Inflation – transitory or not?

After years when inflation in every day prices was not really a concern to most of us, we are suddenly seeing significant inflation everywhere we look.  Demand for certain goods and services has increased since the end of the main lockdown restrictions and prices have risen to reflect the inability of supply to match this demand.

The major question that investment managers and central banks are grappling with is whether this inflation is ‘transient’ – a short term reaction to pent up demand following lockdown restrictions easing – or the start of a return to higher levels of inflation that we last saw in the 1970s and 80s?

UK CPI inflation for May was 2.1% and RPI 3.3%, with factory gate prices up 4.6%. Commodity prices have been rising even faster, with the global effect of the transition to renewables (hypocritically, perhaps, a resource hungry exercise) expected to provide a tailwind for a long time to come.

Central banks, nervous of the potential impact on the economy of raising interest rates, are currently united in peddling the message that the recent inflation spike is transitory. They don’t want to be responsible for bringing the post pandemic recovery to a grinding halt by increasing the cost of debt for both businesses and individuals.

This is understandable: the lower that interest rates are, the harder the shock when they are raised. For someone on a tracker mortgage paying 1% interest or less, an increase in interest rates to 3% would see a tripling in the monthly interest expense. Then there is the increase in the monthly car leasing payment to think about too.

However, the longer that central banks hold off from increasing interest rates, the greater the risk of seeing inflation spiral out of control. The trouble is that inflationary expectations can be self-fulfilling: as we experience price rises, we project our current experience into the future and accordingly our default thought process is to expect further price rises. Which then leads to wage inflation – if indeed there is insufficient elastic in the labour market for employers to push back against it – and people being encouraged to spend their money faster (before it loses value). More, faster, money in circulation then whips up an enduring storm.

With Brexit having removed a large number of low paid European workers from the workforce, we may in the UK find ourselves facing higher wage inflation in certain sectors than most other countries.  Whilst the UK government is currently taking the line that any jobs shortage will provide opportunities for UK citizens who are unemployed, the more cynical view is such individuals will either not be queuing up to fill the lower paid jobs that they might be qualified for, or don’t have the qualifications to take the higher paid jobs that they might wish to.

From an investment perspective, companies that offer cash now through dividend payments rather than the promise of cash in the future, and who have sufficient brand strength or a strong enough market position to increase their prices in line with inflation, have historically done better in an inflationary environment than their peers who can’t tick either box.  If this does prove to be the case, we may see a reversal of the investment trend of the past 10 years which has seen the share prices of growth focussed technology companies who promise much in the future but little today, significantly outperform cash generative businesses paying steady dividends.

This article is issued by Portland Financial Management Limited which is regulated by the Financial Conduct Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

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