Is Inflation Transitory Or Becoming Entrenched?

The truth is that it remains too early to judge. The distortions wrought by the pandemic are still working their way through year-on-year statistics and will continue to do so for some months to come. In the UK, for example, the jump in August 2021 inflation rates was partly due to the August 2020s 50% discount on restaurant food under the Government’s Eat Out to Help Out scheme which has now dropped out of the calculation. The deflationary forces of technology, ageing populations (who spend less) and indebtedness remain and possibly the supply bottlenecks, which have been a feature and problem of the economic bounce-back, may ease.

However, the vast sums now being spent on infrastructure (including decarbonisation), as well as social programmes such as President Biden’s US$2trn American Families Plan and the UK Government’s ‘levelling up’ schemes, are contributing to upward pressure on both wages and raw materials. In the UK, the situation is being exacerbated by the withdrawal of European workers as a result of both the pandemic and Brexit. Incidentally, the well-publicised challenges being presented by skyrocketing gas prices and the shortage of lorry drivers are not peculiar to the UK but are global and a consequence of perfect storms of supply, demand, Covid, climate and politics.

As much as the statistics measuring growth and unemployment corroborate the continuing recovery from the pandemic, it is the inflation numbers that are likely to have the greatest influence on the actions of central banks and hence the future course of financial markets.

Government bonds

Government bonds may widely be regarded as dull investments, but they provided a rollercoaster ride for investors in the third quarter of the year. The price of a conventional bond is very sensitive to the rate of inflation because the regular interest payments and repayment of capital at maturity are fixed sums. If inflation is rising, the price of a bond tends to fall because the value of those payments in real terms is being eroded and investors demand rates of return that are higher than inflation. Central bankers have clearly become more jittery about inflation over the last few months and the timings of expected increases in interest rates and the scaling back of bond purchases under quantitative easing programmes have been brought forward.

Equities

With cash yielding nothing and bond yields still very low (and probably heading higher), equities remain the only asset class in which investors can hope to maintain or grow their capital in real terms, albeit with greater risk to that capital. Past precedent also suggests that stock markets can take moderate inflation and gently rising bond yields in their stride. However, there are challenges on the horizon.

First, higher wages and rising costs for raw materials are putting pressure on corporate profit margins. Second, corporate tax rates are going up. Third, as the worst ravages of the pandemic pass further into the past, year-on-year growth in corporate profits will be harder to achieve and will slow markedly. Most important of all, though, is the risk that inflation remains stubbornly high, forcing central banks to raise interest rates faster and by more than investors currently expect.