Are we on the precipice of an inflation event?

This was a title of my talk at this year’s Insurance Investor Live conference. I hope I didn’t disappoint the audience by answering, “not really”, for three reasons. First, inflation is already here — so if anything, we are in the midst of the event — and the real question is how transitory and/or volatile inflation (or how volatile inflation volatility*) turns out to be. Second, from investors’ point of view, what matters is not what the outlook for inflation is, but whether that outlook is different from what is priced into assets already. [There is a really interesting report on this by McKinsey Global Institute.]

Third, as much as I try, I can’t come up with scenarios (admittedly in my head, and admittedly with a huge number of priors and pre-set mental models about the economy and our fiscal and monetary institutions) in which advanced-economy inflation doesn’t quickly become self-defeating, even in the absence of significant monetary action. [By the way, I’m also a small-scale sceptic that the presence of monetary action would be as laser-sharp and uniformly effective as most models assume…]

Fourth, my view is that the megatrends of the last few decades — digitisation, automation, globalisation, growth in emerging economies, ageing populations, climate change and so on — have not gone away (even though some, such as the advancement of globalisation, may have slowed down), and that they will, on balance, continue to exert material downward pressure on prices in the medium term. (Almost all of them also exert upward pressures — but my view is that the downward pressure is, on balance, going to be somewhat more dominant.)

I presented about 10 slides at the conference, so since these blogs are typically centred around just one, I’ve picked the one that I thought was perhaps new to the debate, and also goes to the heart of my personal interests: links between what’s happening in the real economy (at firm level and sector level, with expenditure, consumption and demand, and with investment, tech adoption, productivity and supply) and how those phenomena might show up in various aggregate statistics of inflation eventually.

In the chart, I show an illustration of the very different implications of higher inflation for different types of businesses. By now, my standard caveats apply: correlation does not imply causality; my use of (nevertheless) causal language is due to lazyness and desire to convey information, not stupidity or desire to mislead; even the correlations I show are a bit dodgy; but I still think that #dataisbeautiful and that telling these stories enriches our understanding of how the world works. If you disagree, please do let me know!

So, the chart contrasts two sectors of the UK economy (picked because they showed the most interesting and distinct patterns — yes, I would be the master of p-hacking if that were part of my job; and yes, my extracurricular hobbies most definitely include both data snooping and selective inference ). Security and investigation activities — which consists primarily of companies providing security guards — is shown on the left; and furniture manufacturing is shown on the right. The x-axis shows the economy-wide CPI inflation in each year; and the y-axis shows the growth in (nominal) gross operating surplus in each sector in each year. [Gross operating surplus (GOS) is a national accounting term referring to the “profits” left over after a company has paid for its intermediary inputs (e.g., energy, raw materials, IT services) and its workers (so-called employee compensation). From a business perspective, GOS is probably closest to EBITDA.]

For businesses in the security and investigation activities, higher inflation has generally speaking been bad news. [Beyond this last time, I won’t keep repeating that this could just indicate that they happened to have higher profits in the same years as high inflation for either random reasons or due to some omitted variables.] A quick look at the components of gross operating surplus also helps understand why: it appears that businesses in this sector faced a significant increase in their labour costs in higher-inflation years (not super-surprising, given how labour-intesive they are and how relatively substitutable their labour is); yet were unable to raise their prices accordingly.

The story is quite different for furniture manufacturing. Here, higher-inflation years are associated with higher profits (despite the long-term decline this sector has been in the UK). Furniture manufacturing is somewhat less labour intensive than security services, so less subject to wage pressures. On the other hand, its profitability is impacted by businesses’ ability to put up prices ahead of, or in line with, increases in raw material costs. On average, this seems to have been the case (even though as you can see from the chart, the pattern is far from uniform).

No doubt, the situation will be even more different between different firms. For example, for super-efficient, large companies that sit in the left-hand corner of the cost curve, overall inflationary pressures tend to be good news, as the price umbrella under which they sit goes up (often much) faster than their costs do and their low-cost position allows them to grab more market share. This is, of course, only true as long as the profit pressures on the inefficient marginal producers are not so large that they go out of business and stop providing that price umbrella altogether. If they do go out of business, it may be an opportunity for industry consolidation, which could bring its own positives and negatives in terms of price and profit dynamics.

So, unfortunately, “it all depends”. There are no hard and fast rules about whether (moderate) inflation is good or bad. Sensible companies as well as sensible investors will conduct serious scenario analysis to understand the implications; and will consider not just possible scenarios for inflation, but possible scenarios for inflation volatility.

(* I recently watched this interesting 3.5-hour video, where Stephen Wolfram talks to Nassim Nicholas Taleb about (mostly financial) economics. It’s fascinating, thought-provoking, frustrating and infuriating in equal measure. I hate that certain male know-it-all types are happy to spend 3+ hours talking about, and pretending to convey some insights about, something neither of them obviously understands very well. Yet, I’m all in favour of cognitive diversity, and it is precisely the fact that neither of them has studied “standard” (micro or macro) economics which also provides some of the key insights and allows them to think “out of the box”. They are not lumbered with all the good and bad assumptions that economists carry around in their heads. The one key insight that I remember from the video was the one I mention above: for any financial variable, it is not just the expected value, or volatility around it, that you care about — but the uncertainty around that volatility. Technically, there is no bound to what the value could be. That is very different from physical systems, where at some point, something can’t be bigger than the universe, or give out more energy than it has embedded in it.)

PS. Someone let me know your best solution to the “footnote problem” when using the Medium platform. There doesn’t seem to be any elegant way of adding little “by the way”-type comments that are tangents to the main story but probably still interesting to the reader. So I’m using the very inelegant asterisk solution and hoping that, by the time people get to the end of the main story, they haven’t entirely forgotten what the asterisk was referring to…