Is Inflation to Be or Not to Be?

One of the greatest debates circulating in financial markets today is surrounding inflation. No one questions that North America has experienced a surge in inflation in recent months. But a one-time uptick in prices does not equate to worrisome inflation. Which brings us back to the original question, is this a short-term price adjustment related to the uneven reopening of the economy or is it a structural shift in the global economy that will lead to ongoing price increases?

Perhaps we should ask a different question. Why, after a decade of battling deflationary pressures, are we suddenly worried about inflation? In the chart below, you can see that prices have increased quickly, pushing inflation outside of its long-term trend lines, opening the debate to whether this is a temporary aberration or the beginning of a new trend.

Data: Statistics Canada

Before we enter the debate on whether this surge in prices is short-term in nature or the beginning of a longer-term phenomenon, let’s discuss why this is important. If inflation becomes embedded in the economy, interest rates will begin to rise. At first glance, this appears to reward savers and punish debtors, and that is at least partially true. However, looking deeper, that is not always the case. Let’s take an investor who buys a 1% GIC at a period when inflation is near zero and compare that to an investor earning 4% with 2.5% inflation. Let’s also assume that the investor pays 30% in taxes. At first glance, it appears that the investor receiving 4% is better off as they are benefitting from both a higher rate and a larger gap over inflation. But when you calculate the actual gain in purchasing power, there is a bit of a surprise.

Sample 1

Although debtors may struggle under rising interest payments, the relative value of their debt is declining. Therefore, inflation distorts the relationship between borrowers and lenders. This distortion will impact bond owners.

Equity markets are also challenged when inflation shifts. In simple terms, the value of a company is related to the purchasing power of its future earnings. In an inflationary environment, the expected purchasing power of those future earnings is diminished. If the future earnings are less valuable to the share owner, they will be unwilling to pay as much for access to those earnings, resulting in lower valuations.

In today’s high debt environment, there are also economic implications. With household debt to GDP at approximately 110%, higher debt service costs could slow the pace of economic growth. Households may need to reduce other spending to cover increased debt service costs. These reductions in spending across the economy may result in lower levels of economic activity.

Shortages

Disruptions to supply chains are creating shortages and pricing pressure, increasing the risks of a “stagflationary” environment. Stagflation exists when prices rise but the economy slows. At the port of Long Beach in Los Angeles, there are currently 36 ships waiting to gain access to a port that pre-Covid, rarely had a ship at anchor. Due to congestion within the port, once a ship is unloaded, it is still taking “weeks” to get the merchandise onto rail or trucks. This story is repeated at ports throughout the world. The ports of Vancouver and Prince Rupert indicate two-week delays getting containers transitioned to rail or truck, once finally unloaded. In the month of August, the port of Xiamen in China reported a quadrupling of the number of ships anchored offshore waiting to be unloaded, while the port of Shanghai/Ningbo had 141 ships waiting for access to the port. This is sending shipping costs through the roof with container freight rates having now jumped from $1,400 in March of 2020 to a September high of $10,800.

But the supply problems don’t end with shipping costs. Throughout North America and the UK, there is a shortage of truck drivers available to deliver the goods that finally make it to port.

Combine this with extremely low inventory levels at retail outlets and customers may start seeing empty shelves at retail stores. When demand exceeds supply, don’t expect to see a lot of discounted items.

We are already experiencing some of the economic risks of supply disruptions. Auto plants have implemented temporary shut-downs due to the lack of computer chips needed for vehicles. We may see other manufacturing and retailers experiencing similar slowdowns.

Retailers Inventories to Sales Ratio falling to 10-year lows

https://fred.stlouisfed.org/series/ISRATIO

Energy & Electricity Shortages

This may tie into the shortage argument, but given its significance to the global economy, it seemed to deserve a section for itself. Europe is facing a serious shortage of natural gas as winter approaches. European gas inventories that are normally built up to manage the winter heating season are approximately 25% below last year’s levels. An exceptionally cold winter last year drained European reserves and Russia declined to increase deliveries to Europe over the summer while addressing its own depleted stockpiles. By early September, natural gas prices in Europe had tripled from a year ago and liquified natural gas prices have skyrocketed. While AECO gas prices in Canada are sitting at approximately $3.30, liquified natural gas (LNG) delivered to Asia (where the highest demand resides) hit $34.

China is experiencing significant electricity shortages with 20 provinces having implemented power cuts. These provinces include several large manufacturing hubs. With local officials being ordered to protect electricity flows to households, it means that business and industry are bearing the brunt of the shortfalls. China’s desperation to obtain resources for power generation may partly be responsible for the spike in LNG prices. However, with these rolling brown outs in place, the supply of goods from China to global markets may face further disruption.

Labour Shortages

Although it is more difficult to explain why so many businesses are experiencing labour shortages, it is unarguably the case. One global survey indicated that 69% of employers are facing difficulty hiring the workers they need, the highest rate in 15 years.

There are many possibilities for the shortages, but there is limited data to confirm the various anecdotal theories. We do know that Covid led to a surge in retirements. Many people close to retirement age or those working past normal retirement decided it was time to stop for good. Ongoing government support for the unemployed may be discouraging some workers to return to full time employment. Data suggests that many individuals collecting CERB benefits in Canada have returned to work part-time, which has boosted their household income above its pre-Covid level. Returning to work full-time and losing CERB would equate to a reduction in income. Others argue that workers have discovered the pleasures of a slower pace and aren’t anxious to return to sacrificing family time for long days in the office to “get ahead”. This has resulted in more workers needed to do the same work.

