Client Update - 22nd October 2021

In a week where inflation news is almost playing second fiddle to rising COVID cases in the UK for the first time in months, our investment team has been spending more time on the consideration that the aforementioned inflationary pressures may actually be neither transitory nor structural (longer term), but a split depending on which areas you are reviewing.

The nature of inflationary pressures varies by sector. Materials and consumer analysts are most confident that the inflationary pressures facing their companies are transitory, and many believe that prices should moderate as supply chain issues fade. Raw materials have been hard to get hold of because of supply chain disruption, driving up costs. This should normalise on a 12-month basis.

Structural inflationary forces are also having an impact on many companies. While we are seeing all of the normal transitory inflationary pressures for the automotive industry, there are some underlying structural pressures due to increasing semiconductor content in vehicles meeting constrained chip supply that will take much longer to be resolved. Wages and the cost of decarbonisation can also push inflation higher.

With both transitory and structural forces at play, companies are contending with an inflationary environment that is far from straightforward. Any prolonging of supposedly transitionary pressures could increase expectations that inflation will be sticky, while structural drivers such as the cost of decarbonisation are likely to impact prices for far longer.

Short-term investment considerations are currently focused on the relationship between real growth and inflation. Where we are today is totally defined by the effect of the pandemic in 2020 and the recovery from that. In our opinion, it is the logistics of recovering from the shutdown in 2020 that is driving wage and price developments, not quantitative easing (QE). It is important to remember that QE was designed to confront the challenge to monetary policy when interest rates hit zero and became necessary because of the deflationary forces generated by the global financial crisis. Any decision to stop QE and normalise monetary policy should be based on an assessment of those longer-term structural themes (potential growth, underlying inflation) and not on pig iron prices or shortages of baristas in coffee shops. By that token, I see limits to how far interest rates and bond yields can rise. Yes, we will get tapering from central banks, but they must be careful not to confuse short term supply-squeeze driven price hikes with longer-term monetary policy decisions.

At some point, higher inflation could provoke a tightening of monetary policy that is beyond what is priced into markets. Real yields and risk premiums would rise, growth expectations would fall. That would be a challenge for investors. Whether that happens depends on how quickly the world economy deals with its supply-side issues. For now, I believe in continued growth and lower inflation in 2022.

We have a break from our weekly reporting next week, so I look forward to writing to you again on the 5th November. Until then, stay well and look after yourselves.