A Perfect Storm

The words ‘A Perfect Storm’ are being used increasingly in recent days as several chickens come home to roost. The evidence that the recovery in GDP from the COVID-19 pandemic may be starting to slow down is gaining credence. There are twin brakes on prosperity. These are supply chain frailties and the rise in inflation. Central banks from the Federal Reserve to the Bank of Japan and our own Bank of England deem the spike in inflationary pressures to be ‘transitory’. In other words, it’s here today and gone tomorrow. How then can one reconcile that with the Bank of England’s statement that inflation could breach 4% later this year? Given we are already in October, that suggests the inflationary spike is strongly positioned. Of course, the Bank will be looking at its chosen Consumer Price Inflation (CPI) measure inflation and not the old-fashioned Retail Price Index (RPI) which due to the way is calculated would show a much higher rate. In my opinion, it is a much better guide. Many UK Inflation linked government bonds are still linked to the RPI and therefore, holders of those will do well as their investments will keep up with what I believe is the real rate of inflation.

Inflation is just one of the things that markets are worrying about. Many are asking why so many investors are worried, given that markets like a modest degree of inflation? The answer lies in the threat of higher interest rates as just about everyone from consumers, companies and of course, Governments have got used to cheap money. This is true not just of the UK, but worldwide.

The pressures have come in two ways. The supply chain problems and the apparent loss of those willing to supply labour. We may think that the UK is a special case with EU workers not returning after the COVID break, but it appears to also be the case in the EU and US that less people are willing to join the Labour Market. There just seems to be less people wanting to be in the workforce. Maybe Covid has radically changed some people’s living habits after a long period of Government subsidy. Many situations exist in the economy which cannot be explained by traditional analysis. Take for example the jobless rate and house prices. We are told that up to a million EU workers are reported to not have returned to the UK. If this were true you would expect high vacancies for rented property and reduced demand generally for housing. Given the lack of supply and increase in house prices this analysis seems unlikely. Certainly, one of the side effects of COVID seems to be disruption in many areas. Uber drivers leaving the industry to set up at Amazon warehouses means Uber fares are skyrocketing; staff in restaurants, pubs and bars are retraining. This is quite understandable as those industries had no work for 18 months. We are still living with the disruption caused by COVID.

Now we come to the energy price rises that are taking place. Something that COVID but also the race for renewables has disrupted. One small business I know came to the end of its electricity contract a couple of weeks ago and the new price offered was 100% higher. Strangely, because they were slow to respond, the business was put onto an emergency one-year tariff. These are normally much higher than a standard tariff, but the one-year tariff had been fixed at the start of the year and was only 50% higher than the last one. Lucky, but still a huge increase. The last time there was an energy crisis in the 1970’s it ended in inflation and a recession. That was OPEC induced. This time is it the Russians? We hear about gas supply restrictions, but the reasons go deeper. Russia only supplies 1% of the UK’s gas. The switch to new sources of energy has meant that less time has been devoted to finding readily available fossil fuels.  This is particularly true in countries that have closed coal fired power stations and replaced their electricity output with wind turbines only to find that sometimes winds are subdued, and turbines are stationary.

This all suggests that massive changes in how we live need to be handled very carefully and planned for a long-term outcome. This does not seem to be happening around the world and there will be many bumps along the way if planning is inadequate. Replacing gas boilers for example with air-source heat pumps will be another big bump. Electric charging infrastructure is another awaiting us – will it be in place before we all have to buy electric cars?

Is the stock market taking any notice? Apparently not as valuations remain at high levels. Albeit some of the recent new issue froth has begun to diminish as planned flotations, such as Marley, have been side-lined. Inflations looks less than transitory as the Bank of England has increased its year end rate from 4% to 5% just while I am writing this article and more importantly, Chinese factory prices are now running at an inflation rate of 10.7%.

The careful investor will be moving away from highly rated equities on PEs of 20- and 30-times earnings and seeking value situations. It’s probably also the wrong time to sell any index linked gilts, given the inflationary storm ahead.

Barrie Newton