The last time inflation was a major issue, Pink Floyd were releasing singles and the majority of Maple Leafs fans could still remember winning the Stanley Cup. Now the new generation of investors are more familiar with crypto than the Consumer Price Index.
In January, 2022, however, Canada’s inflation rate hit a 30-year high of 4.8% after months of articles and analysts identifying it as the number one investment risk for 2022. But what is inflation? Why is it rising? And why should investors care?
In short, inflation is the decline of purchasing power of a given currency over time, reflected in the cost of living. It’s typically measured by the Consumer Price Index, which examines the weighted average of prices of a basket of goods and services, such as transportation, food, and medical care. The opposite of inflation is deflation, which is when the purchasing power of money increases and prices decline.
Why is inflation increasing?
Anyone who owns a car will have winced at some point over the past 12 months, with gasoline prices up 33% during that period. Shelter and food have also seen significant increases.
Arguably the most logical reason for this is the base effect. After prices dropped considerably throughout 2020 as governments-imposed lockdowns to try to curb the spread of COVID, any year-over-year comparison was always going to look scary. However, this doesn’t entirely explain why inflation is soaring.
Supply chain issues are playing havoc with certain sectors. Lumber was in the news last year after prices hit record highs of more than US$1,600 per thousand board feet in May before collapsing and surging again in early 2022. Used cars and trucks, for example, have never been more expensive as the ongoing conductor chip shortage means new car production has slowed.
Central banks maintain that once these kinks have been worked out, costs will return to normal. But as the recent price increase in lumber and other industries show, it hasn’t proved that simple.
Labour issues have also played a role in the inflationary picture. In Canada, employment is back to around pre-COVID levels but the overall statistics mask shortages in certain occupations. The structure of the workforce has changed and while the likes of business and finance have prospered, the sales and service industries remain badly under-staffed and negatively affected by the onset of remote working. Many businesses have had a difficult time hiring enough workers to satisfy demand and some argue that government benefits have hardly incentivised people. Whether this reverts to pre-pandemic levels, time will tell.
“We tend to use [transitory] to mean that it won’t leave a permanent mark in the form of higher inflation,” U.S. Federal Reserve Chairman Jerome Powell said during a congressional hearing. “I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”
From the markets’ perspective, this quote – said in December – laid bare the confusion. Both Canadian and U.S. central banks have explicitly allowed inflation to overshoot their 2% target to encourage employment levels but fears that this would spiral out of control into hyperinflation, penalising workers, savers, businesses and those who receive interest payments, have never gone away.
No one really knew whether the central banks’ understanding of “transitory” meant one month or one year but it’s now clear that supply chain issues have not subsided as quickly as expected and higher prices are not as temporary as first hoped. Policymakers, though, maintain this is temporary and expect the inflation rate to start turning back towards its target range as the year progresses.
What does inflation mean for interest rates?
The inflation-interest rate axis is a fundamental tenet of central bank policy. Typically, in a low interest-rate environment as we have now, more people are able to borrow more money. Consumers, therefore, have more money to spend, the economy grows, and inflation increases. When interest rates are increased, consumers tend to save because returns from savings are higher, less disposable income is spent, the economy slows and inflation decreases.
Getting the balance right between the two allows the economy to grow successfully. With inflation persisting in recent months, speculation is therefore rife about when central banks will start hiking rates. Wait too long and inflation spirals out of control, raise them too soon and the economic recovery (and job gains) will be stymied, potentially causing stagflation (slow growth, high unemployment and inflation) and even a recession.
Both the Bank of Canada and the Fed have already signalled they are close to hikes by beginning to taper off the stimulus programs that protected their economies during COVID. Analysts’ outlooks have now reached fever pitch with the likes of J.P Morgan forecasting a 0.25% rise in January and up to four more through 2022. South of the border, Fed officials are making increasingly loud noises that its first hike could arrive in March.
Naturally, this has put investors on red alert.
Martin Pelletier, a Portfolio Manager at Wellington-Altus Private Counsel in Calgary, told Wealth Professional: “The traditional 60/40 portfolio is being challenged because if there is potential for rising rates, which I think there is, especially if inflation continues to run abated, then you’re going to see interest rate hikes and you could lose a lot of money on your bonds.
“Bonds are not as safe an investment as they used to be, especially offsetting equities. You could see a market correction, and bonds go down alongside equities.”
While fixed income’s lack of appeal may lead investors to take on more risk in the equity markets, the value of a good portfolio manager is in analysing stocks and bonds allocations and knowing what areas will be hurt by, or benefit from, a sustained inflationary period.
Some tech stocks, for example, will be able to weather the storm better than others, while the likes of agriculture and gold typically do well at the beginning of this period but not as well towards the mid and later stages. Value stocks, out of favour for more than decade, are widely viewed as more resilient to inflation.
There are opportunities, therefore, across the energy, utility and power stocks spectrum for the discerning investor. Oil and gas producers, for example, often benefit because the boost in revenue from rising prices more than offsets inflationary increases in labour, materials and fuel costs.
Dillon Culhane, Equity Analyst at AGF Investment, believes that the better-positioned producers tend to be more cost-efficient, with locked-in service contracts and/or low decline rates on production helping drive lower capital re-investment. He also highlighted that regulated utilities stocks should hold up relatively well since they can pass on higher costs to customers via rate increases
If stagflation becomes a realistic threat, a large portion of energy demand can still be relied upon, like power, heat, and petrochemicals. This scenario is when tilting your portfolio becomes vital in protecting capital.
Another area of interest for investors in an inflationary environment is financials, which housed some of the strongest performing stocks of the past 12 months. If the benchmark rate rises, as forecast, life insurers and banks are well positioned. The former because the value of the reserves they require falls due to a higher rate of compounding. In addition, the before-and-after difference can then be the released into earnings. For the banks, higher rates mean expanded margins, although this can turn into a negative if really high interest rates, which still appear a long way off, cause a slowdown or contraction in the economy.
We stand, therefore, on the precipice of a run of interest-rate hikes as the Bank of Canada and the Fed attempt to get inflation numbers under control and tighten up the economy. Their success – or otherwise – will be watched hawk-like by the markets. Investors should be mindful of a market overreaction if there is any deviation from what’s priced in. As a result, volatility is to be expected and a solid investment plan is required.
For one industry insider, this is no flash point but the end of the disinflationary era, which few are ready to accept. Stocks that have thrived in a “lower-forever” environment, particularly growth stocks, are increasingly at risk, while secular headwinds for value stocks are waning. The conditions for a long period of higher inflation have arrived, according to Tyler Mordy, CEO of macro investors Forstrong Global.
He said: “We are not calling for rampant 1970s style inflation. Rather, a gradual uptick in overall inflation will glacially play out over many years. It will be nearly imperceptible at first.” Today’s investors, conditioned by 40 years of disinflation and declining interest rates, may take some convincing that the secular environment has changed.