The unexpected cost of inflation

Inflation is in the mind of everyone, but what might its unintended consequences be and how do you position for them? These are namely 1. Political instability 2. Unsustainable earnings 3. Overconfidence (highly leveraged Companies in in a rising yield and lower growth environment).

1. Political implications

Rising inflation is not too much of an issue when households have a lot of savings but as these dwindle, they become less relaxed and start to wonder how they can pay for their transport bills, groceries or kids’ activities if prices keep rising. Anger slowly and steadily builds as wage growth is often barely keeping pace with inflation. This has repercussions on the political landscape as some ask for a more orthodox monetary policy and less fiscal spending. In the US, the majority in the House could be at stake in the midterm elections, likely forcing a fiscal contraction if the Republicans win. In an economy that runs hot, this is not necessarily a problem and will lighten the pressure on the Federal Reserve to tighten monetary policy. In Europe, however, the ECB is playing a dangerous game betting on its credibility when the housing market is extremely expensive, flushed as it is with cheap liquidity.

2. Unsustainable earnings

Earnings expectations are viewed by sell side analysts as falling below the 10% range in terms of growth globally next year, especially in Emerging Markets. This, however, assumes that consumers don’t have an inflation shock. This seems already the case in the United States according to a poll citing inflation as a key concern in a Wall Street Journal poll (8/12/2021). As savings remain high, inflation is not yet impacting consumption much, but as savings ebb, consumers are likely to become increasingly price sensitive if their wages don’t keep up. This is likely to be the case for many working in mature sectors. It is one thing to hire in an emergency and try to retain staff that quits, but companies becomes increasingly unwilling to raise wages if they can’t get the traction they expect from consumers in terms of higher prices. It is a classic chicken and egg problem: who has the pricing power – consumers or employers? That largely depends on how tight the labor market is. The longer we wait and the Fed fails to act, the more consumers will ask for higher wages leading to a wage/inflation spiral.

3. Overconfidence

With strong but slowing demand and an easy ability to mark-up prices, companies can become overconfident and start borrowing for investments which might not pan out, since demand is likely to slow down structurally in the coming years on the back of ageing and many standing on the sidelines of the economy. In other words, people are not paid enough and some of the reason is that productivity is not rising fast enough. Overconfidence, often referred to as hubris, is a problem identified in management sciences whereby those leading companies fail to use all available resources to come to a rational decision. In this case, we see three potential ways that companies might misread the economic transition we are going through 1. They assume we will return to the pre-covid-19 world 2. They misunderstand the shift in power between employers and workers 3. They misread the future because it is frankly fairly difficult to assess and they may fail to see structural forces emerging such as ESG/disruption technologies (e.g. AI). Knowing which is which is a key quality of any decent equity analyst and portfolio manager.

What does it mean?

The law of unintended consequences and Black Swans as we saw with the Omicron variant suggest holding some assets as safe havens against the unknown. Examples of this are short-dated leveraged Covered Bonds.

Note: Rising productivity in theory means higher real wages but gains in productivity generally favor equity owners except when the labor market is tight and labor costs sometimes catch-up. Productivity should rapidly increase in the coming decades as the inefficient service sector transforms as the manufacturing sector once did with automation, outsourcing, AIs et al. This process driven by new companies and old ones mutating is steadily accelerating and while its’ equity market may suffer sudden stops due to excessive optimism, it is one of the secular trends to latch onto – Disruption technologies are one of the key pillars of the future.

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