Why Investors Can Ignore The Inflation Bogeyman

U.S. equity investors in the six-year period between 1973 and 1978 would have made no nominal return on their investment, with inflation averaging 7.7%. Hence it is understandable that investors remain so concerned about the potential impact of a higher rate of rising prices. This is why all eyes are currently on the bond market and whether it is signaling a return to the 1970s, and whether firms will be able to maintain and grow profit margins.

No need to panic

The U.S. February 2021 inflation data showed an increase of 0.4%, resulting in an annualized consumer price index (CPI) rate of 1.7%. The main driver of the CPI remains energy and food, with other items in the index rising at 1.3%. Next month, the rate will increase due to the slump in energy prices last March through June, but these are once-off impacts on the index, which will subside later in the year. Five-year inflation expectations are currently running at 2.1%, as noted in Exhibit 1.

Exhibit 1: U.S. Inflation expectations

(Click on image to enlarge)

It has been much noted, however, that as consumers emerge from lockdown, supported by government stimulus, the surge in demand for products may not be immediately satisfied, thereby potentially driving up prices.

This tightness can already be seen in the shortage of shipping capacity as well as in commodities data which is ticking up as shown in the top pane in Exhibit 2. Furthermore, the producer price index for manufacturing in China has started to pick up, surpassing early 2019 levels, as demonstrated in the bottom pane.

Such pressures are, however, likely to be temporary given that firms take time to ramp up incremental capacity. Furthermore, the continued low employment participation rate in the U.S. compared to the 1990s and early 2000s indicates significant slack in the labor force.

Exhibit 2: Potential inflation indicators

(Click on image to enlarge)

Another reason why inflation is highly unlikely to lead to 1970s-style rates is that the wage-price spiral – where rising inflation expectations drove workers to bargain for higher nominal wage increases – took place in a relatively closed economy.

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