Inflation stays top of mind for investors
APAC Strategy Team
Summary: The four-decade high in U.S. March CPI of 8.5% y/y may be close to a high, and core demand is likely on course to soften as Russia/Ukraine conflict dampens demand alongside Fed’s tightening. With commodity prices off their highs and freight rates for shipping and trucking pulling back lower, there are signs that inflation may be peaking. But there are new concerns from food prices, services inflation and deglobalization, suggesting the pace of moderation will be extremely slow.
Eroding consumer sentiment, but pricing power intact
The rampant inflation has undoubtedly weighed on consumer sentiment. University of Michigan consumer sentiment on year-ahead inflation expectations has more than doubled, as confidence about the general outlook has slipped nearly 40% from normalized pre-pandemic averages. In fact, inflation expectations for the year ahead are now at record highs, while consumer sentiment is as weak as the early recovery from the Great Financial Crisis. As food prices rise, further erosion in consumer sentiment is likely to be seen.
But thanks to savings and pent-up demand, small businesses are still generally able to pass on the rising costs to consumers to preserve their margins. The National Federation of Independent Businesses (NFIB) survey reported that cost pressures are the biggest issue for small businesses and, for now, they are able to pass them on to customers. A net 72% of the respondents in the March survey (up from 68% in the prior month) said they raised prices over the past three months, with a net 50% expecting to raise prices further. This means significant pricing power for small businesses is still intact.
Food prices will be the next big mover
While concerns around energy prices have likely peaked, it is still too soon to make assumptions of a peak as the war in Ukraine continues and China’s lockdown measures continue to disrupt supply chains. Still, surging food prices have become the bigger headache for now with disruptions in grain supplies from Ukraine as well as unfavourable weather conditions. Food PPI is also highly correlated to energy PPI.
Focus on services inflation as borders reopen
Inflation is now rotating from goods to services. Strong inflationary momentum in some services categories such as car rentals, airfare and hotels suggest appetite for spending in reopening categories is gaining further momentum. Meanwhile, the pandemic has shifted expenditure patterns in favor of medical care, and that will continue to be a persistent source of services inflation.
Deglobalisation will result in medium-term inflation
The disruption to supply chains started with the US/China trade war and intensified by the pandemic. Now, the sanctions targeting Russia only exacerbate the underlying fragility of global trade. This is the reverse of the pre-2008 trends of technology innovation and migration of goods production to low-cost countries that were the structural forces behind persistent price deflation. The current focus on building shorter, diversified and de-globalized supply chains, an outcome of tech nationalism, the pandemic and geopolitical risks, means more onshoring and near-shoring is in the cards, and this will likely raise costs and add to inflationary pressure.
What this means?
While headline inflation may be peaking soon, it’s still more important to watch the pace of moderation from the peak. Unfortunately, the rhetoric of higher-for-longer has gained more weight and a reversal back to the Fed’s inflation target can take considerably longer. Take into the mix, a prolonged war, sustained disruptions from China and still-tight labor market.
This sustained high-inflation environment would likely continue to aid energy stocks against technology, particularly as the Fed stays on course to raise rates. Energy stocks also remain supported by years of under-investment in the physical world, and it is time to re-look into pure equity portfolios and consider exposure to commodities.
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