Goldilocks returns to the forest; we need to hope she doesn’t encounter any bears on her way

The recent moves in financial markets have been increasingly reflective of a benign view of the economic outlook in the developed world.  Arguably this Goldilocks scenario of ‘not-too-hot, not-too-cold’ economic conditions, which have returned over the past few months, are no longer seen as a low probability event but have become much more consensual for economists and policymakers. This view is supported by three key ingredients: robust global growth, passive central banks, and transient inflationary pressures. Most commentators, including us, would not have a problem agreeing with the first two assumptions especially as many economies have witnessed resurgent growth during the first half of 2021 and central banker pronouncements have generally endorsed the continuation of loose monetary conditions. But the widespread conviction of transient inflationary pressure is more difficult to rely on. Last week we saw another reminder that inflation is not dead: UK consumer prices jumped by 0.5% in June, lifting the annual rate of inflation to 2.5% from 2.1% in May – the highest rate since August 2018¹.

Although the rise in UK inflation last month is not as pronounced as in the US, where consumer prices increased by 5.4%² on an annual basis, the trends are similar, nonetheless.  In both cases, these inflation announcements were greater than many expected.

Fundamentally, we do not believe that higher inflation will be fully transitory as the Goldilocks conditions seem to imply, especially judging by the recent declines in yields across the developed world, as central bankers are keen to tell us at every opportunity.

Demand is recovering fast in many economies, driven by robust household consumption which is, in turn, driving a pick-up in corporate investment, especially in manufacturing. The supply side is responding, but this is not a sufficient counterbalance in the near term. We can see the evidence of this everywhere, with supply bottlenecks in the auto and construction industries, inventory problems for semi-conductors and household appliances and transportation challenges across the board (freights rates are currently 500-600% higher than normal)³. Meanwhile, significant demand to hire new staff is being held back by too few workers to fill the vacancies which are now at a record high. Sectors as disparate as construction, hospitality, agriculture and logistics are all struggling to fill vacancies and wages are rising fast to compensate. Clearly, these challenges are more acute in the domestic economy due to the post Brexit disruption.  Almost daily we have heard specific comments from companies about the emergence of these supply-side problems over the past six months.

In the short term, some of these one-off factors are lifting inflation across the advanced world and will drop out of the annual comparisons over the course of 2022. We are sceptical that inflation will be as tame as markets and central banks currently project.  In 2022, we expect that the huge policy stimulus across the advanced world, continued loose monetary conditions (both supported by politicians and central bankers) and ongoing strong consumer demand will persist and that particularly the issues over labour supply will result in further upward wage pressure. The latter point is increasingly relevant for business costs as supply chains are being squeezed by labour shortages. In many ways, this combination of events has not been seen before in my investing career.

Furthermore, historical periods of inflation have shown time lags where the persistence of pricing pressure at the factory gate in one year has ended up in higher wages and consumer prices.

Annual change in key UK CPI components:

Just to be clear, we do not expect a return to the inflation of the 1970s. But we have to contemplate a different outcome than the persistence of Goldilocks, which is priced into so many financial assets and a financial system that has evolved to assume that very low inflation/deflation is the status quo.

The truth is that the market’s willingness to believe in the Fed’s judgement on inflation does come with risks of a policy mistake. To correct this will require a more aggressive monetary response, an unexpected slamming on the brakes moment, which in turn could create greater market volatility and risk an unnecessary economic slowdown. Goldilocks will not be happily skipping through the forest if we contemplate that outcome!

1. ons.gov.uk/economy/inflationandpriceindices/bulletins/consumerpriceinflation/june2021
2. tradingeconomics.com/united-states/inflation-cpi
3. Drewry Supply Chain Advisors

The views and opinions contained herein are those are those of Mark Barnett, Fund Manager. They do not necessarily represent views expressed or reflected in other BennBridge investment communications or strategies and are subject to change.

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