Low inflation is gone for good. Here’s how to position for a new era of higher inflation.

• We believe that the decades of low inflation is coming to an end. The world is moving into a new regime where structural forces will lead to a more persistent rise in inflation.

• The prices of energy, metal, and food prices are likely to stay elevated in the years ahead, contributing to higher inflation.

• Workers will also become scarcer and enjoy more bargaining power in the future, spurring wage growth, which would then be passed on to consumers via higher prices.

• The powerful disinflationary force of globalisation is now in retreat. Rising protectionism and trade tensions will put the brakes on global trade. “Reshoring” will also reduce efficiency and international access to cheap labour, both of which will drive up inflation in the long-run.

• Investors can realign their portfolio around this new reality using the following options: value stocks, commodity-linked equities, cheaper markets, and short duration bonds.

For nearly half a century, inflation in the US was headed one way: down. Since the Great Inflation of the 1970s, the US has achieved a remarkable decline in inflation, supported by structural factors that included globalisation, demographic changes, and rapid technological advances. Fast forward to today, the Fed faces very different circumstances: record low unemployment, strong wage growth, and rates of inflation that are far above the central bank’s target.

A key question facing central banks today is whether the observed inflationary shocks of today are cyclical or structural in nature i.e. will they revert over time, or do they reflect fundamental and permanent shifts in inflation pathways?

We believe that inflation is in a structural shift, and that the decades of low inflation is coming to an end. The world is moving into a new regime where structural forces will lead to a more persistent rise in inflation in the years ahead. In this article, we take a deeper look at some of the factors that are driving inflation higher, and suggest ways that investors can navigate this new era of higher inflation.

Higher oil prices for much longer

Oil prices will remain higher for much longer.

Oil prices are already at elevated levels, with the mayhem in global energy markets pushing oil prices to as high as USD 124 per barrel this year. While they have come down notably since June, oil prices are still substantially higher compared to last year.

It used to be that producers of fossil fuels would respond to such price signals by swiftly ramping up output and investment. Not this time. Climate change has led to unprecedented pressure on oil and gas firms to shift away from fossil fuels. As a result, there has been a structural under-investment in new production as investors increasingly avoid industries that produce fossil fuels and heavy carbon emissions.

(Related article: A new commodities supercycle: Why oil could reach 150!)

The scale of the under-investment is enormous. Based on estimates by the International Energy Forum (IEF) and IHS Markit, upstream investment needs to increase and be sustained at pre-Covid levels of almost USD 525 billion until 2030 in order to restore market balance. However, the industry has been engaged in capital discipline since 2014, with oil and gas companies focusing on paying down debt, returning cash to shareholders, and reining in spending. The result has been a worldwide slump in oil and gas investments to just USD 351 billion in 2021, where it is expected to stay.

Even as oil companies have raked in historic amounts of cash due to the recent spike in oil prices, they have kept their capital expenditures firmly in check and pledged that this discipline will hold in future years. The oil windfall has instead been returned to shareholders in the form of dividends and share buybacks. Rising interest rates further complicate the supply situation, as higher capital costs could hamper sorely-needed energy investments, including renewables.

Besides, there is no evidence that oil demand is in structural decline. If anything, fossil fuels are not going away anytime soon. The increase in renewable energy has not been keeping pace with rising energy demand. The world will have to tap fossil fuels to meet the rest of the demand.

Furthermore, renewables are at the mercy of the weather. In recent years, climate-driven droughts have triggered the biggest disruptions in hydropower generation in decades. Meanwhile, wind droughts have caused wind turbines to stand still, significantly curtailing the generation of wind power. This means that fossil fuels are still needed as backup fuel when renewables fail to carry through.

Make no mistake, fossil fuels are here to stay. With the structural under-investment in upstream oil and gas assets likely to persist, this is setting the world up for an even tighter energy market in the years ahead.

(Related article: Recession fears have struck markets. Can the commodities sector overcome them?)

The green transition will prove inflationary

The green transition will also contribute to longer-term inflation.

The transition is likely to create a huge boom in demand for metals, such as cobalt, copper, nickel, and lithium that are vital for the technologies underpinning everything from electric cars to renewables. The bad news, however, is that current supplies of these critical metals are inadequate to satisfy future needs. As noted by the International Monetary Fund (IMF), the current production rates of cobalt and nickel appear inadequate, showing a more than two-thirds gap versus the demand. Similarly, copper and lithium supplies are also inadequate to satisfy future needs, with a 30-40% gap versus demand. 

