Will Inflation Prove to be Persistent?

As Halloween approaches, our thoughts naturally turn to ghouls and goblins to scare friends and family. Markets have historically given investors a fright, and this year is no different with the re-emergence of one of the investing world’s biggest boogeymen: INFLATION.

Like the zombies that come out in late October, inflation looks terrifying, with consumer prices in August rising 5.3%, the fastest growth rate in 13 years. For investors - especially income investors - sustained high inflation can destroy the best financial planning because investment returns, and spending power frequently move in opposite directions. We would thus like the local forest dwelling soothsayer to peer into their crystal ball and ask: “Is the current round of inflation sustainable, or will the pressures fade like our fear of Halloween goblins?”

To answer this question, we need to know the source of this instance of inflation since not all inflation is created equally. The high inflation regime following World War II was caused by supply shortages, price controls, and a reallocation of resources from wartime production. The most recent period of inflation in the 1970s was triggered by rising commodity prices, especially energy. Conditions today are very different than the post war era or the 1970s. In these periods, real economic growth was structurally higher, the national net savings rate was higher, total debt was lower and the country was surfing the wave of strong demographics. Population growth following WWII was 1.6% per year, and the 1970s was 1.1%. Today, however, it has fallen to 0.5%. The strong population growth in the 1940s led to an annual growth in the population employed of 2.4% from 1966 through 1979 - double the 1.3% rate from 1951 through 1965. The national

savings rate in both the 1940s and 1970s was 9%, whereas today it is 3%. Lastly, nonfinancial debt in the system was below 150% of Gross Domestic Product (GDP) and today it is about 280% of GDP.

The higher debt levels, seen in the chart above, reduce demand which is disinflationary at best.

Despite the decline of the savings rate, deposits have grown faster than loans. The first chart below highlights the fact that deposit growth has exceeded loan growth since the 2008-09Financial Crisis, which has been magnified by the pandemic. This suggests that the credit creation has been impaired and the numerous stimulus programs are not having the desired effect of expanding credit, but rather the cash is being held in banks. The lack of credit growth contributes to the decline in the velocity of money, or the number of times a dollar is used to purchase goods and services in a quarter.

The chart below shows that the velocity of money has declined to near all-time lows, reducing inflationary pressures from the stimulus programs.

During the height of the pandemic oil and other commodities suffered steep price declines. It is partly due to this low base a year ago that inflation numbers are elevated today. In fact, about 60% of the increase in the consumer price index (CPI) in August was from energy and transportation commodities that make up less than 15% of the CPI.

Supply chain disruptions have also produced higher prices since fewer goods are available for purchase, therefore sellers are able to charge more. These disruptions are likely to persist through the end of 2021 and into 2022. However, in recent earnings calls, companies have stated supply chains are beginning to repair and should be back to near normal next year. Better functioning supply chains should reduce inflation pressures.

In addition to the problems getting goods to the end user, the pandemic contributed to a labor shortage which has pushed wages higher. Wage increases are sticky, but it is important to remember that wages would need to increase more than once or twice to lead to sustained inflation and continued big increases in wages are unlikely. Low population growth means GDP growth and therefore overall corporate revenue growth will be muted in the future, resulting in low wage growth and lower inflation pressures. On top of this, it is not higher wages that result in rising inflation, but unit labor costs. As the next chart shows, unit labor costs spiked following the end of lockdowns, but have declined to close to zero, easing inflation pressures. 

Unit labor costs include wages and productivity of workers. The more productive workers are, the lower unit labor costs to businesses, the lower inflation pressures. The chart above shows that unit labor costs change before inflation changes. It is likely inflation will begin to decline over the next several quarters as unit labor costs have plunged since the first quarter.

Conclusion

The recent rise in prices is cause for concern, and our outlook for lower inflation next year may prove incorrect. But we think the conditions for sustained higher inflation are not present. Low population growth, high debt levels, GDP growth that is structurally lower than in the 1940s and 1970s are not supportive of persistent inflation. It is therefore our opinion that the boogeyman of inflation is unlikely to be a threat next year or even over the next several years. It is likely to be uncomfortably high partly because of the level of inflation the past 10 years, and the declining inflation regime we have been in for 40 years. As with every forecast, though, we do reserve the right to admit we could be wrong, and inflation might well be more than transitory.

Clint leads the investment team covering Global Equities, and Fixed Income. He is involved in all aspects of managing client portfolios and has worked in the investment industry for more than 16 years with a strong track record of equity research, portfolio management, and client service. He received his B.S. in Mathematics from The University of Arizona and an MBA/MSF from the University of Denver Daniels.