Nicholas Rilley
One of the defining features of the pandemic was that it led to a boom in some industries and a bust in others. As the world returns to some sort of normality, the sectors that benefitted from the pandemic risk turning to bust, while the sectors most negatively impacted are seeing demand recover strongly.
Counterintuitively, negative correlations between industry sectors can, in fact, help to lower economic volatility as growing industries can help offset contracting ones. However, the magnitude of the swings in demand against a backdrop of extraordinary policy support from governments and central banks have posed major challenges to businesses.
As the pandemic receded, it was hoped that the shift from buying durable goods to travel and leisure activities would help to bring inflation back down, but instead we have seen goods inflation remain high and rising prices are now spreading to services. The pandemic also caused stress in the labour market which has increased the cost of hiring staff, while various supply-chain disruptions have increased the cost of almost all goods and services.
If the combination of these factors did not already make for a complex and inflationary economic backdrop, then the war in Ukraine and the associated commodity price shock has resulted in a perfect storm of inflationary pressure.
A bit of inflation is to be expected and there are good reasons why central banks set low inflation targets. It is not surprising to see technology hardware or home furnishings go up in price while people are confined to their homes, or to see hotel and airline prices rise as the economy reopens. The issue, for both consumers and financial markets, is when inflation is unexpected and broad based.
According to estimates by Citi, global consumers of commodities will pay commodity producers around US$5.2 trillion more during 2022 than they did in 2019, an increase that is equivalent to approximately 5% of global GDP, rising to $6.3 trillion if forward commodity pricing materialises.
Citi further estimates that the rise in the nominal value of commodities consumed during the first oil shock was 237% (1970-74), more than twice the 101% increase during the more recent 2019-2022 period.
However, nominal economic growth was much higher in the 1970s than it is now, so Citi calculates that the change in the value of commodities consumed as a share of nominal GDP during both periods is around 5-6%.
Turning to the sectors that boomed through the pandemic, a number of the equities have already turned to bust, with Netflix, Zoom and Peloton all down by more than 75% from their peak.
Speculative growth stocks, which performed very well, have also seen material price falls.
Things are not quite so bad in the real economy, but we have recently seen retailers such as Walmart and Target left with excess inventories as consumer demand has shifted due to the reopening of the economy and inflationary pressures. Shoppers have moved away from items such as furniture, kitchen appliances and televisions while demand has picked up for more fashionable attire as the desire to socialise has increased.
The bad news for corporates has a silver lining for both consumers and inflation; the price pressures for durable goods is now starting to abate and, if retailers discount goods, it could translate to prices actually falling.
Housing is another area that has boomed over the past two years; however, affordability is historically stretched, given the rise in mortgage rates, particularly in the US. As at the end of last year, only around 5% of US mortgages were adjustable rates, compared to around 30% in 2007, so this tempers the risk that a boom turns to a bust.
While demand for some goods is falling, demand for travel is booming.
Christopher Nassetta, CEO of Hilton, recently said that the hotel chain will “have the biggest summer we’ve ever seen in our 103-year history”, and Target said that it is seeing spending diverted from electronics to suitcases and sunblock.
It is clearly good news that people are travelling again; however, this comes with a new challenge of demand outstripping supply, which is inflationary. We are seeing this most acutely with flight cancellations in the US and Europe as airlines struggle with staff shortages and take-off/landing slot availability. Rising fuel prices are also an issue for airlines and help contribute to an overall price increase of 38% for airfares in the US over the past year.
Inflation has long been a challenge in emerging market economies, but has not been seen in any meaningful way for decades in developed markets. Consumer confidence is plummeting, businesses are struggling to manage inventory and maintain margins, while policymakers are at a loss with how to deal with it all. The focus is now on central banks, as low and stable inflation is a core part of their mandate. Given that we have moved from a shift in relative prices reflecting pandemic distortions to a general rise in prices, central banks are reducing liquidity in the banking system and increasing interest rates at a rapid pace.
A soft economic landing is still possible as pandemic distortions unwind, but the food and energy price shock on top of the existing inflationary pressures have left the runway for a soft economic landing incredibly narrow.
Nicholas Rilley, CFA, is Investment Manager and Strategy Analyst at Butterfield Asset Management.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.
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