Inflation is a topic we have written about many times in these articles. Only a few months ago we were commenting on how inflation was rising, again, off the back of low prices that were falling a year ago at the height of lockdown. And that central banks were suggesting that the inflation numbers coming through would be transitory and that it would begin to ease, so there would be no need to raise interest rates.
However, inflation is remaining stubbornly high, and capital markets seem to be paying attention to this, realising that this may no longer be transitory. This week, US consumer price inflation hit an annual rate of 5.4%, while core inflation, taking out food and energy, is still sitting at 4%, much higher than the Federal Reserve’s target. Similar numbers are rising fast around the world. As a result of this and the reaction from bond markets we have seen that government bond yields have been rising too – the UK 10-year Gilt yield recently passed through 1% for the first time in over two years, while the US 10-year treasury yield has risen above 1.5%. There are now suggestions that we may see a rise in interest rates sooner that we first thought.
Listening to M&G’s CIO of Fixed Income Jim Leaviss this week, this is the most worried he has been about rising inflation in his 30-year career. He suggests that while we have seen lower inflation historically and that there is a long term down trend in inflation, this time may be different as we take into account many other factors, such as the higher energy and oil prices. He said that inflation may well still be transitory, but it would not be a two or three month event, but maybe something that could remain high for the next few years.
The other concerns of higher inflation are which part of the inflation basket will see prices stay higher for longer and which will go lower. For equities, how will company’s earnings be affected, and will they be able to sustain the cost pressures and supply issues that are currently being faced. And while it is the headline inflation numbers are being talked about, for companies it is the more specific underlying drivers that are more important, such as freight costs, higher oil and gas prices, or a tighter labour market which will feed into higher wages.
For consumers, it is about what happens next – if you can’t afford something because of the higher prices will this change your spending habits to either don’t buy that item again or can you change to a lower priced item instead.
The issue for investors is while all of the current issues are temporary in nature, the longer that temporary inflation exists, the more it has an impact on expectations about future inflation which in turn leads to a demand for higher wages to compensate for the higher prices and the loss of spending power.