Active investment commentary & analysis

Unchartered territory for developed economies

Inflation divides equity investors. A consensus based on four decades of disinflation has been turned on its head in just 12 months. On top of a sharp demand rebound facing supply constraints, anecdotal evidence abounds of price rises and shortages. But developed economies are in unchartered territory, with the closest parallel being the end of rationing post WW2. But it is bold indeed to extrapolate a trend of little over one year.

The pressure on the labour market may continue well into 2022. But investors and businesses need a much longer perspective. Is there any reason to believe that the pricing power of firms or bargaining strength of labour has permanently recovered? The downward pressures on prices have reasserted many times since the 1970s, even in the years before technology and global trade were such strong factors.

Thinking about inflation embeds emotion. Price rises grab attention, but there are rarely headlines for stable or falling prices. And the power of central banks now is a matter of faith. In theory, they have the tools to come down hard on inflation and frothy growth. The question is whether that is what governments want. A degree of wage inflation could help economic readjustment, tax rises, and even re-election.

The rebound, with its rapid shift to value stocks, has so far favoured short term recovery over sustained growth. But the summer has seen a more balanced picture emerge. Many manufacturers – in autos for example – are facing bottlenecks forcing production cuts. Those capacity constraints contrast with the ready scalability of digital services. Investors need to factor-in the impact of inflation on inputs and capacity, rather than just recognising the short term boost to profits that comes from output price rises. As the recovery progresses it may become harder to pass on price rises. Businesses able to cut costs and add value though product innovation may be in a stronger position than traditional manufacturers.

The impact of inflation and higher interest rates on investment is complex. There are likely to be winners both in value and growth sectors. Businesses that support resilience and sustainability can perform well in the recovery, as governments step up to have a bigger say in the economic agenda.