Market Musings 030922: What if… inflation fell sharply?

Market Musings 030922:

What if… inflation fell sharply?

Search for the chinks in the consensus narrative - that is where money can be made.

Summary:

1. The consensus narrative: Inflation is everywhere, and will be persistent
2. The causes of today’s inflation: COVID, employment growth, supply chains, Ukraine conflict
3. Sowing the seeds of lower inflation rates tomorrow: higher interest rates, renormalised inventories, lower demand
4. How could inflation fall faster than expected? Petrol/diesel prices fall, housing markets cool, unemployment rises, discounting of surplus goods
5. Investment conclusion: where to benefit, what to avoid

Podcast this week: Are we in a bull or bear market?

• Will the mini-rally continue or could stock markets post further falls this year?
• Has all the bad news been priced in?
• In today’s morose environment, what hope is there for investors?
• What evidence are you looking for before turning bullish on equities?
• What are your favourite stock markets and sectors?

Recent (short) article: Talking Themes: Income from the corporate world

The consensus narrative: Inflation is everywhere, and will be persistent

The spectre of inflation haunts everyone, both households and companies, with daily reports of sky-rocketing energy bills, rising supermarket food prices and rising rents in major cities everywhere.

As investors, we need to focus more on how we think the future will evolve, as opposed to just what the current environment is today. No-one would claim that this is an easy exercise, but that essentially is what we are doing when we invest.

The causes of today’s inflation

There is of course no single cause of today’s explosion in prices across the board - there are several root causes. But we cannot lay the blame for today’s price shocks solely at the feet of the Russian President.

Let’s lay out some of these inflation precursors:

1. The COVID-19 pandemic, lockdowns and government + central bank response to lockdowns to prevent the global economy from melting down. The combination of government handouts (direct to households and companies, plus tax cuts and other forms of government support) and zero or negative interest rates (to stimulate borrowing for investment in growth) were very successful in spurring economic recovery post lockdowns. But perhaps too successful in encouraging demand, to the point where we have had too much demand chasing too few available goods and services.
2. The success in driving employment growth to new highs. The European Union registered its highest level of total employment in Q2 of this year, while US total employment has just surpassed its pre-COVID end-2019 total employment record. Unemployment rates are close to historic lows, resulting in turbocharged wage growth after a long period post 2008 of subdued wage progression.
3. The effect of COVID lockdowns on reducing the supply of both goods and services. Disrupted global supply chains (largely goods exported from Asia) and the reduction in service sector capacity given the overnight collapse in demand (think hotels, restaurants, airlines, car rental etc.) rendered companies unable to then respond adequately to the explosion in demand once lockdown measures were removed, as so much capacity had been removed (services) or delayed (in the case of delivery of goods).
4. The Ukraine conflict and associated energy war with the West. Oil prices were recovering well anyway on the back of a post-lockdown recovery in global demand. But then we add the deliberate reduction in both oil and natural gas supply from Russia as it seeks to put maximum political pressure on the West, and we find the principal reason for today’s double-digit inflation rates in much of Europe. Bear in mind that pre-conflict, Russia was supplying 40% of Europe’s total natural gas needs.

So from a developed world which had not experienced significant inflation rates for two decades, it seems that we have gone back in time to the 1970s or post World War 2 in terms of rampant inflation.

Then the key question becomes: how long will this high inflation regime last?

Sowing the seeds of lower inflation rates tomorrow

We should first recall that we are exiting two extraordinary economic regimes: the zero interest rate policies that remained in place post the 2008 Great Financial Crisis, and secondly the disruption from COVID-related lockdowns and then re-opening of economies.

Higher interest rates. The economic boost from these zero interest rates (and associated Quantitative Easing policies) has well and truly vanished now, as central banks continue to raise short-term interest rates in their attempt to tame the inflation beast. Remember the crude economic tool (commonly portrayed as a sledgehammer) that they are using: they raise interest rates to make borrowing money more expensive. This then triggers a slowdown in economic activity at a broad level, which reduces demand and then in time, cools prices.

The US economy has registered negative economic growth rates for the first two quarters of this year. In addition, the Eurozone is facing a recession square in the face in the coming months, with the European Central Bank set to raise interest rates yet further this year. Thirdly, economists continue to cut projected 2022/23 GDP growth forecasts for China to levels not seen in many years. Conclusion: it is clear that economic demand for goods and services is indeed slowing quickly.

Supply chains renormalise. Secondly, the distortions on the supply side of the economy (i.e. the provision of goods and services) post lockdowns and re-opening are finally fading. Inventories of goods have returned to normal, and services are also returning to normal as higher prices have incentivized companies to add back capacity, e.g. in air travel, car rental and so on.

