April marked our first in-person “Wise Men” meeting since the start of the pandemic. For the uninitiated, we use the colloquialism of “Wise Men” to refer to what is effectively a macroeconomic advisory group, used to pick the brains of our two long-term economic advisors.
We have had many virtual editions over the last two and a half years – and technology allowed us to replicate the vast majority of the benefits of these meetings over the period covered by various travel restrictions – but it became immediately clear in the meeting that the quality of debate and information sharing had stepped up a notch from the Zoom versions. As businesses grapple with the right mix of office and home-based working going forward, the immediacy and nuance of face-to-face engagement between employees, customers and suppliers is likely to result in better outcomes over time.
However, the meeting was arranged to discuss prevailing global, macro-economic conditions – not serve as evidence in yet another treatise on the benefits of office working. Whilst the meeting covered the full gamut of economic indicators that we normally look at, it will surprise no-one that the conversation was dominated by the outlook for inflation, and the impact of any consequential policy responses.
The backdrop to the debate is well understood. As many western developed economies have pursued a “living with Covid” strategy over the last year, steadily opening up their societies in the process, the freeing of pent-up purchasing power – whether that be in household or corporate bank accounts – has seen too much money chase too few goods. And it is a problem that has its origins on both sides of the equation. Unprecedented government support during the worst of the pandemic bolstered household finances, but ongoing ramifications in the aftermath severely dented supply chains’ abilities to respond to increased demand. A lack of labour mobility, shipping and other transport inefficiency, a shortage of microchips, and intermittent lockdowns were all contributory parts to supply chain dislocation. The New York Federal Reserve Bank’s measure of supply chain pressures hit record levels at the end of 2021, recording measures that were more than double the previous worst conditions in the aftermath of the financial crisis.
Prior to Russia’s invasion of Ukraine, this bout of inflation was generally accepted to be transitory. Most major forecasts had inflation in the UK, US and Europe returning towards 2% by the end of 2023. However, the war in Ukraine has dramatically altered that picture. Across all of its members, the OECD estimates that the war will add 2 percentage points to inflation this year, whilst dampening growth by 1 percentage point. Dramatic price changes in high profile commodities like oil, gas and wheat have made headlines around the world. However, there have also been exceptional price distortions the markets for soil fertiliser and certain other precious and industrial metals.
History shows that price rises of this nature – and particularly in the case of oil – tend to be self-limiting. Behaviours change, and activity slows, reducing demand to a level where prices inevitably have to adjust. Clearly, the speed of that adjustment in this case is complicated by how quickly tensions in Eastern Europe settle. The supply picture in many impacted commodities may be clouded for a number of years.
We have seen commodity induced spikes in inflation in the fairly recent past that have not had serious macro-economic ramifications, most noticeably in 2011. The big difference between now and then is the tightness of labour markets and the likelihood that long term expectations for wages and prices become unanchored from the 2% orthodoxy that characterises Western policy setting.
Wage inflation in the UK and US are both running at c.5% per annum, with recruitment pressures intensifying. The latest set of unemployment figures confirmed that the UK economy has more job vacancies than it has identified unemployed people. This is unprecedented in the time period that these data have been measured. Even with some momentum coming out of business activity, business surveys still report availability of labour as a constraining factor on their growth. Against that backdrop, Governor of the Bank of England Andrew Bailey’s aspiration that employees should show self-restraint in their wage demands is one of the more incredible policy signals we have heard. There is a very real risk that wage growth across the Western world further intensifies the rate of consumer price inflation.
As observers of markets, we need to try and understand what the policy response to this is likely to be, and thereafter how markets will react to that response. Again, the picture here is potentially cloudy. The US Federal Reserve is talking tough about getting ahead of the curve on price inflation. Its commentary associated with this month’s 50bps rise in the Fed Funds rate guided to further substantial jumps to come in very short order. By contrast, the Bank of England’s 25bps increase in the Base Rate left some question mark over its commitment to price stability in the short to medium term.
The counterpoint to such criticism of the Bank of England’s approach is that its actions alone are going to have very little impact in addressing the underlying causes of such inflation. And there is merit in that claim. Slowing the UK economy materially will have little overall impact on demand in world commodity markets. Being overly hawkish with UK monetary policy risks exacerbating the squeeze on household incomes, depressing wage growth, whilst still suffering input cost inflation. By contrast, any substantial slowing of the US economy almost certainly will affect the price paid for industrial commodities on the world market. If the US economy is robust enough – and Jay Powell’s touch is deft enough – it is entirely possible that a slow down in the United States economy can be achieved to the extent that it alters economic agents’ inflation expectations without dragging the country (and by extension the global economy) into a deep and damaging recession. Over the period of time that this takes place, one would reasonably expect that supply chains in many industries would have healed to a much greater extent than they have today.
The question arising out of this for equity investors, is what does the path to that “new equilibrium” look like? Is it worth holding on through the uncertainty that inevitably comes with a deliberate slowing of the economy? As ever, with markets and economics, the answer is “it depends…”. Markets are forward looking, and in this instance it may be the case that if markets believe that the US Federal Reserve is “getting ahead of the curve” in terms of bringing inflation back into its target range, then the subsequent upswing in activity that will come from the eventual easing of monetary policy will begin to be priced into equity valuations.
At this stage, it is worth considering just how the environment has changed in the last year for trading companies. Contrary to the trends for the last two decades or so, many company’s sales lines this year will driven more by pricing actions than by volume growth. For those businesses who can sustain these higher prices going forward, and have the market presence to maintain margins, this constitutes a rebasing of future sales and profits. It potentially leaves businesses pushing on with volume growth into the next phase of the cycle from a much higher sales base. Note the two conditions, however – the non-retrenchment of sales prices and defence of margin. Not every company will be able to achieve this, but many will.
As a result, the companies that exit the uncertain period ahead with maintained margins could see their equity performance supercharged into the upswing.
None of this is meant to downplay the challenges of the remainder of this year; neither in terms of stock market volatility, nor the real world imperative for households and businesses to balance the books. However, there are reasons to believe that the outturn could be less painful than in earlier slowdowns. As noted earlier, both the personal and corporate sectors have exited the pandemic period in strong financial shape, aided by government support packages and the aggressive repayment of debt in the pandemic’s early stages. This offers some capacity for these cohorts to dip into savings or modestly extend borrowings to sustain consumption/expenditure when inflation erodes the real terms purchasing power of their incomes. Furthermore, it is our contention that pivotal to the economic pain any slowdown will bring is the extent to which it is characterised by increasing levels of unemployment. We believe that financially robust businesses will be much more inclined to carry staff through any period of weakness given the challenges experienced over the last year in hiring and retaining high quality employees. So long as employment remains high, it is likely that the coming months will be manageable.
Markets have already incorporated a lot of this into equity prices this year. Particularly in the UK (outside the obvious commodity sectors), there is not an awful lot of hope factor priced into valuations. This means that any improvement in sentiment or outlook should be quickly reflected in equity returns.
Written by Glen Nimmo