INVESTMENTS UPDATE

The ups and downs of inflation

  • Shunil Roy-Chaudhuri
  • 23 February 2022
  • 10 mins reading time

Domestic inflation, as measured by the Consumer Prices Index (CPI), hit 5.5% in January 2022, up from 5.4% in December 2021. This is the highest UK inflation rate for 30 years.

CPI inflation is a measure of the cost of living and is based on the price of a typical basket of goods. When the price of these goods rises, this suggests the cost of living has gone up, which means your money probably won’t go as far as it did previously.

A significant rise in the inflation rate could make a big dent in your pocket. Equally, it could erode the value of your investments. High CPI inflation can affect everything from children’s pocket money to grandparents’ pensions.

Read more: How could rising inflation affect me?

Paul Stratton, a financial planning director at Schroders Personal Wealth, has witnessed the impact of inflation first hand. ‘People are concerned about it,’ he said. ‘The breaching of the 5% CPI inflation level has had a definite impact on clients I’ve met and on their financial decision-making.’

So how worried should we be about inflation?

Weak energy costs during 2020

Well, in our opinion, perhaps less worried than we might initially expect. The US CPI inflation rate, for example, hit a 40-year high of 7.5% in January 2022. But energy prices, which largely comprise oil and gas prices, are a key component of US CPI, as they are for the CPIs of many nations, including the UK. And energy prices were low throughout much of 2020 and into 2021, as lockdowns due to the pandemic led to reduced demand for fuel. But energy prices rose during 2021, as lockdowns were lifted.

It was the weak costs of energy during much of 2020 and into early 2021, rather than abnormally high energy prices, that contributed to high rates of CPI inflation during 2021 and January 2022. To give a perhaps rather stark example of energy price changes during the period, the average monthly price of Brent crude oil stood at $63.6 (£46.9) per barrel in January 2020, sunk to $18.4 in April 2020 but rebounded to $64.8 in April 2021. Between April 2020 and April 2021 the price of Brent crude oil rose by 252%, an enormous increase. But between January 2020 and April 2021, the rise was a much more modest 1.9%.

Supply chain pressures

If the rise of global inflation was solely due to weak costs in 2020 and early 2021, we may have little to be concerned about. But, sadly, it isn’t, as the supply and price of goods has been impacted by government-imposed lockdowns and restrictions during the pandemic. The truck driver shortage, which dominated UK news in September 2021, was just the tip of the iceberg here. There were factory shutdowns, particularly in Asia, which hit the supply of many components (1). And widespread lockdowns and restrictions on mobility drove up shipping costs, lengthened delivery times for goods and disrupted global logistics networks. Added to this was the blockage of the Suez Canal by a gigantic 400m-long ship in March last year.

In order to assess such supply chain disruption, the US Federal Reserve Bank recently devised a new index: the Global Supply Chain Pressure Index (GSCPI). This index measures the pressure on global networks between companies and their suppliers (supply chains) by combining a range of data going all the way back to 1997. The data that feeds into the GSCPI includes shipping costs, air freight charges, manufacturing data, delivery times, stock accumulation and customer demand data.

The jumps in the GSCPI prior to 2020 are dwarfed by what has happened since the beginning of the COVID-19 pandemic. As Chart 1 shows, the index spiked upwards when China went into lockdown at the start of the pandemic. It then dropped briefly as global production started to recover during summer 2020, before rising swiftly in winter 2020, as COVID-19 re-emerged strongly, and in the following period of recovery.

Chart 1

Source: Federal Reserve Bank of New York, 4 January 2022

These figures refer to the past and past performance is not a reliable indicator of future results.

Goods shortages

Supply chain disruption has, for example, created a shortage of microchips, which are an essential feature of many products, from laptops to automobiles. The microchip shortage has led to the dwindling supply of new cars. This, in turn, has driven up (if you will forgive the pun) the price of used cars and contributed to the rise in CPI inflation. And the increase in cost of transporting goods, which is also part of the GSCPI, has also helped drive up inflation, as these costs are passed on to consumers via an increase in the price of items in the shops.

We expect that these supply chain issues will be overcome as we emerge from the pandemic and that this should help dampen inflation. The crucial question is how long it might take for supply chains to get back to normal.

The positive news is shipping prices, as measured by the Baltic Dry Index, were at the time of writing down by 74% since 7 October 2021. But this index refers to the carriage of so-called ‘bulk cargo’, which comprise commodities such as iron ore and coal.

Unfortunately, this good news doesn’t hold for container shipping. Most of our goods come in containers, and the transportation of these boxes is suffering from delays. This is partly due to the spread of the Omicron variant but, according to a Financial Times article, the imposition in the US of high tariffs on the import of Chinese truck chassis has also played a part (2). These chassis are fixed to the backs of lorries and enable containers to be transferred from ships or on to railway carriages. These issues have had a global impact, as ships end up stuck in ports or sail more slowly to save on port charges.

Mercifully, evidence suggests the Omicron variant has not been as severe as the Delta variant for most people (3). So restrictions, including those relevant to shipping, can hopefully be lifted more quickly than with Delta. In addition, truck chassis are low tech products, which suggests to us that their production in the US could be ramped up relatively easily. In this light, we see scope for global supply chains to potentially improve markedly by the second half of the year, with a beneficial effect on global inflation.