Higher prices slow consumption. Thirdly, the shock of higher prices is itself putting the brakes on demand. Consumers are choosing increasingly to delay purchases as their purchasing power is squeezed by high inflation. The combination of higher costs for housing via rents and mortgages, for energy and for food is obliging consumers to cut back on spending for everything else (so-called discretionary spending).

Remember policy lags. We as investors need to remember that there is a lag time between the application of higher interest rates and the effect on growth and then finally on inflation, that can be as long as 18-24 months sometimes. This explains why market pricing of future inflation in the US and Europe remains somewhere between 2% and 3%, far away from today’s multi-year highs.

How could inflation fall faster than expected?

The common narrative today follows the line that inflation rates will come down gradually from today’s lofty heights, but will remain far above central bank targets of 2% for at least 2-3 years. The key twin fears are that strong wage growth will persist for some time as the employment markets remain tight, and that energy prices will also remain elevated as there seems to be no resolution in sight for the Ukraine conflict.

But, watch out for the following trends:

• House prices should fall in many overstretched markets as mortgage costs rise, employment growth cools.The twin motors of rapid house price growth in the US and many European countries have been record-low mortgage rates and strong employment growth. But, mortgage rates are rising sharply just about everywhere as both short-term and long-term interest rates rise. Secondly, companies are already warning of tougher times ahead as demand slows and as costs (e.g. wages + energy) rise sharply. Employment growth is set to slow. There is a significant lag between a change in economic conditions and house price growth, but I think it is fair to expect house prices (and perhaps rents) to fall in the year or two ahead.

US, UK mortgage rates rise sharply

Source: Bloomberg

• Employment growth to slow/reverse: CEO confidence has collapsed over the last few months in the US and Europe as economic growth has vanished. This has been correlated in the past with hiring intentions. Large companies are already slowing or changing hiring plans, which should lead to rising unemployment and slower wage growth in time. In addition, the risk of widespread bankruptcies or shuttering in the Small and Medium Enterprise (SME) segment in Europe is high in many European countries, given the explosion in energy costs over the next few months.
  
  US small business confidence at lowest since 2012
  
  Source: Bloomberg
  
• Petrol and diesel prices are falling: the combination of the easing of crude oil prices plus the calming of refining margins is driving lower petrol and diesel prices, particularly in the US where the average unleaded gasoline price has already dropped 24% from recent peak.
  
  Petrol prices are falling (at last)
  
  Source: Bloomberg
  
• Goods prices in several categories could fall on destocking: large retailers are faced with a surplus of inventories as a result of over-ordering given global supply chain difficulties, and now cooling consumer demand. In the US, Wal-Mart and Target have already signalled that they will have to clear stock at a discount, hurting their profit margins. Both new and used car prices are also renormalising quickly, as big-ticket consumer spending is impacted by record energy prices.

US used car prices falling after a post-reopening surge

Source: Manheim

Investment conclusions: winners and losers

The losers are probably easier to identify from this trend, as they tend to be cyclical industries where costs are still rising but where demand is now easing back or falling outright.

These include the following (by no means an exhaustive list):

• European energy-intensive industries involved in metals processing (steel production, aluminium smelting), nitrogen fertiliser production;
• Estate agents, although they should see some support from an increase in rental demand even as property transactions slow;
• Non-food retailers and car dealers tied to discretionary consumption trends, although these have already suffered a lot in many cases
• Arguably tech hardware companies making and selling smartphones, as pressure on the consumer could lengthen the replacement cycle..
• Video streaming companies who are seeing their subscription model pressured at a time when production costs increase;

Who, however, are the potential winners from lower inflation? (again, just some suggestions)

• Insurance companies who will continue to benefit from a higher inflation environment even as inflation cools, as they are able to push through higher insurance premia on the motor and home insurance side,. On the life insurance side, they should able to offer more attractive long-term savings products on the back of higher bond yields which should drive savings inflows;
• Financial service companies offering bankruptcy-related services, as demand will clearly increase;
• Food & Beverage and Branded Goods companies that offer affordable luxuries like perfumes and skin creams or chocolate and coffee, as these consumption categories tend to be more resistant to economic slowdown;
• Retailers that can benefit from trading down by more cost-conscious consumers, including discount retailers;
• Technology companies that propose cost-saving solutions to corporate clients e.g. via automation and use of artificial intelligence and machine learning techniques to replace labour-intensive manual processes;
• Companies involved in providing energy efficiency and conservation products and services, as the current energy shock will drive faster adoption even if prices cool;
• Listed infrastructure companies in energy, transportation, telecoms and healthcare that can continue to use the above-average inflation backdrop to raise tariffs ahead of their cost inflation

Bankruptcy service companies that have resisted particularly well of late include Frp Advisory (LON:FRP) and Begbies Traynor (LON:BEG) .

Have a great week

Edmund