

While lower local inflation is welcome for a number of reasons, including the fact that it allows for lower interest rates, the path to this point has been painful for many. This is because lower inflation reflects lower income growth for some firms. It also resulted in lower tax revenue growth for the government, certainly compared to earlier estimates. The rand value of economic activity would have been much bigger had the 5% inflation rate of 2017 been sustained subsequently.

Investment implications

What are the portfolio implications? Firstly, on global inflation, expect moderately higher inflation for a while, not runaway prices. Longer-term inflation should remain muted. This should not upset the equity market, but companies whose high valuations rest on low bond yields could de-rate if those bond yields continue rising.

These developed market bond yields are still very low in historic terms, and even a modest acceleration in inflation is enough to cause negative returns. The same is true for global cash. In fact, the major central banks have pretty much promised negative real returns in cash, by committing to keep rates low until inflation rises, rather than trying to pre-empt higher inflation with hikes. This also gives our Reserve Bank cover to keep rates lower for longer.

Equities are a natural hedge against inflation since company earnings are linked to price increases, but valuations are vulnerable to inflation surprises. Not all shares are equally exposed. Since persistently higher inflation is extremely unlikely without a much stronger global economy, some companies will benefit.

If global inflation is associated with higher commodity prices, the impact on South African inflation should be small since the rand tends to appreciate as commodity prices rise.

Local long bond yields remain high, pricing in fiscal risks but seemingly ignoring lower inflation. This is an opportunity. On the other hand, short-term interest rates have declined substantially. Money market funds will therefore struggle to eke out real returns and investors will need to think carefully about what role such funds play in their portfolios. Similarly, enhanced income or cash plus funds are likely to see returns roll down over time. The free lunch of earning high returns without enduring volatility seems a thing of the past.




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