The inflation debate watchlist for investors

Headline monthly consumer price index (CPI) figures are not enough to tell us if inflation will linger beyond the coming months. The pace of economic recovery and the jobs market shifting gears are the real triggers investors should be watching out for.

Equity markets watch inflation carefully. Investors generally see moderate and stable rises in inflation as a positive indicator of economic growth. Sharp and sustained rates of inflation growth can rattle markets, as investors fear unexpected upward pressure on interest rates and increased costs for businesses and consumers. It comes as no surprise that the United States’ (US’) largest inflationary surge in 13 years has brought about the debate: is inflation transient, or is it here to stay?

The US Federal Reserve is holding firm on inflation being transitory. Minutes from its June meetings show The Fed expects elevated inflation for the remainder of the year before it moderates, on the view that the supply chain disruptions and bottlenecks triggering inflation will be temporary. The test of this position will be if we move from the rarer cost-push inflation, which we are currently experiencing, to demand-pull.

Inflation is driven by imbalances between supply and demand, and cost-push inflation encompasses the supply side – that is, how much it costs to supply goods to a market. Cost-push inflation occurs when production, labour or materials costs rise, and businesses have to pass those costs onto a consumer. It is typically caused by temporary and disruptive events, such as the current semiconductor chip shortages, skyrocketing shipping costs and supply chain bottlenecks. Labour shortages are so pronounced in the US that major restaurant chains have raised hourly wages and offered bonuses to attract workers.

Demand-pull inflation occurs when production of goods and provision of services is outpaced by consumer demand. If on aggregate an economy’s supply cannot keep up with its demand, the prices of goods and services will rise. This is often described as ‘too much money chasing after too few goods.’ Demand-pull inflation typically occurs when the employment market is at, or edging closer to, full capacity. The state of the jobs market is the single-most important watch point of all for The Fed before it adjusts its emergency settings.

Effectively we are now watching a race between supply chains normalising and gross domestic product (GDP) coming online. With the former widely expected to occur over the coming year, our focus is on monitoring inflection points in the latter. This demand-pull inflation is what generally triggers a policy response, such as higher interest rates. By current measures, demand-pull inflation could kick in by the end of the year, but the next few months will provide more clarity.

As we have said before, nothing will be more important this financial year than being ahead of the curve with these inflection points. The market narrative in FY2021 was one of easing and highly supportive financial conditions. FY2022 is on track to see tapering and pulling back monetary policy settings, as economies continue their push to normalise.

The composition of returns in this kind of environment typically favours cyclical stocks, such as financials and energy, because of their exposure to real GDP growth. Within these sectors we are focusing on quality, cash-flow generative companies. Conversely, valuations for growth stocks in this environment are likely to fall as they are reliant on easy money rather than a strong, cash-flow generative business model.

There may be temporary pain in local markets as the Delta variant outbreak continues, but globally normalisation is edging closer. We think it is critical for investors to position for this inevitable shift in the market narrative, to capitalise on the opportunity for outperformance. 

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