Ed Smith, Co-CIO of Rathbone Investment Management, examines why the inflation rate is higher than even the most hawkish forecasters expected this time last year and looks at how investors might position for the year ahead.
- For energy to continue to make the same contribution to inflation for the remainder of the year as it is right now, the oil price would need to almost double again from here. With demand growth moderating, US shale oil rigs coming back onstream, and OPEC nations beginning to act to add supply too, this seems highly unlikely.
- We see inflation falling back steadily this year, and then quite sharply in the spring of 2023, when energy price rises rotate out of the annual rate of change.
- Those two-year rates are still below 2% in the Eurozone, in annualised terms, in stark contrast to the UK and US. It potentially puts Europe in something of a sweet-spot, which attracts us as investors.
The following Q&A will cover:
- Why is the inflation rate higher than forecasters expected?
- Could war in the Ukraine alter our view?
- Inflation elsewhere in the world. Is the British experience unique?
- Concerns about wage growth spiralling higher;
- Do we think a repeat of the 1970s is likely?
- BoE and Fed response to inflation through 2022;
- Does the BoE increasing the base rate really have much impact on reducing inflation?
- How could investors position for the year ahead?
1) Why is the inflation rate so much higher than even the most hawkish forecasters expected this time last year?
Inflation has risen to a new 30-year high, coming in a fraction above consensus in January with an annual rate of 5.5% (5.4% expected). Of course, with the 54% increase in the energy cap, rising petrol prices and the normalisation of VAT in restaurants, UK consumer price inflation is on track to match US CPI by reaching c.7.5% in April.
It is largely explained by three reasons:
- a larger-than-expected rebound in global energy prices (energy price inflation caused six-tenths of the increase in developed market inflation last year);
- persistently unusual consumer spending habits caused by COVID (spending more on goods than they are on services);
- and this, against COVID-related and Brexit-related supply-chain disruption
Understanding this is crucial when it comes to assessing the probabilities of different inflation outcomes in 2022 and 2023.
For energy to continue to make the same contribution to inflation for the remainder of the year, the oil price would need to almost double again from here. With demand growth moderating, American shale oil rigs coming back onstream, and OPEC nations beginning to act to add back supply too, this seems highly unlikely.
The normalisation of consumer spending away from goods and back towards services begun in the second half of last year, paused in the face of Omicron, but now looks to be gathering pace again. High frequency datasets in the UK, such as those that look at restaurant reservations or Pret-a-Manger sales have rebounded very strongly in January, while retail sales growth looks more subdued. Goods inflation excluding energy is normally not much above 0% – largely due to technological innovation. It is highly unlikely that the price of services will rise by the same amount that goods prices rose over the last year, and the normalisation of spending habits is likely to be significantly disinflationary.
Supply chain disruption also appears to be easing. The global price of microchips has fallen by 25% since last summer, while the cost of container shipping peaked in the autumn, despite China continuing with its zero-COVID policy. The latest business conditions surveys in the UK also indicate a significant easing of delivery time and input price pressures.
That’s why, in our base case, we see inflation falling back steadily this year, and then quite sharply in the spring of 2023 when energy price rises anniversary out of the annual rate of change.