Increased savings

Lockdowns and continuing global restrictions have not just disrupted supply chains: they have led to an unbalanced economy. On the one hand, demand for services, such as entertainment and hospitality, fell dramatically as travel and public events were curtailed. On the other hand, demand rose sharply for goods that could be used or consumed at home, with an accompanying inflationary impact.

COVID-induced restrictions also led to an increase in savings for some as people spent less on leisure activities. This has left many consumers with greater spending power as we tentatively emerge from the pandemic and it has strengthened demand for goods and services in many parts of the global economy. Such increased demand has also had an inflationary impact, as those people have more money and there is a restricted supply of goods. So retailers can increase prices without consumers pulling back from spending.

Labour participation

The question now is whether, supply chain disruptions aside, global economies have the capacity to meet this robust demand. And key to answering this question is whether or not an economy has a sufficiently large workforce to provide this capacity.

Turning first to the US, there seems to have been a decline in the size of this workforce in America since the pandemic began. The US unemployment rate now stands at a comparatively healthy 4%. This is way down from the 14.7% rate recorded in April 2020 and not far from the 3.5% recorded in February 2020, just before the onset of the pandemic. But the US labour participation rate, which measures the percentage of the population that is either working or actively looking for work, has dropped from 63.4% in February 2020 to 62.2% in January 2022.

As a result, around three million more Americans are out of work compared with February 2020, despite the fact that the unemployment rate is not much higher than February 2020. This gap is largely attributed to people’s worries about COVID-19, childcare issues and early retirement. Unfortunately, it suggests that, unless the US government steps in to support these people back into the workplace, the economic capacity of America (its ability to ‘grow’) will have become smaller. This, in turn, means US industry could find it harder to meet today’s increased economic demand, which could result in higher prices, higher inflation and perhaps higher imports.

Thankfully, the same labour participation declines have not been seen in Europe. Indeed, Chart 2 shows labour force participation is now higher than before the start of the pandemic. And this suggests labour participation issues may not be a global phenomenon.

Chart 2

Source: Eurostat, 27 January 2022

These figures refer to the past and past performance is not a reliable indicator of future results.

Wage rises

Even so, European Union countries are experiencing staff shortages in IT, healthcare, construction and hospitality. Indeed a deal was agreed in the French hospitality sector in January, amounting to an average pay rise of 16% (4). This suggests that such shortages might be starting to impact wages.

Average wage increases have gone up markedly in the US. As Chart 3 shows, annual wage increases rose to 4.5% in the final quarter of 2021, a significant increase on the 2.6% figure at the end of 2020. And rising wages lead to rising costs for employers, who may then need to raise the prices of their goods and services to compensate, thereby creating a higher inflation rate. However, if some of those people who appear to have left the US employment market can be encouraged to return, then this could exert a dampening effect on wage rises.

Chart 3

Source: US Bureau of Labor Statistics, 1 February 2022

These figures refer to the past and past performance is not a reliable indicator of future results.

Attempting to forecast future levels of inflation is always a challenge, as none of us has a crystal ball. And we now have to consider the human and economic dangers from the situation with Russia and Ukraine. Even so, we expect that supply disruptions will unwind as we emerge from the pandemic, and this could reduce some inflationary pressures. Furthermore, central banks could step in and raise interest rates in an effort to bring inflation down. The Bank of England (BoE) did this when it increased rates from 0.1% to 0.25% in December and to 0.5% this month; and we expect it to raise rates again later this year. However we believe the rates rises will be incremental and overall rates will remain low by historic standards. The BoE is forecasting inflation to rise to close to 6% in February and March, before peaking at around 7.25% in April. But we believe inflation will then decline more steeply than the BoE currently predicts, due to lower energy inflation.

Need for diversification

From an investment perspective, it is worth noting that different assets respond in different ways to inflation. And active multi-asset managers can position their holdings to try to benefit from these different responses.

Commodities and commodity producers, for example, can often benefit from rising inflation. Meanwhile, retailers of consumer staples may have some immunity from inflation, as they are the companies selling the more highly priced goods. And inflation-protected bonds can perform exactly as their name suggests.

Simon Ross, financial planning director at Schroders Personal Wealth, highlights the potential dangers of holding cash when inflation is high, although these will depend on your individual circumstances. He says you must consider the real rate of return on cash deposits after accounting for inflation. ‘If a cash deposit account offers an interest rate of 1% and the inflation rate is 5%, then you’re losing 4% of your cash’s spending power,’ he said.

We believe investors should generally hold diversified portfolios comprising a mix of assets that is appropriate to them. ‘It could prove costly to have all your eggs in one basket,’ said Ross. ‘For example, you require some cash, but you also need the right balance of cash versus investments for your individual circumstances and for your capacity for loss.’

Putting together a portfolio and a financial plan that caters for today’s inflationary environment and meets your personal needs can be complex. You may find speaking to a financial adviser helpful here, because they can look at the bigger picture. Call 0808 296 6659 to book a free initial consultation today. There are no hidden fees or charges, and you’ll only pay if you choose to go ahead with the recommendations in your personalised financial plan.

(1) Financial Times, 26 October 2021, European carmakers warn industry risks a repeat of chip shortage crisis

(2) Financial Times, 22 January 2022, Supply chain delays prove more persistent than expected

(3) Schroders Economics Group, Johns Hopkins University, 21 January 2022

(4) Financial Times, 25 January 2022, Cash bonuses for interviews a sign of the times in eurozone jobs boom

The value of investments and the income from them can fall as well as rise and the investor may not get back the initial investment.

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