The labour shortages may be the result of any one of these or a combination thereof, or other factors we haven’t considered. But if labour remains in short supply, in the near term, that likely means competitive bidding for qualified staff.

Demographic Shift

One other argument for inflation is the shift in demographics that has quietly been taking place. The population between the ages of 20 – 39 now vastly outnumbers the baby boomers. The baby boom has been a defining factor in western economic trends since their birth, but now for the first time, there is a generation larger than the boomers and this group is now hitting their prime spending years.

One of the impacts of this generation will be in the housing market. New housing starts have slowed over the years, to reflect smaller generations. Now, with baby boomers living and staying in their homes longer than previous generations, combined with fewer houses being built, the housing stock is not ready to keep up with demand. Nor are there sufficient skilled trades people available to ramp up construction.

Money Supply

Many commentators argue that the surge in money supply created by central governments around the world when the Covid-19 pandemic began, will inevitably lead to inflation. As can be seen from the chart below, money supply surged at the onset of the pandemic and has continued to grow rapidly.

https://fred.stlouisfed.org/series/M2SL

However, inflation is not linked to money supply growth alone, but is a combination of growth in money supply and the velocity of money – how many times the same dollar circulates in the economy. So, while money supply has exploded, the velocity of money has collapsed. Until the velocity of money returns, money supply is not likely to be the driver of inflation.

https://fred.stlouisfed.org/series/M2V

Central Bank Apathy

After a decade of inflation running below the targets set by most central banks, it is easy to see how these organizations have lost their fear of inflation. The U.S. Federal Reserve is at the head of this pack, having officially changed its target last year from 2% inflation to 2% average inflation. That is generally interpreted to mean that after a decade of inflation below 2%, inflation can be allowed to run hotter than 2% for some period of time. The question becomes, how high above the average is acceptable before the Federal Reserve will act to slow it down?

Central banks also appear to have embraced the concept of Modern Monetary Theory (note the word theory), which claims that central banks can print as much money as they want if interest rates stay near zero. That money can be used to finance fiscal deficits run by the government, and the governments must increase or decrease spending based on inflation. Essentially, the central banks become the financing arm of the government and the elected officials become responsible for managing price levels. A quick lesson in history to end this thought – one of the reasons independent central banks came into being was that governments could not be counted on to rein in spending when inflation needed to be controlled.

Shifts in Demand

Having listed many of the reasons that inflation could stick around longer than the market currently anticipates – and admittedly it is an intimidating list – let’s look at the other side, the forces that keep inflation in check.

One of the reasons that inventories are low and demand for goods is high, is the pent-up demand created during the pandemic. But that wave of demand already appears to be subsiding. U.S. retail sales numbers have been volatile through the pandemic, rising when government cheques were sent out and retreating after. However, sales growth now seems to have settled into the pre-pandemic range. In fact, there was a decline in retail sales in two of the last four months reported.

https://tradingeconomics.com/united-states/retail-sales

As government wage subsidy programs roll off over the next several months, support for consumer spending will likely decline, further slowing consumption.

Technology

New technology has always been anti-inflationary. As we are now in the early stages of many game-changing technologies, such as machine-learning, artificial intelligence and blockchain, there is no reason to believe this cycle will be any different.

When you consider this bigger trend in context of a world with low interest rates and labour shortages, the incentive to implement new technology only increases. Capital spending on new software has spiked higher during the pandemic. IT equipment, R&D plus software spending combined now exceed 50% of all capital expenditures in the U.S. As companies gain efficiencies from these investments, that will help offset strains elsewhere.

Final Comments

We aren’t going to conclude today on whether the spurt of inflation we are currently experiencing is short term (transitory), longer term, becoming a secular pressure. The argument for transitory inflation relies heavily on the shortages of both labour and goods being resolved. Those arguing the longer-term case, tend to be focused on money supply and central bank apathy, while also noting that wage inflation has tended to be trickier to slow down once started.

Financial markets appear to be biased towards the short-term case, although the short-term now appears likely to extend longer than many – including us, originally expected. It is unlikely that these shorter-term pressures will ease until at least the end of the first quarter next year and could drag on longer. The supply shortages leading to the inability to produce goods could put the economy at risk of having economic growth stall.

The impact on individual companies is less clear. For companies with heavy fixed costs and lower variable costs, this could improve margins. However, that may be partially offset by lower revenue if the companies are unable to produce as many goods as desired.

In other words, we are in a period with few historical markers to guide us. What happens with inflation could impact, earnings, valuation levels and interest rates, yet there remains significant uncertainty in how this plays out. Although we have hedged away from making any predictions in this piece, we will end with one – the period of extremely low volatility that has benefited investors over the last year is likely over.

Disclaimer:  Please note that the publication is designed to provide general information only. It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as financial advice, nor should the information be considered a substitute for personal advice. Information used in this publication has been gathered from sources believed to be reliable. Logan Wealth Management is not responsible for and assumes no liabilities or responsibility for any loss or damages suffered as a result of the use or misuse of, or reliance on the information or content of this publication. Please consult your financial adviser to determine whether the information is applicable to your personal situation.