Where to invest if inflation takes hold
Will inflation be transitory or more long lasting? Right now, the jury is out, and only time will tell. But the signs do not look good due to surging energy prices, supply bottlenecks and worker shortages. My advice is to focus on high quality companies with real pricing power.
Inflation is the stock market’s current bogey-man and that’s because investors are doubting the US Federal Reserve Chairman’s April reassurance that triggers for the current bout of inflation would prove transitory.
Many in the financial press are describing the supply-chain bottlenecks as a veritable disaster that could worsen.
While all eyes are currently on the semiconductor microchip shortage threatening supply of, and driving up prices for, everything from new vehicles to laptops and headphones, an emerging crisis might also find its seed in the current aluminium market.
China is the world’s largest producer of aluminium and a power crisis there has resulted in rationing of power for many industries. The hardest-hit have been the power-intensive metals manufacturers including aluminium and magnesium. It takes four to six megawatt hours to produce a tonne of steel but 16 to 17 megawatt hours to produce the same quantity of aluminium. Consequently, China’s aluminium production has declined by 2.3 million tonnes since the power rationing began in September and production has been falling for five months. Consequently, prices have risen to the highest level in 13 years.
There is little doubt the cost of manufacturing everything containing aluminium, including passenger cars, power cables, window frames, household appliances, consumer electronics and bicycles, will rise compounding supply shortages already being endured by original equipment manufacturers, wholesalers and retailers.
Perhaps the real reason however, for the current shortage of manufactured goods supply, might just be Japan’s 1980’s fondness for the Just-In-Time (JIT) Inventory management system, since widely adopted by the rest of the world and now ensuring the None-in-Time supply of finished goods from furniture and cars to caravans, reinforced steel.
No matter. What’s done is done. Now the question is whether the higher prices will be passed on to consumers. Already the supply shortage has brought forward purchase intentions. Consumers are getting wind there’s a problem and are making their Christmas purchases well in advance. The competition among consumers for limited product is resulting in retailers raising prices. When an esteemed Barossa wine brand is reported to have sold out of a museum release of wine in three minutes, there’s no logical reason to believe they won’t raise the price next time.
Perhaps however retailers and suppliers will have to raise prices. Logistics is only one part of the supply-chain issue besetting manufacturers and besieging investors. The other is the labour market.
As we’ve previously observed, a labour shortage is driving wages up in some sectors here in Australia. That phenomena is now also being observed in the US and Europe. And while the long-term picture for wage pressures might be alleviated by the eventual return of immigration and massive investment in automation, the immediate impact of rising input costs for suppliers is higher prices for consumers.
One issue on everyone’s mind at the moment is whether the excess capacity thought to be available in the economy – which would render transitory current pressures on supplier costs and supply chains – is somewhat reduced by a permanent shift lower in the employment participation rate.
The US workforce appears to have shrunk since the COVID-19 crisis with many employees dismissed during the pandemic failing to return. It is reported there are some three million fewer workers participating in the US workforce than prior to the pandemic, which would suggest there may be less capacity. And of course, if a labour shortage remains persistent and workers don’t return to the workforce, salaries could remain high and bottlenecks tight.
If suppliers are forced to charge higher prices to fund higher salaries and reduced turnover due to restricted supply, and consumers, flush with higher salaries, continue to meet higher prices with unquenching demand, there might suddenly be some merit to IMF chief economist Gita Gopinpath’s early October warning of a “destablising wage price spiral.”
Such an eventuality would be a negative for equities requiring many other offsetting positives – such as faster earnings growth, analyst upgrades and/or expanding margins. The answer of course is not to forecast the participation rate or any other economic indicator. The answer is to remain in constant contact with the higher quality companies we own, and those we’d like to, ensuring they remain on track to meet earnings growth expectations or even exceed them.