Nancy Euvrard, investment manager for Close Asset Management, argues why inflation fears should be unfounded.
Inflation has been one of the main economic concerns during the first half of this year. In Northern Africa and the Middle East the ‘Arab spring’ uprising of societies against their totalitarian rulers has to some extent been explained with the discontent caused by rising costs for basic food and other items.
And food price figures are absolutely petrifying agrees Euvrard. The CRB Food Index, a commodity food price index, has shown over the last 12 months a 38.6 per cent increase.
“The scary thing about this is that over the last year we have seen a 30 or 40 per cent increase in the price of food and yet if the CPI index comes out, the official index for food inflation, it is telling us that over the last year food inflation has been 3 per cent,” Euvrard says.
This difference in cost increase has to be borne by someone along the supply chain and essentially squeezes the margins for those involved.
But food prices are not the only driver of inflation.
Both personal income as well as personal expenditure had peaked in 2008 just as the financial crisis took hold, Euvrard says. In 2009 and 2010 those numbers have declined.
“Everybody this year probably feels a little bit poorer than they did last year,” she says.
When examining what a typical household spends its money on it becomes clear that housing makes up the largest portion of spending at about a third of the budget, followed by transportation (15.6 per cent), food (13 per cent) and pension and insurance (11 per cent).
Unhealthy health care spending
In addition to the already mentioned food price increases healthcare costs are another main driver of inflation, says Eurvrard.
“What we have seen over the last decade is a very consistent and really unhealthy rise in inflation in medical care, which has averaged about 4 per cent over the last decade, whereas all items in the consumer price index averaged only about 2.4 per cent inflation.”
Euvrard argues that the problem is mainly that consumers’ “ability to get better prices for health care somewhere else or actually not to purchase certain medical services is very limited”.
This inelasticity in terms of demand in medical care is reflected in the health care costs.
“As a component of our expenditure the amount that we spend on medical care is pretty scary,“ she notes, adding that in the US as a factor of GDP expenditure, medical care has gone from around 8 per cent to 14 per cent of GDP. “This is very unhealthy indeed.”
Another major price driver is oil. Quoting US figures, she explains that the price of gas at the pump per gallon has reached the $4 mark, exactly where it was in 2008, except that in 2008 the oil price per barrel was $142 and presently it is just over $100.
This oil price increase has affected economic behaviour. For instance the S&P tumbled 8 per cent as a result of the news that American consumers are actually driving less because of the price of gasoline, she says. The psychological effect of gas prices reaching $4 is having an impact on demand, something that is very unusual during an economic recovery.
“Normally, with the economy recovering, you’d expect gasoline demand to go up, but that’s not happening,” she says, quoting energy consultant Jim Ritterbush.
“So we have to look at this global recovery with a little bit of a pinch of salt.”
Shrinking pie economy
Euvrard believes we are in what can be regarded as a shrinking pie economy.
“At the same time, because we have inflexibility in terms of a number of things that we have to spend money on, the piece of the pie that we are able to spend on what we want as opposed to what we need is getting smaller,” she says. “So we have a smaller pie and a smaller piece of the pie.”
Not afraid of inflation
Yet despite these economic realities Euvrard believes large levels of inflation are not going to take hold in the near term and gives a total of seven reasons for her belief.
Reason 1. The relationship between supply and demand in an economy results in an equilibrium, which determines the price and quantity of goods and services sold.
“If we are in a shrinking pie economy, this could be considered a demand shock and if we lower the demand the new equilibrium will mean we see lower prices and lower quantity,” she explains.
“So if we see lower prices that really flies in the face of the inflationista out there but what it also shows is that lower quantity is a good indication of what we will see in terms of global growth.”
This argument is strengthened, for example, by the most recent retail sales data out of the US in May, which indicates that consumers are not buying as much as they did two years ago.
Reason 2. Euvrard is further not concerned with inflation, because US consumers spend about two thirds of their available income on services. Service providers, however, are not finding themselves able to impose price increases and as a result price inflation in the services industry is negligible.
Reason 3. Her third reason for not being overly concerned with inflation is that in real terms we are actually getting poorer. There is a real lag in terms of wages relative to prices and if wage increases do not match price growth, the resulting lower demand will make further price increases unsustainable.
Reason 4. Housing is also not supporting the consumer at the moment and it looks like we are going through a double dip in terms of housing data, Euvrard says. “Housing prices are trading down after an uptick post 2008 and we had quarter after quarter of negative news.”
Currently, 22 per cent of homeowners in the US have properties with negative equity, where the price of the mortgage exceeds the value of the property, and the prediction is that house prices could drop a further 15 to 20 per cent in order to get to their long-term mean. This would increase the share of homeowners with negative equity to about one third.
“When you feel that you have negative wealth, your desire to spend is just not there,” Euvrard states.
Reason 5. Although we have witnessed a dip in the US unemployment rate from 10.1 to 9 per cent, employment data is also not supportive of high inflation. The problem with the unemployment data is that it only counts people who are active in the workforce and actively seeking employment. Instead the more reliable labour force participation rate is at the lowest level since 1984 (64.2 per cent).
Reason 6. The high level of speculative interest in oil and other commodities exceeds the real fundamentals of what is actually in demand, “suggesting a possible pullback in price to actual supply and demand fundamentals”, Euvrard notes, adding that with rising commodity prices there is “probably more downside risk than there is upside risk”.
Reason 7. The final reason why people should not be overly concerned with inflation is that surveys of inflation expectations 12 months from now, which indicate high inflation in a year’s time, are very rarely accurate. “There is a psychological element that makes us believe what happened recently is going to persist in the future,” she says. “So when the oil price was at $142, the inflation expectation for one year later was 7.5 per cent, but actually one year later oil traded at $50 a barrel and inflation was a negative 2.4 per cent,” Euvrard recalled.
“We do get a bit emotional about the inflation issue, but if we sit down and break it into the components of what makes up inflation, it is really not as bad as we think.”