Meme. Supply chain. Variant. Inflation. Of all the buzzy buzz words of 2021, inflation is without a doubt the buzziest, along with its heretofore sidekick, the modifier “transitory”. We will address here just exactly what inflation is and why it matters to investors as well as different ways of measuring it. We will provide some historical perspective on current inflation trends at a high level and at the component aggregate levels for several of the key Consumer Price Index components. We will weigh in on the “transitory vs. entrenched” inflation debate and will touch upon the Bank of Canada’s recently re-reviewed inflation targeting framework. Finally, we’ll turn to the outlook for inflation and how the various asset classes we manage – stocks, bonds and preferred shares respond to inflation.
Inflation is the rate of change in prices. One of the most foundational concepts in finance is what’s known as the time value of money – the notion that a dollar received at some time in the future is generally less valuable in purchasing power (real) terms than a dollar received today, and inflation is inextricably linked to this concept. The inflation metric most often referred to and most relevant to investors is the year-over-year rate of change in the Consumer Price Index (CPI), which is updated by Statistics Canada monthly. StatsCan also publishes other narrower measures of inflation, such as the “core” (i.e., excluding certain volatile prices series like food and fuel), the median and the trimmed mean inflation rates, as well as a non-seasonally adjusted inflation rate. All these measures can be thought of as statistical gymnastics intended to shed better light on the enduring or underlying impulse of price increases in the economy, stripped of the random statistical noise inherent in measuring prices of a broad basket of goods and services monthly. It’s also possible to compute different variations on the rate of change in the CPI, such as the monthly change in prices, or the quarterly change in prices, sometimes expressed as an annualized rate (i.e., multiplied by 4), and for better granularity, StatsCan also maintains regional CPI indices for each province and territory and several key cities. The U.S. Bureau of Labour Statistics maintains a conceptually similar suite of inflation measures, also updated monthly, albeit with some methodical differences in computation. For our purposes we’ll primarily refer to the common year-over year rate of Canadian national inflation.
In order to understand, what’s being measured and cited as “inflation”, it helps to understand in broad terms what the Consumer Price Index basket is comprised of. The basket is comprised of a sample of roughly 700 goods and services and is intended to be representative of typical consumption in an urban household, and to that end the composition of the basket is periodically reviewed and updated to reflect changing consumption patterns, new product innovation, etc. Of course, there’s no such thing as a typical household – millennials presumably consume more lattes, Baby Boomers presumably consume more prescription medication - and accordingly published inflation figures may drastically overstate or understate price inflation as experienced by any given individual household. Nevertheless, by understanding what the CPI basket is comprised of, we can better understand where price pressures may be originating in the economy and how these might affect a given household or a given company. The 700 priced goods and services are categorized into eight major groups, with index weightings as shown below, reflecting their relative importance in a typical household’s consumption.
The current annual rate of inflation of 4.7% is at a level seen only twice briefly in the past twenty years, during the first Gulf War in 1990-91 and then again during the second Gulf War in 2003. Inflation has not held at these levels on a sustained basis since the 1970s and early 1980s –a period of time which precedes the experience of most professional and non-professional investors alike. U.S. inflation is running at an even more torrid pace, currently printing 6.8%, handily exceeding the brief spikes experienced in both Gulf Wars as well as the spike seen in mid-2008 and is running at levels not seen since the 1970s and early 1980s. To a Brazilian, an Argentine, a Zimbabwean or a Venezuelan, these rates of inflation probably look like a textbook picture of price stability as these countries have all recorded bouts of devasting hyperinflation within recent memory, to the point of money effectively becoming worthless prices escalated so rapidly. Perhaps the most notorious example of inflation’s wealth obliterating effects is the post World War 1, Weimar Republic period in German history when women were known to wear dresses made from banknotes and the practice of burning banknotes rather than pricey firewood for the heating value was not unheard of. Nevertheless, for Canadians and Americans comfortably habituated to decades of relative price stability, the current high rates of inflation are understandably concerning. Central bankers for their part are on high alert as well, as the Bank of Canada (and the U.S. Federal Reserve) have a formal price stability mandate, which in the Bank of Canada’s case stipulates a target range of 1-3% annual inflation, with a midpoint of 2%. Both central banks, and the Federal Reserve particularly so, given that it has a formalized dual mandate to target both price stability and the nebulous concept known as “maximum employment” had been until recently willing to overlook high inflation rates in the belief that price pressures were transitory. The Bank of Canada in its very recent review of the formal 1-3% inflation targeting framework gave a somewhat stronger nod towards the importance of maximum employment, hinting perhaps at a greater tolerance for temporarily above target inflation. We too were firmly in the “transitory” camp until as recently as 3-4 months ago, when it became clearer that base effects (i.e., unusually depressed prices in the comparable COVID-19 ravaged period a year ago), supply chain problems and commodity scarcities didn’t fully explain or capture the underlying price pressures in the economy, which now appear to be more deeply entrenched than first thought.
