BY GUY CARSON
The most discussed economic issue currently is inflation. We have seen a rise in Consumer Price Indices (CPI) globally as the world emerges from the Covid pandemic with record low interest rates and fiscal stimulus. For the first time since the Great Recession, inflation is starting to hit and exceed the targets of Central Banks.
With the world shut down and globalisation meaning supply chains are international, the world is experiencing bottlenecks in the manufacturing of goods. The question that is being debated currently is whether inflation is a symptom of these bottlenecks or whether combined monetary and fiscal stimulus is having a larger than intended impact.
The Bank of International Settlements (BIS) has now released research on this (https://www.bis.org/publ/bisbull48.pdf) and the below chart quantifies the impact of bottlenecks.
From this chart, we can see that bottlenecks have driven much of the recent inflation increase. There are numerous causes behind these bottlenecks. The most obvious is the pandemic-induced supply disruption. Producers severed relationships with suppliers early and have found it hard to re-establish them when demand has picked up. Secondly, demand has picked up significantly faster than expected. Due to the global pandemic, people have switched from spending money on services (i.e. dining out) and are spending more on goods. Thirdly, a global management obsession with efficiency and high returns on capital for several decades, has meant manufacturing and supply chains are “lean” and difficult to scale. As a result, supply has lagged demand.
One of the areas that has been severely impacted is semiconductors. Taiwan and South Korea dominate the semiconductor industry and after several years of declining demand, they weren’t prepared to meet the new increased demand.
The semiconductor shortage has hit industries such as cars and electronic goods. The car shortage has been particularly severe and has forced 2nd hand car prices up.
Companies in the semiconductor sector are now spending money on expanding production and we are starting to see that flow through in the exports as the chart above shows. This is how the bottlenecks will ease, companies will invest in production and supply will rise to meet demand. Eventually this will ease the inflationary pressures. How long it will take is the question, are we in for another 6, 12 or 24 months of supply disruptions and price increases?
However long it takes, we do know that the bottleneck part of inflation will ease and that is having a significant impact currently. However, there are other issues at play. There are supply issues with regards to certain commodities. Oil and Gas for instance has seen significant underinvestment over the last decade and with OPEC keeping supply down, prices have risen. The cure for higher prices is continuing higher prices, as companies will invest in more production. Over time, production will rise and the price of oil will come down. This will take longer than the current production bottlenecks to ease. Alternatively in the case of Oil, OPEC may just increase supply which they have done in the past to hurt US Shale profitability.
There is also speculation around pending shortages in commodities such as Lithium, Nickel and Copper which are used extensively in electric cars. If governments have their way and production of these vehicles meet their targets, we will then need a lot more of those commodities. The first point to make is that it is unlikely those targets will be met (although adoption of electric vehicles will increase). There will be shortfall in supply which will lead to higher prices, which in turn will lead to greater production. Commodity cycles typically last a few years whilst supply adjusts and typically oversupply then occurs which drives prices down.
Due to all the factors above, we have seen significant volatility in commodity prices recently and some have come down considerably after significant rises (lumber, iron ore). Ultimately, technology and ingenuity will catch up with needs. The history of inflation in recent decades is dominated by technological advance. Essentially as technology allows us to do more with less, the cost of production and the cost of goods goes down. There is nothing from the pandemic or the current bottlenecks that suggests this trend is under threat. Once life returns to a new normal, inflation will return to trend.
The other aspect of inflation which needs to be discussed is wage increases. Due to the pandemic, fewer people are moving and job vacancies are harder to fill. This is most notably the case in countries that were previously reliant on immigration as part of their economic growth in recent years (US, Australia, NZ). Economic growth hasn’t stalled due to stimulus but there is no growth in workers. If these pressures start to force wages up, then inflation starts to rise. On the flip side to this are the central banks: if wage inflation starts to rise, then they will be in a position to raise interest rates. In a world floating in debt, small interest rate rises will have a large impact. If this occurs, it is potentially the healthiest economic cycle in recent times. Wages rising is a good thing for the economy and has been the missing piece of the economic puzzle for the last two decades.
Asset prices, particularly in hot sectors such as Cryptocurrencies, non-profitable tech and electric vehicles, will be very vulnerable. We are starting to see significant moves in the share market. Whilst indices are holding near all time highs, a look at the internals show some stocks are already down substantially. The list below shows this is most notable in the Tech Sector.
The tide appears to be shifting in global markets: what has worked over the last 18 months will probably not work going forwards. Portfolios will need to adjust and boring things such as cash flow and valuations will matter.
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Disclaimer: The above contains the opinion of the author and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice