While lockdowns continue in New Zealand, the global economy and financial markets have all but put Covid in the rear-view mirror. Consumer spending in most countries is back to pre-Covid levels, as are US house prices, wages, and industrial production. Two very different pictures are now being painted of what comes next. Are we in for a stint of high inflation (or even stagflation), or is it back to the low inflation and growth world of the last decade?
The economy marches on
Looking beyond our borders most countries are gradually learning to live with Covid. Lockdown rules have been rolled back and offices have reopened. In Europe, visits to shops and entertainment venues have now almost fully recovered to pre-pandemic levels. In the US, domestic travel volumes and hotel occupancy rates are back near 2019 levels, and consumer spending is at all-time highs. This has all flowed through to drive strong corporate profit growth, which has pushed share market indices to all-time highs.
But this strong economic momentum has also caught many industries off guard. The rapid surge in demand has led to product shortages, shipping bottlenecks, a shortage of labour – and as a result a level of inflation we haven’t seen for over a decade.
The path from here is a guessing game. Will we see continued high inflation, or are these factors temporary? The answer here will determine the speed with which the US Federal Reserve tapers their quantitative easing and starts to hike interest rates - two factors that have had a major impact on markets in the past.
Inflation returns from the distant past
The spike in inflation has also seen the return of a term many had thought relegated to economic textbooks - stagflation. Shipping costs have surged over 200% in the last year and oil prices have almost doubled - putting upwards pressure on the price of everyday goods. Even used cars, an asset class I would never have expected to experience material inflation, have seen their prices jump over 40% compared to pre-pandemic levels. The prices of oil and natural gas have also surged.
All these price increases have links to supply chain issues driven by Covid. In the case of shipping costs, the boom in demand for goods (instead of services like dining out) has seen a spike in shipping from China to the developed world. This has led to a bunch of empty containers in the US and Europe, with a smaller number returning full of exports due to lockdowns impacting production. This has resulted in a shortage of shipping capacity out of China and a spike in freight rates.
These price increases are causing employees to demand higher wages – which is further exacerbated by a shortage of labour. This shortage is illustrated well by sign-on bonuses in the US fast food industry – where even McDonalds is offering $500 starting incentives.
Some are saying that this will lead to a structural pickup in inflation. When the economic surge caused by reopening dissipates, we could be left with elevated inflation and a stagnant economy – or stagflation. This would cause a real problem for central banks, which could be faced with the need to hike interest rates and head off inflation, despite a weak economy.
Inflation could also prove temporary
Others argue that this environment of high inflation is unlikely to persist. Supply chain bottlenecks and labour shortages will be worked through in time. We have already seen this with lumber prices which spiked last year and were up over 300% at one point, but they have now returned near pre-pandemic levels.
Some of the more recent economic data also shows that the surge in growth could be short-lived. Recent US employment data showed that US hiring slowed in August and September, enhanced unemployment benefits and stimulus cheques are coming to an end, and there are signs that the post-reopening spending surge may be starting to dissipate. This could leave us with the disinflationary forces we have lived with over the last decade – including high debt levels and demographics that create a structural growth headwind. If this scenario plays out, then the outcome could be a continued accommodative stance by central banks and interest rates that stay lower for longer.
Corporate fundamentals matter more than the economic path
I have painted a world of two extremes and a near-term fork in the road. But in markets there are never just two possibilities – where one leads to good outcomes and one to turmoil. There is a myriad of paths the economy and market could head down.
Since the Global Financial Crisis we have been warned of numerous existential risks for markets: the European debt crisis, the China trade war, Fed tapering, the Trump administration, the Biden administration – and the list could go on. These sorts of events often cause short-term volatility as they transpire, but five years later they seldom matter.
What does matter is picking the right companies to invest in and holding tight through thick and thin - not getting deterred and selling due to macroeconomic ambiguity. High quality companies with pricing power and the ability to reinvest in high returning projects have historically outperformed in periods of elevated inflation. They have also done well in periods of low growth and inflation as we have seen over much of the last decade. These are the types of businesses we seek and intend to own over the long term on behalf of our clients.