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A return to 1970s-style inflation? Unlikely

Street Sign the Direction Way to Inflation versus Deflation

By Rupert Thompson, Chief Investment Officer at Kingswood

Covid is once again front of mind for markets due to the emergence of the Omicron Covid variant, which is considerably more transmissible than existing strains and potentially quite resistant to the current vaccines due to its number of mutations. Global equities sold off 2.5% on Friday but recovered around 1% this morning.

The extent of the threat posed by the new variant is far from clear, with the crucial issue of how vaccine-resistant it is unlikely to be resolved for a few weeks yet. If it does prove resistant, it should be possible to tweak the MRNA vaccines within a few months. However, this still leaves open the possibility or even probability of a wave of new restrictions being imposed over the winter.

This reinforces our view that we are in for a period of market volatility, particularly now the Fed is thinking of speeding up its QE tapering, potentially paving the way for a rate hike as early as the spring. We are not at the moment planning to make any significant portfolio changes on the back of the Omicron news. Any new restrictions are unlikely to derail the economic recovery and we still believe equities have further upside in the medium term.

Assuming the worst fears over Omicron prove unfounded, investor attention should in time revert back to inflation. How the latter pans out and how central banks respond will likely be the most important market drivers over the coming year. With this in mind, we spend the remainder of this week’s commentary outlining our latest thoughts on the subject.

Consumer price inflation is now running at the highest rate for a decade or more in a number of countries. Most notably, the headline and core rates in the US have hit 6.2% and 4.6% respectively, their highest level in 30 years. Inflation has also increased to 4.1% in the Eurozone, while in the UK it is at a 10-year high of 4.2% and looks set to reach 5% in the spring.

Supply shortages have been the main factor behind this surge. These have been exacerbated by strong demand and have been concentrated in goods. Some supply bottlenecks were always to be expected given the strength of the economic rebound and the disruption caused by the pandemic but they have proven considerably worse than anticipated.

Shortages in semi-conductor chips, for example have slashed new car production and used car prices have risen some 40% in the US as a result. Shipping costs have also escalated and bottlenecks at ports have caused widespread disruption. Moreover, firms are now hoarding components if and when they get their hands on them, exacerbating the problem.

Meanwhile, commodity prices are at their highest since 2011 and have added to the inflationary cocktail. The UK has been particularly hard hit, with gas prices surging on the back of a lack of storage, a lack of wind and Putin’s geopolitical games.

Price pressures were initially concentrated in a few outlying market sectors but have subsequently become considerably more widespread. QE-financed furlough and income support payments to individuals have exacerbated the supply-demand imbalance. Initially, they primarily pushed up the savings ratio but as fears and restrictions receded, significant demand has been released.

As concerning as they are now, these bottlenecks should ease over the coming year as supply will be stepped up, in response to higher prices, and spending on goods should fall back to more normal levels. Demand should lose some of its current strength as the fiscal boost fades, monetary policy is tightened and higher inflation eats into people’s purchasing power. Consumers should also re-orient their spending back towards services which still remain depressed.

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