Are we heading for inflation ?
We are living in exciting times. The huge developments in technology that makes our lives better, but this is accompanied by difficult and turbulent world events.
New technology typically leads to higher productivity which leads to greater supply of goods and services creating more competition in the marketplace. This leads to lower prices and a higher standard of living. However, it does not contribute to inflation because typically the quality of the goods supplied increases creating more choice in the marketplace.
But when productivity goes up, so does activity and this leads to people earning more money. With more money, consumers buy more which does lead to inflation.
However, we have also been living through difficult times: the covid pandemic, terrible weather and climate issues, and now a war in Ukraine. All this hampers supply levels, meaning consumers are paying more for the limited available stock.
So this type of inflation is not caused by the abundance of wealthy consumers, each feeling confident of their income so driving up prices. Instead, this is the sad sort, caused by restrictions in the supply of goods that consumers are already comfortable buying. This type of inflation is called stagflation, an increase in prices caused by a decline in volume.
What can the Fed do?
Stagflation creates a difficult decision for the Fed. With regular inflation, the answer is easy - increase interest rates to cut down the available money for consumers. But with stagflation, interest rate hikes don’t really solve the problem - they do not help free up the blockages in the supply chains. All it does is divert cash away towards interest payments, which can be a drag on the economy and add another burden on an already upset consumer economy.
Consequently, we see the Fed is talking up large interest rate hikes, but in the forecasted dot points, they are actually predicting only short term rises.
How does interest rates affect the market?
A rise in interest rates always pulls down the market because it increases the cost of capital for business. It also increases the opportunity cost for investment by providing a higher yield elsewhere.
Because interest payments accumulate over time, interest rates have a higher effect on low yielding growth stocks where investors expect their money back over a longer time horizon than on dividend paying value stocks where investors are looking forward to an immediate steady stream of dividends.
Consequently, we can see concerns of higher interest rates affecting companies like Tesla, Google and Amazon more than McDonalds and Caterpillar However, if interest rates hikes turn out to be more mild than expected, we may see a resurgence in these growth stocks going forwards.
How to spot inflation in the markets
The most obvious signs of inflation can be seen in the commodity markets. There are generally two types of commodities – long term ones like gold and silver where you can hang on to the commodity forever, and short term ones like corn, wheat, oil and gas where you expect to consume the commodity fairly rapidly.
By looking at the difference in how these to move over time, you can see the effects of inflation and interest rate expectations.
More obviously, there are also US bond rates that indicate how much interest would be expected risk free over different time horizons, 5, 10 and thirty years.
How about house prices
Houses are important investments in any economy. Higher house prices are obviously bad because it prevents young families from owning their own homes. By contrast rising house prices are good, as it shows an improving economy and the increased equity allows people to invest in projects and companies. The conundrum is that rising house prices usually leads to high house prices, and rather like eating good food, what’s nice today isn’t always good for you in the long run.
So overall, we can see there will be short term inflation, leading to a rise in interest rates to bring this under control.
However, due to the highly leveraged economy, we expect the interest rate hike to be short and affective by having an exacerbated affect on the economy. Although house and asset prices may fall in the short term, in the longer term we expect to see them continue upwards with an emphasis on longer maturing instruments like growth stocks, houses and long-lasting commodities.