RICARDO SMITH: Never waste a good inflation print

At the height of supply side shortages and elevated inflation last year, a growing narrative — most probably driven by elements of fear coupled with recency bias — was that inflation was out of control and would not be contained. That has proven not to be true, particularly when looking at the US and SA. At their recent meetings, both the Federal Reserve and the Reserve Bank’s Monetary Policy Committee (MPC) kept their interest rates unchanged. Yet inflation continues to be stubbornly high in other economies, including the UK and parts of continental Europe. That begs the question what lessons can be learnt?

A starting point is understanding the drivers of the recent bouts of inflation over the past 18 months. The main contributor was the recovery from the Covid-19 pandemic, with demand for goods exceeding supply, and supply-side shortages worsened by business liquidations and closed trade channels during the pandemic.

Then came the Russia-Ukraine crisis. Both countries are major suppliers of commodities — in particular Russia, which contributed more than 10% to global Brent crude production. That saw commodity prices surge, especially  energy. Meanwhile, China, the world’s manufacturing hub, was in hard lockdown due to its zero-Covid policy, further adding supply side disruptions and input cost pressures.

Normalisation is the norm

Many of these factors have now subsided. Commodity prices have eased significantly, though with some recent rallies in oil as Opec members seek to cut production. China has been steadily opening up their economy, albeit with slightly disappointing growth, and there are signs of easing demand and supply chains are steadily being rebuilt. Furthermore, base prices have significantly adjusted, easing prices pressures.

Monetary policy isn’t the only tool

However, not all economies have participated in the cooling prices. The UK and Europe’s proximity to Russia, and their reliance on Russian energy in particular, has added to stubborn inflation in the region. Meanwhile, North America is largely self-sufficient on the energy front contributing more than 20% to global crude production. The US has therefore had a couple more levers to pull, including supporting their local energy sector, ramping up production and tapping into their fuel reserves.

Monetary policy is essential in controlling demand-side pressures. However, supply-side pressures require fiscal policy interventions. Though the US has continued to run a fiscal deficit, authorities have attempted to narrow it over the past 18 months and part of their spending has been directed towards easing their supply side issues.

Policy alignment is crucial

At times, UK fiscal policy has seemed disjointed from their monetary policy efforts, often working against each other, with contradictory statements between the Bank of England (BOE) and the government, combined with a couple of cabinet reshuffles and changes in prime minister.

Policy certainty remains essential

Economic participants need to be clear and understand where you are taking them. Unfortunately, the UK has not fared well on this front either. The above-mentioned factors and the effects of Brexit on uncertainty of trade, the pound and import costs that continue to linger have added inflationary tailwinds, spurring it higher and stickier for longer.

Confidence is key

Containing inflation is as much about the technical economic aspects as it is about setting psychological expectations. Inflation expectations drive what is commonly referred to as second-round effects. Once the initial shocks around Covid, Russia-Ukraine and supply side issues have subsided, to what extent do economic participants believe that inflation will be contained? That will determine wage increase demands, input cost pricing, margin protection and pass-through inflation to consumers which will render inflation stubbornly elevated.

Though the Fed, and the MPC locally, faced criticism of initially underreacting when inflation was rising and then overreacting once inflation was elevated, their strategy to front-load rate hikes as opposed to a more steady path seems to have paid off. That achieved two things. The first was to get the effects of the rate hikes in the system faster as they tend to lag monetary policy implementation by a couple of quarters. The second is that it sent a clear message that the reserve banks were serious about containing inflation and therefore more likely to achieve that objective.

Though the end goal may be the same, the steadier path chosen by the BOE, when facing unprecedented levels of inflation takes too long to make a material economic impact. In the meantime confidence that inflation will be contained is lost, which leads to upward wage and price revisions. This becomes a self-fulfilling prophecy.

There are always opportunities in the market

As we reach what markets anticipate being the peak of the rate hiking cycle, at least in the US and certainly in SA, tech stocks such as Amazon, Alphabet, Micron Technology, Apple, Microsoft and Netflix have continued to perform well, delivering high double digit returns to our global equity portfolios.

Over the long term we continue to like these counters, but are wary of near-term recession risks given the aggressive monetary tightening we have seen. We have therefore taken some profit, allocating to some of our more defensive companies in healthcare such Bristol-Myers, Johnson & Johnson, AbbVie and Medtronic.

Despite additional challenges locally, including load-shedding and rail issues, counters stocks as Bidcorp and Bidvest, as well as Aspen, have added great performance to our local equity portfolios.

• Smith is chief investment officer at Absa Global Investment Solutions, Stockbrokers & Portfolio Management.