There are several reasons why we believe inflation will turn out to be stickier than what the market and the Fed believe. Fiscal stimulus cannot meaningfully be reduced as it will weaken the economy into a 2022 US midterm election which is not a political option for the Biden administration. It is much more likely that fiscal deficits will remain higher for longer adding long-lasting fiscal impulse keeping GDP above its potential for longer than expected. If the transfer income schemes remain then businesses relying on low-wage workers will have to bid up wages to get them back into the labour force and hike prices to offset the increased wage costs. Lennar’s Q2 earnings yesterday was quite interesting in that the US homebuilder is lifting its fiscal year guidance for gross margin to 26.5-27% from previously 25%, indicating that the homebuilder easily can pass on rising input costs and expand margins. This is a sign of strong demand and excess buying power. In other words, the market is not in equilibrium yet and prices can rise further.
Green transformation and the capex drought
The potentially biggest driver of inflation going forward will come from the green transformation under an accelerated decarbonization policy in the US, Europe, and China. It is the biggest physical transformation of our society since WWII and will require enormous amount of capital and physical resources putting immense pressure on our technologies and resources. A few clients have recently shot back at our view saying mining will just expand capacity because higher prices incentivise them to expand. This sounds in theory and is likely also the long-term reality, but in the short-term the reality is very different. As the chart below shows, capital expenditure in the MSCI World Materials and Energy sectors (covering global mining, metals, and energy industries) has dropped 65% from the peak in real terms (adjusted for inflation) and is now at the lowest level since 1997. Our fiscal stimulus and green transformation policies are driving enormous demand which is not being met by expanding supply. As Glencore’s CEO said in May, copper prices have to rally 50% for supply to meet demand, which feed through into prices of housing, electrification and EVs ending up with higher consumer prices. This is exactly why the Fed’s econometric models will fail at model the regime shift on inflation. The green transformation and subsequent commodity rally are driven by a political choice to change society and thus the driver cannot be captured in a model until the autocorrelation in inflation figures sticks, but at that point inflation is already out of the box creating new dynamics in consumer behaviour etc.