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What you need to know about inflation and why headlines are likely overblown

A professional using a laptop with a pile of loonies in stacks big to small.

Inflation is once again top of mind for investors, economists and central banks. In Canada, inflation (the Consumer Price Index – which I’ll explain later) rose 3.1% year-over-year in June.1 Similarly, the U.S. saw a jump of 5.4% over the same time frame.2

So, what is inflation? Is it good or bad? What does the current situation mean? Will inflation continue to rise? Should we be concerned? How does this impact investment portfolios? In this article, I’ll explain.

What is inflation?

Put simply, inflation is the rate at which prices increase over a period of time. Another way to look at it is the rate at which the purchasing power of your money decreases over time. Most commonly, inflation is quoted as an annualized percentage measuring the change in the price of a basket of consumer goods and services – the Consumer Price Index or CPI.

Is inflation good or bad? Since inflation erodes the purchasing power of your money, it’s understandable to think that it is bad. However, overwhelming evidence suggests that a moderate amount of inflation is good for the economy – it encourages spending, investing and growth. It’s why the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) adjust policy to target 2% inflation over the long term. With that being said, deflation (decreasing prices over time) and hyper-inflation (out-of-control price increases) are associated with economic distress.

Why is inflation important? Understanding inflation is important because it impacts the real value of things – your money, the price of goods and services and even your investment returns (your investment return needs to exceed inflation if you want to maintain or grow purchasing power). Beyond that, it can be a contributing factor to economic conditions and can influence policymaker decisions.

What’s causing the uptick in inflation right now?

The short answer is a combination of base effects and demand and supply imbalances brought about by the pandemic. These have manifested across different parts of the economy and markets and at different intensities. Supply chains, buying behavior and employment levels (and much more) have all been disturbed since the onset of the pandemic.   

The CPI measures above compare prices from June 2020 and June 2021 – when the world was in the midst of restrictions and lockdowns versus where we are now in the recovery. Low or falling prices this time last year are the base to which changes in prices this year are being compared. This is what is referred to as base effects, where lower than average prices that simply revert to average prices, looks like above average inflation. This effect is temporary.

On the demand side, we’re generally seeing demand for stuff increase as people are looking to buy things and do things they couldn’t before. In other words, deferred spending is being pushed into this period. This is also likely to be temporary as pent-up demand from the pandemic is exhausted.

On the supply side, producers, manufacturers, distributors and retailers alike may still be wrestling with shortages, bottlenecks, higher transport costs and delays. The question becomes, are these supply constraints temporary or structural? On balance they appear temporary. The pandemic created uncertainty around the business cycle, making it difficult for companies trying to determine appropriate production and staffing levels. This is particularly true for services that require in-person interaction.

At the manufacturing and industrial level, labour shortages due to quarantine or illness can cascade through the supply chain. A factory that makes an input needed for another factory can lead to shortages down the production line. Even in logistics, a shortage of people to unload ships has led to record backlogs at the Port of Los Angeles. Ships are anchored off the cost of California and containers full of goods are trapped, resulting in rising shipping costs. While this illustrates how complicated global supply chains are, history shows that such shocks eventually pass.

This all adds up to higher prices, particularly for items most impacted by the supply chain disruptions. Used car prices, which were up 45.2% year-over-year in June, is perhaps the most extreme example of this.2 Rental car agencies shed inventory during the pandemic and are now scrambling to rebuild fleets as demand increases. At the same time, a global semiconductor shortage has limited new car production. This resulted in a surge in used car prices. But we’re already seeing the impact of that surge moderating in the July CPI data for the U.S.

Unfortunately, these imbalances don’t correct overnight. It’s going to take some time, but things will eventually settle. Demand and supply for personal protective equipment last year provides a good analogy. In March 2020, masks and disinfecting products were impossible to find and prices surged (with maximum purchase limits). Eventually, supply increased and everyone could get more than their fair share. Similarly, this current bout of inflation is widely seen as transitory.

Should we be concerned? It is something we are watching, but considerations that were in play prior to the pandemic that led to stable, low inflation (aging demographics, increased automation, etc.) are still in play. Some argue that the unprecedented monetary and fiscal support enacted by global policy makers to stabilize the global economy during the pandemic will lead to runaway, out of control inflation. We do not believe this to be the case.

Historical examples of extreme inflation have occurred when there are not enough goods to supply the economy – giving people more money won’t create more goods – it just means more money will chase the same amount of goods, forcing prices even higher. The policy response to the pandemic was the opposite of that – support was enacted to prevent a collapse in demand relative to supply which could have risked a deflationary spiral. 

At this time, our expectations remain that financial conditions will remain supportive and that inflation will remain elevated in the short term due to the imbalances. As things eventually settle, both the BoC and the Fed will start to wean support (rates will start to rise, asset purchases will decrease) and inflation should settle around 2% (normal and healthy inflation).

How is MD positioned?

Given our thoughts on recent inflation activity, it doesn’t mean we’ve been sitting idly by. Many of our portfolio decisions have been influenced by changing inflation expectations.

In the fixed income portion of our portfolios, we were tactically short duration (we significantly reduced our sensitivity to rising interest rates) earlier in the year. The thinking was that inflation expectations would rebound materially as effective vaccinations made the rounds and the global economy reopened.

Later, as inflation expectations increased (we saw measures higher than pre-pandemic levels in the second quarter), we took a more neutral stance on interest rates.

More recently, we’ve started to move towards a short duration position once again to manage the risk of higher interest rates. While we don’t think the current bout of inflation will trigger policymakers to raise rates now, we certainly believe that the recovery will continue and that global economies will continue to move towards fully reopening. Given that scenario, interest rates should at least move marginally higher and bond yields lower.

So overall, while interesting to observe and analyze, inflation is not a major red flag at this time. For more information about inflation, the economy or your portfolio, please contact your MD Advisor*.

1 Statistics Canada – Consumer price index portal

2 U.S. Bureau of Labor Statistics – Consumer price index news release, July 13, 2021

*MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.

About the Author

Mark Fairbairn, CFA, B.Eng., is a Portfolio Manager with the Multi-Asset Management Team of 1832 Asset Management L.P. He is responsible for the non-North American equity funds and pools as well as the currency overlay program within the equity funds.

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