The US Federal Reserve’s (Fed’s) message on inflation has changed. Fed Chair Jerome Powell recently characterized supply shocks, bottlenecks, and disruptions as “frustrating” and as “holding up inflation longer than we had thought.” The Fed’s mea culpa is small consolation for investors whose portfolios have not been positioned optimally for a longer-than-expected period of higher inflation.
The question now is: Has inflation already peaked? The short answer is no, in my opinion.
The systemic nature of supply shocks
Inflation is being pushed higher by three catalysts — labor, raw materials, and transportation — that are interrelated in ways that create longer-lasting systemic risks for the economy. (I use the term “systemic” because of the parallel to systemic financial risks.)
Regarding supply-side inflation, it’s not just semiconductors that are in short supply, but also plastic, resin, copper, and steel. Plus, the container ships used to transport the hardware are backed up at US ports. And a scarcity of truck drivers and port workers means that getting the finished products to stores is delayed. Thus, it would seem that the ongoing bottlenecks could take at least another year to resolve.
Why supply-side inflation could persist
- Labor: US wages are up 4.6% over the past year (as of September 2021) amid a tight labor market. Indeed, Figure 1 shows the highest job “quits rate” in 20 years, suggesting workers are pretty confident in their ability to find other employment. This is a good predictor of potentially even higher wages going forward. Meanwhile, some 5 million people have left the labor force during COVID, half of whom are age 65+. Lower immigration rates and lingering health concerns have also shrunk the labor pool. Finally, strikes at large corporations across industries reflect a shift in power from management to labor, which could put more upward pressure on wages.
- Raw materials: The price of oil is up 80% this year. Other commodities, like metals, are up around 30%. This is partly demand-driven as the global economy reopens, but another contributing factor is that commodity supplies are constrained due to much lower capex and greater capital discipline after a period of overinvestment and underdelivering to shareholders. Also, decarbonization is raising the “breakeven” price at which companies can increase production economically. The result: shortages of everything from computers to cars, canned goods, and clothing!
- Transportation: The average price worldwide to ship a 40-foot container has quadrupled over the past year.1 Bottlenecks at temporarily shut-down seaports and a flurry of congestion at rail terminals, warehouses, and distribution networks are extending the time it takes to move goods from China and other Asian ports to the US. Shortfalls may be peaking though, as some labor conditions ease and more transportation assets come online.
- Housing: Could housing become the fourth prong of higher inflation? Quite possibly. US home prices are up around 20% over the past year, while rents are up around 10% nationally.
- Seek inflation protection for your portfolio. Effective inflation hedges may include commodities, certain equities, and real assets:
- Commodities exposures in natural resources and industrial metals tend to be the most inflation-sensitive assets.
- Consider more value-oriented, cyclical equity sectors, such as energy, financials, materials, and some industrials.
- Real assets and some equity real estate investment trusts (REITs) could provide another means of defending against inflation risk.
- In fixed income, keep it short. While I still expect high-quality bonds to confer diversification benefits in the event of an equity sell-off, shortening fixed income duration and adding shorter-duration Treasury Inflation-Protected Securities (TIPS) exposure might make sense.
1Source: Drewry Shipping Consultants