Looking under the hood a bit, at individual components that make up the aggregate rate of inflation, a couple of interesting observations arise. First, note that “goods” are currently more inflationary than services, in a sharp departure from the experience of the last few decades (note the overall level of service prices at 156.7 and the overall level of goods prices of 130.9, relative to the “base” year prices of 100 for both in 2002). Consumption patterns have shifted over the past year and a half, with much of the service sector locked down, and consumers indulging in “revenge spending”, buying all manner of goods. In our view, today’s well known supply chain problems notwithstanding, the likelihood of goods prices rising faster than service prices on a sustained basis is unlikely. Goods in most cases can be traded globally whereas services more typically cannot, and accordingly, the underlying price pressures for goods have been consistently lower as outsourcing, offshoring and the deflationary impulse that low wage Chinese manufacturing has foisted upon the world for over two decades is unlikely to abate. Moreover, many goods are durable, and although there may currently be heavier than normal demand for bicycles, jet skis, cars, patio furniture, boats, etc., these tend to be one-time purchases that last for many years, and thus today’s excess demand simply pulls forward purchases from 2022 and onwards, potentially creating a disinflationary glut of supply down the road. Similarly, shelter, the biggest basket weight in the CPI at just under 30% is rising quickly on the back of a blockbuster rise in housing prices and rents, again, likely a one-time COVID-19 induced behavioural phenomenon that is unlikely to carry on at the current pace, even if only for reasons of extreme unaffordability for the typical household. For somewhat similar reasons, transportation is highly inflationary today as strong household balance sheets, high savings rates and a desire to avoid public transit collide with temporary shortages of critical auto parts, drastically driving up new, used and rental car prices. But again, we don’t all need five cars, so today’s excess demand sows the seeds of tomorrow’s disinflationary supply glut. And lastly, turning to energy - which is the biggest wildcard of all – we see rapid inflation here now primarily as a function of oil prices recovering from last year’s recession induced lows. Where oil prices, and indeed prices for all petrochemicals go is difficult to predict at the best of times, clouded by policy and politics (i.e. releases of oil from the U.S. Strategic Petroleum Reserve, changes in carbon taxes, OPEC output decisions, etc.), but suffice it say, the forces of supply and demand have not been repudiated, and as the saying goes, the best cure for high commodity prices is high commodity prices – a supply response will undoubtedly arise if prices stay here or rise further. Moreover, high prices for carbon-based forms of energy create an environment conducive to investment in cleaner forms of energy to calibrate the current supply/demand imbalance and keep oil/gas/coal prices in check.
Apart from the overall consumer price index and some of the key sub-components, probably the most informative economic data series to help gauge where future inflation is headed is average wage increases. As North Americans learned in the 1970s, when prices rise rapidly, workers demand higher wage settlements to offset their rising cost of living, which in turn prompts their employers to further raise output prices for their goods and services to offset the wage cost pressures they face. The result is what’s known as a wage/price spiral, a dangerous and self-reinforcing cycle of ever accelerating inflation that is difficult to bring to heel without crushing central bank interest rate hikes that risk causing recession. Fortunately for investors, but unfortunately for workers, wage pressure has not drifted into the danger zone here in Canada, with the average hourly wage for permanent employees of $31.18 up just 3% in the past year, not far off it’s ten-year average of 2.7%. In the United States, labour scarcity is rampant, with recent data showing over 11m unfilled jobs across the country – roughly double the ten-year average number of job vacancies, and accordingly, wage pressure is acute, with the average hourly wage for all employees of $31.03 up 4.8% over the past year, well above the ten-year average annual increase of 2.8%. In neither country, however, are average wage increases keeping pace with headline inflation and anecdotally, workers are taking action to preserve their purchasing power, with widespread increases in strike activity.