Don’t count on supply to ramp up quickly in the short-term: building mines can take anywhere between five and 25 years. At the same time, investment in mines has been depressed by environmental, social and governance (ESG) concerns, with mining companies under increasing pressure to source metals responsibly.

A big copper project in Peru, scheduled to open in 2011, remains unfinished due to strong resistance from the local community. Chile has also adopted stricter environmental rules governing its mining industry. The majority of metal deposits are also in countries where high ESG risks are compounded by widespread corruption and poor government oversight, such as the Democratic Republic of Congo (DRC), home to the world’s richest cobalt deposits.

Even if there is theoretically enough metals deposits in the ground to satisfy the world's demands for clean energy, it is becoming harder and more challenging to extract them out because of ESG concerns.

The unintended result of the green transition will likely be “greenflation”, sharply increasing prices for the metals and minerals that are critical to the transition. But herein lies the paradox: the harder the world pushes the transition to a greener economy, the more expensive these metals will get. We should be under no illusion that the green transition will be a painless one.

(Related article: REMX: Metals that benefit from the transition toward a greener world)

Food prices to continue upward trajectory

Until recently, the Russia-Ukraine war has been one of the key drivers of food prices, and unsurprisingly so, as both countries are agricultural powerhouses. Fears that food exports would be disrupted by the war, and that shortages would persist have led to a sharp surge in food prices this year. While a landmark agreement allowing Ukrainian grain exports to leave the port of Odessa has brought some relief to food prices in recent times, there is no guarantee they will not rise again.

Fertilisers are still expensive. In Europe, rising input costs and increasing gas prices have resulted in decreased production of ammonia, a key ingredient for nitrogen-based fertilisers, which are used in agricultural processes. Similarly, China has limited the exports of phosphates, a key fertiliser ingredient, in order to ensure domestic availability amidst shortages.

The impact of climate change will also continue to challenge agricultural yields, making it a long-term driver of food price inflation. Good harvests need good, or at least moderate, weather. However, farmers have been confronted with rising instances of extreme weather patterns. China, the world’s largest wheat producer, has been grappling with scant rainfall and one of the most severe heatwaves in six decades. Extreme temperatures have also sapped food production in India and Europe. The Horn of Africa is being ravaged by its worst drought in four decades.

Meanwhile, food protectionism has been on the rise as governments try to safeguard local supplies. India, the world’s biggest rice shipper, has been discussing curbs on rice exports as its domestic supply is under threat. Earlier this year, India also announced restrictions on the export of wheat and sugar. Indonesia imposed a ban on palm oil exports in April, while Malaysia announced a chicken export ban in June. These countries are not the first to engage in food protectionism, and they won’t be the last.

Consumers should expect higher food prices from here.

Workers will enjoy greater bargaining power

Workers will likely get scarcer, too.

The jobs market in the US has rebounded from the pandemic to historically tight levels. The pandemic has been associated with a large drop in labour force participation due to early retirements and concerns about health, resulting in a much smaller labour force. This has coincided with record-high demand for labour as the economy reopened. As a result, the unemployment rate in the US has remained doggedly low at 3.7% in August. There were nearly 11.2 million job openings in July. This means that there is now in effect almost two vacancies for every person currently registered as unemployed (Chart 1).

Chart 1: Demand for labour in the US remains high

The labour shortage could be a structural change in the economy.

Demographic changes will have a strong influence on the labour market. The rate of population growth in the US has been falling for nearly two decades, with changing life priorities and shifting attitudes towards parenting contributing to a decline in fertility rates. The population is also not getting any younger. By 2040, about one in five Americans will be age 65 or older, up from one in eight in 2000. A broader decline in immigration, an issue exacerbated by rising anti-immigration sentiment (symbolised by the Trump wall), will also make it harder for companies to find workers in the future.

Additionally, a change in workers’ mindset is underway. The Great Resignation has been gaining momentum, with workers quitting their jobs at a near record pace, as many people have decided their work-life balance has become more important to them after an extended period of working from home with no commute. “Quiet quitting”, a trend of employees choosing to not go above and beyond their jobs, has also been catching on in recent times.

The end result? Workers may enjoy more bargaining power in the future, spurring wage growth, which would then be passed on to consumers via higher prices.

Deglobalisation will drive up inflation

And then there is the slow-burning threat of deglobalisation.

Globalisation has held down prices for three decades. The rise in global trade, with the entry of China and Eastern Europe into the global trading system, has brought about greater competition and lower tariffs, reducing the prices of many manufactured goods. The large-scale shifts in production facilities to low-wage countries have also suppressed wages and contributed to lower inflation.

