When we think about inflation getting out of hand, we faintly remember the 1970s when the oil exporting Middle East, outraged by the strategic damage inflicted by Israel to its Arab neighbours and its own Palestinian population, decided to punish the West by imposing an oil export embargo. Its effects were exorbitant petrol price rises and long queues at petrol stations, fuel rationing and eventually economic stagnation as well as galloping inflation, only brought under control by central banks hiking interest rates to punishing levels, regardless how much suffering it caused.
We picture inflation with images of the Weimar Republic in the 1920s when people bought meagre groceries with rucksacks of money, rushing to spend their hastily printed bills before they became worthless only a few moments later.
Both scenarios seem outlandish and unlikely to materialise anytime soon. Yet as the world emerges from lockdowns and their economic destruction, it is inflation that investors fear the most and see as the biggest danger to their recent, exorbitant portfolio gains. US data for April showed the Consumer Price Index shooting up to a high last reached 39 years ago when measured on a month-to-month basis. Inflation data exceeded what could have been explained away by a low base scenario.
As the economy is cranking up, the cost of raw materials, components and energy is rising sharply. Supply orders reduced in the crisis, lowered investment and rundown inventories cannot keep pace with newly rising demand. Consumers, buoyed by historically unprecedented fiscal and monetary stimuli and long deprived of shopping opportunity, seem to put up little resistance and are willing to pay whatever it costs, splashing it out on building materials, clothes, furniture, and most notably on used cars, which cost 10 per cent more in the US than just a month ago (caused by yet another bottleneck, a lack of microprocessors needed in newly manufactured cars).
It is astonishing how quickly we move our perceptions from seeing the economy, and hence the labour markets, ruined more and for longer, to being overheated and over-buoyed. This sudden inflation scare caused shares not only in the US but all over the world to drop, including countries still savaged by the virus. Even in Japan, which has not seen inflation for two generations and is inconceivable to suffer from it, shares fell as the news spread. As was to be expected, techs suffered most. With profit prospects trimmed by consumers now preferring to socialise, their businesses was scrutinised more scrupulously. Once interest rates start to rise – as they must in an inflationary environment – their present value will be depreciated to size.
Interestingly enough, bond market investors seemed less perturbed by recent inflation scares. Ten-year treasuries fell only marginally, resulting in a yield of less than 1.7 per cent – lower than a couple of months ago. Investors’ inflation expectations as measured by ‘break evens’ – subtracting the yield of inflation-protected bonds from unprotected bond yields – seem to suggest that there will be a spike in inflation, yet it will not last. Bond investors expect inflation to be lower five years from now, while stock investors fear for the worst. Can they both be right?
What investors fear... are unexpected incidents, those still lurking below our radar. Inflation, so much feared already, is clearly not one of them
I think yes. Inflation may be kept at bay even without too painful central bank intervention but this does not mean that stock valuations are not vulnerable.
We perceive inflation in our daily shopping, when milk, groceries or coffee gets more expensive, yet this has little bearing on the CPI, which explicitly excludes our very volatile food and fuel purchases. We worry about inflation quite individually, when school fees, health insurance and rents get more expensive, although this does not bear on all equally. Owning a house outright does not make rent rises more painful, and with no children to put to collage, school fees are not much of a bother.
The pandemic caused its own set of price rises. The cost of disinfectants, protective masks, testing kids and toilet paper went through the roof. It proved temporary.
Today, travel, despite all its limitations, is more expensive than ever before. Air carriers have high debts to service, exorbitant costs, and look back at staggering losses. Given the limited availability of flights they can hike prices and practically charge at will (and ignore our refund vouchers). It will not last. Most of our indulgences will go the same way. First, after many months of incarceration, we will splash it out. Once the sugar rush is gone we will start to look at prices again.
What would put us all in the same boat are universal price rises, affecting all our expenses, effectively giving us less life for our monthly income. Then all alarm lights will blink read. We will demand a pay raise which – having re-established our previous expenditure habits – means we will have more money to pay for the same.
We then talk about devaluation. We will learn that if we buy later we will get less, letting us fiercely compete for today’s limited supply of goods, thereby causing the spiralling price effects we fear. This is when central banks will step in, reducing money supply by selling off the assets they once had acquired to support a stagnating economy and by making credit painfully more expensive. This will slow down economic activity. It will increase business costs for all the listed companies we treasure.
Even without central bank intervention, rising prices at the factory floor can damage corporate profits. They can pass on their higher production costs to consumers only as long as the latter are willing to put up with it. With prices for cobalt and copper going through the roof, electric vehicles will become dearer, but only if we’d still wish to buy them. Eventually sales will come down, making EV enterprises less profitable.
This is the lesson OPEC countries had to learn. The consequences of their embargo were hyper-investment and the development of more fuel-efficient cars. It took the oil price 28 years to come back, to then plummet 70 per cent in a matter of months.
Google searches for the word “inflation” have doubled during the last few months. What investors fear is not so much rampant inflation, which we cannot fathom at all, but central banks acting hard to pre-empt it. This is plausible, but unlikely. What will bring down the roof on our heads are unexpected incidents, those still lurking below our radar. Inflation, so much feared already, is quite clearly not one of them.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com
Andreas Weitzer, Independent journalist based in Malta