Fund Manager Q&A: Inflation – 24th May 2022.

24th May 2022

Hannah Owen, Portfolio Specialist, and our Fund Managers Peter Quayle and Jonathan Wiseman discuss inflation.

Hannah Owen:

So Peter, let’s start with you. We’ve seen inflation in the UK hit 9% for April.

How does this impact your outlook for the UK Market?

Peter Quayle:

You are quite right, inflation in the UK is at a multi-decade high but I have to stress, it’s not a UK-specific phenomenon. Most regions across the globe are facing a fairly similar backdrop, as Covid and the induced lockdowns forced factories across the globe to close and suspend production. It’s as they come back online that they’re facing a number of bottlenecks such as the supply of labour, supply of raw materials or even shortages in ships and trucks just to transport the finished goods.

There are nuances from UK perspective, such as Brexit, but by far the biggest contributor to inflation more recently has been the large jump in oil and gas prices over the past 12 months. Initially both commodities lifted as demand bounced back as economies reopened after the Covid lockdowns and typically this type of imbalance would settle naturally as supply catches up. But given Russia’s invasion of the Ukraine, prices of both commodities have remained elevated and the price of oil and gas impacts us in many ways. It accounts for large proportion of the total cost to produce lots of everyday products such as plastics, household products, clothes, food, and to power and heat our homes. So from a demand perspective, spending habits were impacted during lockdowns, as services were unavailable, like restaurants and hotels, but as the economy has reopened spending habits have normalised, consequently the inflation we’re experiencing right now is driven by supply constraints and not excess demand.

We therefore believe that inflation expectations are too high and the market underestimates how quickly inflation will self-moderate, when last year’s lower base prices pass and the elevated prices become the base price.

So technically if the prices haven’t continued to grind higher, then they should just wash out.

As such, we believe the Bank of England will be cautious with interest rate increases and the threat to growth (like killing demand) is greater than the risk of inflation becoming unanchored in the long term.

Financial markets are expecting, and have priced in, aggressive increases in interest rates, but further interest rate hikes are likely to be relatively limited. This means market expectations for inflation and interest rates will need to be lowered over the course of the year, which is supportive for financial markets.

Hannah Owen:

Thanks, Peter.

And Jonny, as we’ve just heard from Peter, it’s very much a global phenomenon, this high inflation. How do you see this impacting our outlook for global markets?

Jonathan Wiseman:

Absolutely, Peter’s absolutely right, most of the inflation backdrop, even in the UK has been impacted by what’s going on globally, and principally, there are two factors at play here: in the past two years we’ve had two extreme events, the first one being the global pandemic, the second one clearly being the tragedy that is the war in Ukraine between Ukraine and Russia at the moment.

The way we view inflation globally and in the UK is very much the same; we’re not ambivalent towards what’s going on and the price pressures at the moment, but clearly what’s causing those prices to rise are very much what we would deem temporary effects and you know that plays into the hands of what central banks are doing at the moment – they’re not really raising rates as much as perhaps the broader market and economists are expecting, planning or largely expecting to have done. What they’re doing is taking a more cautious approach, a lower-for-longer sort of stance, and in our mind that is very, very much a sensible thing to do.

If you look further along the line, in 6 or 12 months’ time and see where inflation is at then – if you take the pandemic for example, the inflationary pressures driven by the pandemic were because most countries were offline, manufacturing basis were offline and supply chains were pretty much dried up. This was a supply issue not a demand issue, but artificially it looked like demand was higher than supply and you get that upwards price lift. As markets slowly come back online and principally somewhere like China, a large manufacturing base globally comes back online and slowly opens up, you’ll start to see those supply chains normalise and prices come down slightly.

Similarly with the war in Ukraine and Russia, we’re not agnostic to the fact that it is an absolute humanitarian crisis. It is horrendous, but from an economic perspective you’ve got two countries that are some of the biggest manufacturers, producers and distributors of the likes of corn and wheat, as well as oil and gas in the case of Russia

Clearly when you’ve got frictions, this is going to put a dent on those supply chains. Somewhere like Ukraine that produces wheat and corn can’t get that out to the broader market, and consequently you’ll see an uplift in prices of food like many people will be seeing in the supermarkets. On the flip side, once there is a resolution, which there will be at some point – it doesn’t look like it the moment, I can imagine, but there will be at some point – then those supply chains reopen and price pressures come down in terms of the food space.

Consequently, as a result of the war in Ukraine, there were many sanctions imposed on the Russian government, which has meant the supply of oil and the supply of gas has very much dried up to the West. Now in our mind whether there’s a resolution or not to the Russia and Ukraine war is largely irrelevant – not to make light of the tragedy that’s going on, but from an economic standpoint this is a redistribution issue. There is very much not a supply issue. There’s plenty of oil, there’s plenty of gas, and we’re already beginning to see that slow redistribution mechanism happen. Yes, the West may not consume as much but we’ve already got countries such as India, one of the largest populations globally and one of the largest oil importers globally, beginning to negotiate with Russia about consuming oil at lower prices from them. As soon as they begin to consume from Russia, that means the previous suppliers to India will be able to reallocate their resources elsewhere.

So, to sum up to the point in question – absolutely, it is a global phenomenon. We believe a big, big proportion of it is short-term. However, whilst we envisage inflation to come down from its current massive highs, because from an economic standpoint it very much isn’t sustainable, we do suspect and believe that it will remain slightly elevated for the longer-term. Just not at the levels that people are worried about at the moment, and certainly going into 2023, we envisage those levels will come off quite considerably.

Hannah Owen:

Perfect. Thanks Jonny, and thank you both for your time.