This powerful disinflationary force is now in retreat.

Even before the US-China trade war, growth in the volume of international trade has already been slowing significantly. With geopolitical tensions now on the rise, protectionism and trade conflicts will likely be a regular occurrence, putting the brakes on global trade. The trend of “reshoring” – shifting manufacturing back to home country – to improve supply chain resiliency, as well as “friendshoring” – shifting manufacturing to countries with shared values – will reduce efficiency and international access to cheap labour, both of which will drive up inflation in the long-run.

Position for a new era of high inflation

The Fed remains committed to fighting inflation, as recently reaffirmed at the Jackson Hole meeting, during which Jerome Powell reiterate that the Fed is ready to inflict “some pain to households and businesses” and will likely follow through with higher interest rates to bring down inflation. As such, inflation is unlikely to stay at the 8-9% level seen over the past few months.

However, we note that tighter monetary policy will do little to address some of the structural drivers of longer-term inflation as mentioned earlier. The Fed can bring down inflation down to its 2% target by hammering demand with substantially higher rates, but it risks pushing the US economy into a deep recession. We believe the Fed will eventually accept higher inflation to avoid inflicting unnecessary pain on the economy. We see longer-term inflation settling at around 4%.

The world is entering a new era of high inflation, but this does not have to be apocalyptic. Investors can realign their portfolio around this new reality using the following options.

1. Value stocks

An environment of rising inflation is usually good news for value stocks.

In an inflationary environment, money now is worth more than money further down the line. The further into the future the money is, the less it is worth. It is for this reason that investors should consider adding value stocks, which derive their valuations more from current cash flows and fundamentals, to their portfolios. Growth stocks, which depend more on earnings potential in the distant future, will likely underperform in this environment.

If investors continue to favour stocks with lower valuations, which we think they will in a higher inflation environment, value may continue to outperform growth. As such, investors with growth-heavy portfolios should consider diversifying their equity exposure to include more value-oriented strategies, such as the JPMorgan Funds - US Value A (acc) USD and the HGIF - Europe Value PD SGD.

(Related article: US: Value to lead the way)

2. Cheaper and more attractive equity markets

Similar to value stocks, cheaper equity markets i.e. markets with a lower price-to-earnings ratio can be considered ‘short-duration’ assets. A market with a PE ratio of 5.0X suggests that investors can breakeven within five years. A market with a higher PE ratio of, say, 15-20X, means low profits today, and investors are paying up in the hope of making their money in 15-20 years’ time.

Amongst the equity markets under our coverage, we like Asia ex-Japan, particularly China. While China’s bad news just keep getting worse, there are compelling reasons to remain optimistic. With a lot of the negatives already priced in to the markets, a further easing of regulatory pressures and a policy backdrop that still remains accommodative means that there is scope for Chinese equities to outperform. Investors who wish to seek exposure to the Chinese equity market can consider the JPMorgan Funds - China A (acc) SGD or the iShares Core MSCI China ETF (HKEX:2801).

(Related article: China’s bad news just keep getting worse, but the risk is worth taking)

We also like Japan, given the Bank of Japan’s accommodative stance. Japan’s inflation also remains benign relative to the US and Europe. Meanwhile, we expect an uplift in Japan’s economy when the re-opening gains traction. For Japan’s equity market, our fund recommendations are the JPMorgan Funds - Japan Equity A (dist) SGD and the iShares MSCI Japan ETF (NYSE:EWJ).

(Related article: Why Japan is our top pick over US and European equities)

3. Commodity-linked equities

Commodity-linked equities are also a natural choice for investors seeking inflation protection.

With energy, metal, and food prices likely to stay elevated, investors would do well to consider exposure to commodities as an inflation hedge. They can do so via commodity-linked equity funds such as the Blackrock Natural Resources Growth & Income A2 USD.

4. Short-duration bonds

Inflation will be higher than many expect over the next couple of years. This means that bond yields will continue to rise. If inflation rises to 4%, we wouldn’t be surprised to see the 10-year Treasury yield rising to as high as 5%. As such, we see long-term yields moving up further as investors demand a greater term premium, and think that it is premature at this juncture to add significant duration risk. 

Meanwhile, short-term bond yields have moved significantly higher as compared to long-term yields, implying that investors can receive alluring yields without having to take on greater duration risk. Hence, our preference is for short duration bonds within the fixed income space. The Nikko AM Shenton Short Term Bond SGD, LionGlobal Short Duration Bond Cl A Dis SGD, and the United SGD Fund Cl A Acc SGD are all viable options.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.