Capital Ideas^TM

What is your view on inflationary pressures and the outlook for global growth?

Philip: Global growth was recovering strongly post-pandemic, particularly in the US and Europe. The inflation spike is going to dampen this growth, the ramifications of which depend on how long the inflation spike lasts.

From a cyclical inflation perspective, as we emerged from the pandemic we started to see a perfect storm of lower supply and strong demand, resulting in a pickup in inflation. Some of this is transitory inflation that should start to drop away towards the end of the year.

However, I think there are structural reasons why inflation will be higher over the next cycle relative to the last 20 years. Even before the pandemic we were starting to see signs that some of the factors that had been keeping inflation down – such as globalisation - were beginning to change.

Over the years, cheap labour supply and cheap goods production in other parts of the world has helped bring inflation rates in Europe and the US down. Globalisation also helped keep the bargaining power of local labour very much suppressed relative to the rest of the world.

Donald Trump's ‘Make America great’ campaign to bring production home and Brexit are both examples of a reduction in globalisation. We are starting to see some of these pressures exacerbated even further with the Russia-Ukraine conflict. Geopolitics is now playing a bigger role in decisions by countries to try to bring production closer to home.

The environmental cost of long supply chains and shipping goods all over the world provides another reason to bring production closer to home. This in turn means that the bargaining power of local labour starts to increase. Over the years, the share of labour and decline in the power of unions has led to wage increases being very moderate in the US for example relative to overseas. I think this will begin to change. 

Which sectors have the potential to cope better with increased costs?

Julie: If you look back at inflation over time, excluding periods of extreme inflation or significant deflation, US equity and fixed income markets have delivered value over the long-term. It is therefore important not to take short-term decisions while investing in these kinds of inflationary periods.

There are some sectors that are particularly well-placed to respond to inflationary pressures, simply because of their pricing power and their ability to pass through price increases, either in their services or their products, or in areas where they have strong consumer demand.

One such sector is semiconductors, which continue to command very strong pricing power in this environment. This is partly due to supply-demand dynamics, but also because of their ability to pass on price increases. For sectors such as beverages, household items, apparel and luxury items, demand for these products tends to remain relatively stable even in this environment. Therefore, companies that are in these sectors are also able to pass through cost increases and better protect their profit margins. 

1. Data as at 31 October 2021 in US dollar terms. Sources: Capital Group, Bloomberg Index Services Ltd., Morningstar, Standard & Poor’s
All returns are inflation-adjusted real returns. US equity returns represented by the Standard & Poor’s 500 Composite Index. US fixed income represented by Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index from 1 January 1970 to 31 December 1975, and Bloomberg U.S. Aggregate Bond Index from 1 January 1976 to 31 October 2021. Inflation rates are defined by the rolling 12-month returns of the Ibbotson Associates SBBI U.S. Inflation Index.