Stagflation – A Risk Worth Noticing

The supreme art of war is to subdue the enemy without fighting – Sun Tzu, The Art of War

Much is made in the news of the risk of inflation. We can’t step far outside our doors without being faced with the challenges it brings. From shockingly high petrol prices to rising agriculture costs hitting our shopping bills, the fear is setting in. However, when we strip out these volatile elements, just how much of a problem is core inflation? Instead, with economic growth precariously fragile, when it does become a concern, won’t we be left fighting a ‘war on two fronts’? It’s time we start to notice the ‘Elephant in The Room’.

An Anaemic Recovery

The economic recovery remains weak. Still driven by the consumer, the environment for spending is tenuous. Retail sales for December were downgraded and January’s figures can only be described as “unspectacular”. We saw the first increase in the claimant count in four months (which would have been even higher had people not given up the job search entirely). Moreover, earnings growth slowed to the lowest rate in six months (from 2.5% to 2.0%). With Hometrack, the property analytics business, foreseeing homebuyers facing a continued struggle to obtain mortgages in 2011, the outlook for spending and GDP growth looks tough.

Source: Capital Economics “UK Labour Market Data” Regular pay growth slowed from 2.5% to 2.0% (Published end Feb 2011, data to end Dec / Jan)

Consumer Companies Highlight the Headwinds

Highlighting the problem were the many consumer companies missing Q410 earnings estimates and downgrading their forecasts for this year. Diageo, Colgate-Palmolive and P&G were among those that struggled to meet expectations. Falls in demand were blamed, with the situation looking none the rosier going forward. Renault predicts the demand for cars in their home market of France will fall by 8%. In addition, rising input costs is adding to woes. Pepsi is budgeting for a whopping 8 – 9.5% increase in the amount of capital they will spend on oil and agriculture commodities, which contributed to the firm lowering their forecast for earnings growth from low double digits to high single digits. The question on everyone’s lips is – can they continue to pass on higher costs to the consumer? With the aforementioned weakness, the most likely answer is “no”.

Source: Bloomberg. Next share price (white) and the Cotton price (orange) + >10% YTD already.

Inflation ‘Illusion’ Tempting Risky Action

So just how much of a problem is inflation, when compared to the weakness of the recovery? True, headline Inflation has held stubbornly above the Bank of England’s target at 3.7%. However, stripping out food and energy prices, core inflation falls to 2.9% and recent reports show that after excluding taxes, we hit the 2% jackpot. Regardless, the political environment poses a risk. The MPC (Monetary Policy Committee) is under immense pressure to defend its credibility after keeping rates on hold for 23 months consecutively. Markets are now pricing in a 25bps rise in May. Crucially, these expectations alone have consequences. In one week alone, more than 10 mortgage lenders pulled their best fixed rate deals – hitting credit availability to the already weakened consumer ‘spenders’.

Only an idiot fights a war on two fronts. ~ Londo Mollari, Babylon 5

Stagflation – A ‘War on Two Fronts’

This is the crux of the problem – promoting growth can at times risk inflation and fighting inflation can risk weakening growth. Currently the biggest challenge of the two is strengthening growth. If the recovery remains weak, then when inflation rises and poses a far more serious challenge, the government will not be able to implement policies to fight it without dragging the economy into another recession. The possibility of stagflation is real. In this situation the government will feel even more pressure to raise rates but unemployment will still be high and so if rates rise, many will suffer. At the moment the MPC have a “wait and see” attitude – let’s hope this continues and they don’t succumb to ‘peer pressure’ too soon.

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