Inflation: Newton’s Laws of Motion

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22/07/2021
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Inflation: Newton’s Laws of Motion

Sir Isaac Newton was credited with many things and has inspired many. Perhaps the most famous of his achievements outside of mathematics is simply stating that what goes up must come down or that every action has an equal and opposite reaction. This applies to mechanics but is also often referred to in a similar way in the investment markets where it is called reverting to the mean or longer-term average.

It is a feature of our times that the media do not report headlines in the same symmetrical way which tends to lead to a distorted picture of negative stories relative to the positive. Rising inflation is now the top investor concern according to surveys and general feedback from market commentators, replacing a resurgence of Covid variants. It is noteworthy that we never heard or read about the benefits of plummeting inflation in the depths of the pandemic. We heard about the oil price future briefly turning negative but nowhere was this reported as a positive because it is a huge cost saving for business.

Hysterical inflationary talk spooked the bond markets in the first quarter of 2021, but they have now calmed down somewhat despite the actual reported inflation numbers exceeding previous pessimistic estimates. This is confusing some who believe there is a nasty shock to come and that the Central Banks have got it wrong. We have also seen comments from Andrew Bailey, Governor of the Bank of England, where he has publicly rebuked his outgoing Senior Economist, Andrew Haldane, who has speculated that we face dangerous times and that persistent inflation lies ahead. The Governor clearly disagrees and argues that the UK economy is still below its full capacity and still smaller than its pre-Covid size. Many may be inclined to agree, especially as the unlocking process is being hindered by the Delta variant and possibly future variants yet to be discovered.

Uncontrolled inflation requires an excess of rampant demand and inelastic spending regardless of price. These price rises then cause workers to demand higher wages and so you have a spiral. We can all quote examples of builders with two-year backlogs and shortages in materials supplies. However, this is a consequence of increased demand for home improvements whilst we have all been at home with excess savings to deploy, along with a renewed appetite for DIY as normal leisure pursuits have been curtailed. This will wane as we all return to pubs, restaurants, and travel, and with it any thoughts that builders may have of exploiting the demand by raising their prices. Consumers are not stupid, and they know when they are being taken for a ride – excessive prices will lead to curtailed projects for when global supply chains have recovered.

The same goes for staycation prices as UK holidays are the only option for many. A week in an Airbnb property this summer can easily cost £3,000, a ridiculous price but one that some are prepared to pay just to get away. This will be temporary as the green list expands and foreign competition returns. It is a very small part of the economy that didn’t exist a few years ago.

This is also true for second-hand car prices and the apparent inability of employers attracting workers. The former has been impacted by the disruption of the global supply chain involving semi-conductors whilst the latter is partly affected by the furlough scheme where hospitality employees have saved money which they can now spend and may be considering a summer at leisure, returning to work in the Autumn. Even if these employee shortages lead to wage pressure, this only affects the lowest salaries, many of which are minimum wage. This is less of an issue in the professions and skilled manufacturing industries and so wholesale demands for wage increases, outside of the NHS, are unlikely.

On balance, it is inevitable we will see higher inflation numbers as the economic recovery evolves and the economy unlocks. The rebasing of the numbers, year-on-year, the recovery in the oil price and resumption of activity is guaranteed to revert to the mean or adhere to Newton’s law of equal and opposite forces. Much of this is reversing the impact of Covid in 2020. Importantly, many workers didn’t receive pay rises or bonuses in 2020 and those on furlough suffered a 20% pay cut. It is entirely reasonable to expect some catch-up as the economy recovers but it should be remembered that as companies also recover, they are now much leaner which should lead to higher profit margins. That must be positive for equities.

 

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