Behind the buzz: what's driving inflation?

Rising inflation is one of the biggest challenges for investors today and it turns out that covid, climate change and the war on Ukraine have had driving roles in this.

According to Paul Loudon, Portfolio Manager at Walter Scott, these concerns have all placed pressure on energy markets, supply chains and logistics. For example, lockdowns have mean shortages in supply and labour forces and in turn driven higher prices to meet demands.

While Loudon views some of these challenges as transient – after all, as lockdowns end and ports reopen, supply issues may start to ease – this is also a concern dominating central bank activity. The question facing many central banks is how aggressively they should raise interest rates to manage inflation.

“The worry is that higher rates will really lead to a weaker economy and by design, they will dampen consumer sentiment.” 

Loudon cautions against short-term plays in this market.

“Over time, you’ve seen individuals throughout the investment world make bad decisions, selling out in times of maximum fear. Even if you make the first decision right, selling out at the start of a downturn; getting back in at the right time, is in our experience, incredibly difficult.”

He advocates a consistent investment approach across markets. For Loudon, it’s a long-term focus on quality businesses with characteristics like strong cashflow and pricing power.

In this interview, Loudon explores the drivers of rising inflation, the outlook for markets and investing in the current environment.

Key takeaways:

• Energy markets, supply chains and logistics are significant drivers behind rising inflation.
• For the inflationary outlook to change, investors can consider a combination of signals like increasing supply, lower energy prices or more people returning to the workforce.
• Investors should be wary of selling their holdings in times of volatility and consider their longer term strategy.

Edited transcript

What are some of the challenges facing investors in global markets?

It's clearly a volatile time in markets and investors are grappling with quite a few separate issues. I think inflation is probably the most obvious one, which is getting a lot of attention, and rightly so. There are several underlying causes of inflation, and we're just trying to get a handle on all these different causes. I think first and foremost, we've seen a huge amount of disruption in energy markets. So years of structural underinvestment in energy have really left a shortage of supply. And then that's been compounded with obviously the invasion of Ukraine by Russia.

So that issue there is, first and foremost, getting a lot of attention. You've also got other inflationary dynamics at play in the logistics and supply chains around the world. So lockdowns, the mismatch between supply and demand, really the shift from services to goods, all of these factors are really exacerbating these supply chain issues. So yeah, lots to grapple with at the moment. 

How are supply chains affecting inflation?

There are certainly some transient short-term issues that are impacting supply chains and leading to this inflationary environment. And in many respects, we do see the avenues for these issues to resolve themselves in time. So as economies open up, as lockdowns ease and as more supplies broaden stream, there's definitely a sense that supply-side should work itself out. 

However, clearly, with inflation rising, central banks are becoming far more aggressive in trying to tame that inflation. What they're really trying to do is to prevent inflation from being written into labour contracts, which would be a lot more of a structural issue. So we want to see that entrenched inflation is tamed. And therefore, clearly central banks should be more aggressive. So the worry is that higher rates will really lead to a weaker economy. And by design, they will damp in consumer sentiment, and therefore, demand might be more of a structural nature. 

Which trends are transitory and which are here to stay?

There are a number of different drivers of inflation as we've talked about, and we really need to assess them on a case by case basis. So starting with energy, are we seeing energy prices starting to come down, more supply coming to the market to offset the challenges in Eastern Europe, for instance?

If you look at the logistical supply chains, are we starting to see the number of container ships backed up in ports starting to come down, for instance? The other kind of issue like the labour supply. We've had this great resignation. Do we start to see a bit more slack in the labour market with more people coming and trying to get jobs, and returning to the workforce? So on a case by case basis, we'll look at the individual data points because it's such an all-encompassing issue with multifaceted dynamics. It's hard to have a single metric in mind. So we'll have to just watch it all very closely.

Is now a time to stay fully invested?

We definitely think staying invested is the right approach. I think that generally speaking, over time, you've seen individuals throughout the investment world make bad decisions selling out at times of maximum fear. And even if you make the first decision right of selling out maybe at the start of a downturn, getting back in at the right time is, in our experience, incredibly difficult.

Now, a select few individuals might have the ability to do that. We wouldn't say that we do, and most people don't. So we think investing in quality businesses that are increasing their intrinsic value over time, getting better, getting ahead of their competition, and throwing off lots of cash, will always stand you in good stead over the long term.

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