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Natalie Taylor, portfolio manager at CIBC Asset Management.
I would say an inflation scare has been on economists’ radar for the last few months, and there’s really two reasons for this. First, the period between March and May 2020, some meaningful deflation as a result of the global economy shutting down. There’s a strong base effect when calculating inflation a year out.
Second, the amount of liquidity injected into the economy has been unprecedented, and there are many that believe this could have meaningful inflationary implications as that liquidity increases purchasing power and demand for goods, putting upward pressure on pricing. This is certainly what we’ve been seeing recently. It’s been exacerbated, I think, by the strained supply chains that are still trying to catch up.
Economists and investors have been aware of the risk of inflation. However, this was clearly not in the base case. Mid-May, we received CPI data for the month of April, and that showed a month-over-month increase of 0.8%, which was nearly four times the level of expectations. While that number doesn’t sound large, on a year-over-year basis CPI was 4.2%, and that’s the highest level we’ve seen since 2008.
As a result, investors started to question whether inflation could derail economic growth and force central banks to raise interest rates. The Fed in particular has been quite clear that they are willing to let inflation run above its 2% target in order to ensure a proper recovery. But there is a risk of a policy mistake, as this playbook hasn’t been tested in recent history. I would say in the days and weeks following that CPI release, we saw a broad-based market weakness and investors really grappling with some of these questions.
I think it’s important to determine whether inflation is here to stay or is likely to be more transitory in nature. I think the risk of higher inflation is more credible than it has been over the last number of years, but there’s also good reason to believe that it would be more transitory. Though the arguments in favour of higher inflation really centre around de-globalization, the onshoring of supply chains, as well as unprecedented levels of stimulus. And there’s also an element of a self-fulfilling prophecy with inflation, because rising inflation expectations can often drive actual inflation higher.
But, on the flip side, there’s still considerable slack in the economy: over 8 million more unemployed than prior to Covid, and we’re unlikely to see any form of sustained wage inflation until that unemployment rate drops.
Also, the nature of the pandemic and the restrictions on mobility: we’ve seen demand be more concentrated in goods, and spend in service has fallen off pretty significantly. As the economy continues to reopen, consumer spend is likely to increasingly shift back to services, and that should take some of the pressure off of consumer goods categories, where we’ve seen some inflation.
I think lastly, over the longer term, there’s some powerful trends, such as shifting demographics and increased digitization and adoption of technology, that should continue to be deflationary. As such, I think it’s more likely that the inflation we’re seeing is more transitory in nature, but we’ll be watching the data carefully over the next few months to determine the outcome of this debate.
Inflation would typically benefit raw materials initially, and we’ve seen very significant moves in energy prices, copper, corn, iron ore, other base metals and commodities. While materials companies benefit from those higher prices, the higher margins are difficult to sustain over the longer term, as typically supply and demand will balance out.
We do think it’s slightly different for copper in particular, as copper is required for decarbonization. And there has been a significant under-investment in copper projects, and sanctioning of new projects could be a lengthy process. So, we think that there is reason to believe that inflationary pressure in copper will continue.
Moving on to financials, and banks in particular, they would benefit from higher inflation initially as interest rates rise. However, if inflation starts to overheat and impact the economy, the overall impact is likely to be negative. But in the meantime, we would expect them to benefit from higher interest rates through their margins.
Utilities are likely to struggle the most, I think, in an inflationary environment, as they’re highly levered and their returns are regulated. Often, those returns would be adjusted on a lagged basis.
I think in other sectors, the impact is less clear cut, and it really comes down to the business model, pricing power and the degree of input cost inflation that company is seeing. For example, packaging companies often have commodity passthroughs embedded into customer contracts, so there’s often a lag in realizing those higher prices. I think branded consumer products can often pass on the impact of higher cost inflation to a certain extent to customers over time. I think B2B type companies, such as industrials, may have a more difficult time passing on inflation. Part of the difficulty in predicting the impacts of inflation is really the fact that we haven’t seen meaningful inflation in some time, and I think that, really, it needs to be evaluated on a company-by-company basis based on the factors that I described.