What goes up, must come…

Inflation is back in the news again and I thought it would be useful to explore the risks of inflation and its impact on your portfolio. So, what is inflation? Generally speaking, when economists and policy makers refer to inflation, they are invariably speaking about price inflation. That is the general increase in the level of prices of goods and services. Back in university, we also learned about monetary inflation which is an increase in the money supply (M1 in the US). But for this article, I am referring to price increases.

COVID-19 has had an enormous impact on economic activity around the world. Every country is unique in how they have handled it, and I am not sure if any one country has done it “right”. That aside, one of the things that can be a catalyst in rising prices, inflation, are supply shocks. It is unlikely to read an economic or financial article right now that is not mentioning the shortages or blockages of goods movements worldwide. For instance, WTI (West Texas Intermediate) started this year at roughly $47.62 per barrel and is currently around $81.93 per barrel according to Bloomberg as of 9 November 2021. That alone shows an increase of circa. 72%.


https://finance.yahoo.com/chart/ as of 9 November 2021 at 07:00 GMT

While oil alone doesn’t explain the general rise in prices, it certainly a very big factor. Oil is an input into a great many goods including transportation fuels, heating and electricity generation, feedstocks for making the chemicals, plastics and other synthetic materials in many items humans use. Oil has a very big impact on developed industrialised countries like the US and Europe/UK.

Based on the above, we can look forward to a much more expensive upcoming holiday season combined with slower shipping times. Why? Because of the increase in oil, buying bananas will be more expensive due to the higher shipping costs for freighters, railroads, and lorries. There was/is a huge pent-up demand for many goods and services during the pandemic. Sometimes, it is hard to remember that many countries still have very strict travel policies and even movement of human capital. Moreover, many countries are still in the early phases of dealing with COVID-19 and some haven’t even begun large-scale vaccination initiatives. Therefore, this scatterplot of countries, all of which are at different points of recovery, lead to a dislocation of supply of goods and services. The real question being debated today amongst economists and central banks is whether or not inflation is transitory, or more alarmingly, structural. For instance, will the wage pressures persist, or will they level off at some point?  The Fed has consistently stated that inflation appears to be transitory and will moderate in the second half of 2022.

How does inflation impact investment portfolios?  It has a major impact on many different sectors.  However, one of the big beneficiaries of inflation are those companies with strong balance sheets such as value companies. Sectors that historically performed well during inflationary periods are energy companies, industrials (heavy machinery, building products) and materials or companies that provide commodity related materials.  Other areas that tend to do well are physical gold, real estate, and inflation-protected bonds.

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