As for what experts expect and what’s priced into markets, a survey of 30 professional economists conducted by Bloomberg LP shows a median forecast of 3.2% for Canadian inflation in 2022 and 2.2% in 2023, both somewhat moderating from the full year expected increase of 3.3% this year, but these forecasts have been rising rapidly, from as low as 2% for next year back in May to the current level of 3.2% as economists play catch up with reality. The Bank of Canada itself is validating these private sector forecasts, with its own outlook for inflation calling for 3.4% and 2.3% in 2022/23. And finally, the yield differential between Canada’s five year real return bond (which is “indexed” to inflation, much like a government pension plan, for instance) and the maturity matched conventional bond is currently 2.2%, which means investors expect five year average inflation to come in around 2.2%, somewhat above the central bank’s midpoint target of 2%. Where we stand on the matter, taking the word “transitory” quite literally to mean “non-permanent”, is we expect current high inflation rates to be transitory, but not as fleeting as some, including ourselves expected as recently as a few months ago. Higher inflation is likely to persist into the middle of next year before drifting back towards the central bank target range.
As for how best to manage through it all, the approach varies by asset class. Inflation is important to investors insofar as it typically triggers a response or reaction function by central bankers mandated to ensure price stability. Economic doctrine holds that low interest rates stimulate aggregate demand, particularly in interest rate sensitive sectors of the economy like housing, autos, business investment, etc., and accordingly, in the face of excess supply (best observed via a stubbornly “too high” unemployment rate) central bankers often respond by lowering overnight interest rates. Conversely, when faced with excess demand (best observed via a stubbornly “too high” inflation rate), central banks often respond by raising interest rates. Investors anticipating excess demand/high inflation would do well to anticipate increases in the Bank of Canada overnight rate, and indeed are doing so, with 4-5 quarter point rate hikes implied by market pricing through the course of 2022, with the first coming around March. In the bond market, higher interest rates are a double edged sword, with short term pain for long term gain. Bond prices initially fall in response to rising interest rates, but good credit quality bonds will ultimately mature and be repaid at par ($1,000 per bond), affording holders of maturing bonds the opportunity to reinvest at the now higher prevailing interest rates. Risk mitigation is thus key, and our stance has been to invest exclusively in high credit quality bonds with 1-3 year maturities, which both avoids credit risk and the sharper short term sting of interest rate risk and the longer term opportunity cost of forgoing higher reinvestment yields that befall owners of longer term bonds in a rising rate environment. Within the preferred share asset class, we own primarily rate reset preferred shares, whose dividend is reset every five years at a predetermined spread over the then prevailing ten bond yield. These securities thus benefit from both a stepped-up dividend payment, and typically price appreciation as well as interest rates rise, and indeed, even amidst a very strong stock market this year, preferred shares have been very competitive, with the Solactive Laddered Canadian Preferred Share index earning a total return of 21% year to date. Finally, within the equity portion of clients portfolios, we have been favouring price makers over price takers, with Canada Goose and Apple being poster child examples of price makers –manufacturers of well branded, differentiated, innovative and highly sought after goods that can likely increase prices to counter inflationary pressures they may face. We have favoured companies that can substitute relatively cheap productivity enhancing technology for increasingly expensive labor over those that cannot, or by extension companies whose business model supports such a transition, with CN Rail and CGI Group being prime examples. And lastly, we have favoured companies that cater to the mass market over those that cater primarily to the affluent in expectation of a more inclusive economic recovery (i.e., faster wage inflation for low wage occupations vs. high wage occupations), with Alimentation Couche-Tard and Lowes being obvious beneficiaries. To generalize though, equities as an asset class are a superb long term hedge against inflation, as corporations earn profits in nominal as opposed to “real” dollars and their shares trade in nominal dollars, and thus both their profits and their share prices stand to benefit from an increase in the overall price level, other things being equal.
The late, great Yogi Berra probably said it best when he quipped that, “a nickel ain’t worth a dime anymore”, and indeed over time this will surely be true in real, purchasing power terms. We can no more avoid inflation than we can death or taxes, but we can certainly invest accordingly, and are indeed doing so.
