Spring is heating up, and so is the inflation narrative. Should investors really be concerned?

Spring is always a time of renewal, but this year even more so, with pandemic-induced lockdowns being gradually lifted and longed-for pastimes that can be resumed. People are raring to return to normality, and consumer spending is accelerating.

We’ve already seen the effects from the release of pent-up demand in the US, where consumer price inflation (CPI) hit 4.2% in April, which well exceeded expectations. That contrasts with last year, when the equivalent figure for US inflation was languishing at 0.3%, giving a first insight into how the prices of goods and services could move from here.

As we’ve discussed before, unrestrained money printing is ultimately inflationary, and the Federal Reserve has pledged to maintain this course, despite the inflation iceberg that may lie ahead. And, until last week, the line from the Fed had been that inflation wasn’t an issue, with the increase attributed to base effects caused by the lockdown. Policymakers have generally dismissed concerns surrounding higher inflation, arguing that such moves in prices are likely to be transitory.

But what if they, and the financial markets, have been underestimating the longevity of this inflationary spurt? The pronouncement of Treasury Secretary Yellen regarding the need to increase interest rates if inflation became a problem appeared to be a restatement of basic economics. There could be very few market participants who would have disagreed with her logic. However, the market’s negative reaction, and the speed of Yellen’s ‘clarification’ of her own comments, made it clear that investors are still betting on a continued benign inflationary environment, despite the mounting evidence that this could be ill-founded.

Attributing the recent inflation spike to base effects is all well and good, but there are other pressures that will drive prices higher. Firstly, more companies will move their supply chains closer to home in order to future-proof themselves from similar shocks to those experienced recently. The practice of outsourcing manufacturing and labour overseas was once vaunted as a big cost saver, but Covid-19 and Brexit have reminded companies of the potential downsides.

The US-China trading relationship is also significant in this context. White House officials have remarked on Beijing’s “coercive and unfair economic practices”, and President Biden has spoken of his concern about human rights abuses. Those who looked for a warmer relationship following President Trump’s more belligerent approach will have been disappointed. With more and more businesses looking to return manufacturing from China, higher production costs are likely – and that, in turn, will lead to higher prices.

The second issue to consider is linked to pent-up demand. The pandemic caused many businesses to stop manufacturing goods. After exhausting their stockpiles during the pandemic, they now have to play catch-up. The release of pent-up demand means more money will be chasing fewer available goods. In other words, the perfect recipe for old-fashioned inflation.

In the short term, government stimulus plans are driving commodity prices higher. In the longer term, the US government needs to balance the books, to pay for its largesse. As a result, extra taxation of corporate profits is on the cards, with a global minimum corporate rate gaining support. That would put obvious pressure on distributable profits, and the most straightforward solution is to pass it on to the consumer.

There’s an urban myth that says if you were to place a frog in boiling water, it would immediately jump out. But place it in tepid water and heat the water slowly, and the frog will boil to death. We believe that the prospect of higher inflation is inexorable; by the time it becomes obvious, it may be too late to get out of hot water.

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12 May 2021

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 Please note that SIT Savings Ltd is not authorised to provide advice to individual investors and nothing in this article should be considered to be or relied upon as constituting investment advice. If you are unsure about the suitability of an investment, you should contact your financial advisor.