After years of quiescence, inflation seems to be re-emerging as a major factor for investors to consider.
In the US, wholesale prices are rising at the highest rate for more than a quarter-century – up 7.4 per cent over 12 months. The European Commission has sharply raised its estimate for eurozone inflation this year. In China inflation is at its highest in 11 years, in Singapore it’s at a 25-year peak.
There are some highly visible causes. Oil is trading at more than $100 a barrel, thermal coal at close to $120 a ton. Prices of top-quality wheat reached an all-time high a few days ago; global food prices have risen by more than 75 per cent since 2000. Metals are also on a tear – Japanese steel mills recently agreed to pay 65 per cent more for their iron ore supplies.
Is this going to be a problem for investors? It could be.
Inflation is deadly for traditional bonds, as it destroys the purchasing power of the interest they pay and the future real value of their maturity proceeds.
Contrary to common belief, it isn’t good for equities or real estate, either, except in moderation. High inflation is so politically painful and damaging to long-term economic growth that it forces central banks – eventually and reluctantly – to hike interest rates, which hurts company profits.
“Inflation,” the Wall Street Journal rightly comments, “is the great thief of the middle class.”
The world hasn’t suffered an inflation problem for years because globalization has released a flood of internationally-traded goods from new factories in the emerging economies, especially in Asia. That competition has kept a lid on wage inflation and on prices of manufactures in the advanced countries.
What is changing now is that growth in demand for basic resources is outpacing growth in their production, pushing up their prices. China alone has accounted for about half the increase in global demand for metals since 2001 and almost two-fifths of the extra demand for oil.
If consumers want more mobile phones, computer games or clothing, it’s comparatively easy to ramp up their production, fast. But if they want more beef and dairy products, requiring huge additional quantities of grains and other feedstuffs, availability of land and water restricts the scale and speed of output increases.
Increasingly the world’s economic growth is being driven by expansion in emerging economies. Much of their demand derives from construction (homes, business premises, public buildings) and infrastructure (roads, harbours, airports and railways).
Their needs are for huge quantities of industrial metals such as steel, copper and aluminium. There is a scarcity of mine capacity, but shortages of human skills and other resources to expand, restrict the scale and speed of output increases.
Energy resources are needed everywhere – imagine what life would be without electricity or motor vehicles – but growth in the emerging economies is boosting demand at the margin faster than production is increasing.
Traditionally, inflation has erupted when demand for goods and services as a whole – especially consumer and government spending — has been allowed (or even encouraged) to exceed their available supply. Although it’s a painful business, the imbalance can be corrected by depressing demand, mainly through raising the price of credit and restricting its supply.
Natural resources now in short supply
But the kind of inflation we’re now experiencing is not being driven by excess demand generally, but shortage of supply of specific, important resources – oil, foodstuffs, industrial metals.
Raising interest rates wouldn’t dampen the high prices, even if central banks were free to act in this way. At the moment, however, all the pressures on policymakers are to cut rates to combat the threat of recession, not hike them.
Fortunately, there are grounds for believing that inflation pressures are at or close to a peak:
- If you believe, as I do, that equity markets generally are still under-rating the deflationary impact of the global credit squeeze, then economic growth is soon going to disappear, at least in the US, and to slow down markedly most places else. That will take some of the pressure off general demand for resources.
- Although demand for specific major resources, such as oil, seems to be impervious to high prices, that is not the way it works… given time. Markets are dynamic. When prices are high, consumers and industrialists find ways to use less or substitute cheaper materials. I was recently fascinated to learn that an Indian engineer has developed a way to use waste plastic as a substitute for coking coal.
Economizing of this kind is slow to come through, but can be great in its eventual scale.
- Markets are dynamic on the supply side, too. We read much about the difficulties of the oil and mining industries in finding and developing new sources of supply. Rather less attention is given to the way companies improve the efficiency of existing operations to increase their output.
High prices will also eventually work their magic on supply as well as on consumption of commodities.
The best evidence that rising inflation is not going to be a serious threat to investors, at least for a while, is the behaviour in the prices of traditional longdated government bonds.
Treasuries are still trading at long-term yield lows/value highs, Bunds are still in a long-term uptrend. Gilts and Japanese government bonds are also not priced to suggest any significant inflation risk.
For the next two or three years I expect the market-dominating factor to be the credit squeeze and its consequences. Only after it becomes apparent that the global economy is going to recover, and especially if central banks are slow to start raising interest rates, could inflation emerge as a significant problem.
It’s not something to worry about at the moment.
By Martin Spring in On Target, a private newsletter on global strategy