My anecdotal experience of inflation in the hospitality sector (a glass of wine and a pint of beer) got me thinking about how developed economies are placed for the present inflation challenge.
There was a certain naivety on my part but when the waiter (table service) asked what we wanted and the list of alternatives was reeled off, I chose to focus on the choice and size rather than establishing the price. The Chardonnay and real ale must have been at least 25% higher than this time last year. Perhaps not a great example to be extrapolated into future, and not the basis to make an investment decision, but it did remind me that service orientated economies will find it more difficult to rein back current inflation trends.
In the service sector competition is predominantly domestic. My local barber’s competition is 100 metres up the road – not from China or Germany or US. And these services businesses are facing the same cost pressures, especially from a shortage of workers. Stories that restaurants and pubs are not opening for lunch time service due to the unavailability of staff sound surprising for an economy that suffered a 10% contraction last year. But the reality is that unless real wages go up it will be hard to attract waiters, chefs, shop assistants, hairdressers etc. The UK is not alone in facing these issues: a recent University of Chicago study found 42% of those on benefits receive more than they did at their prior jobs due to current support schemes. Come September it may be a different story as programmes come to an end but in the meantime those higher costs will be passed on.
A complicating factor in the UK, highlighted by Tim Martin of Wetherspoons, is the lower number of European workers post Brexit. Unless the government changes its stance on the criteria for worker entry into the UK there may be no alternative but to pay staff more.
So what does this mean for monetary policy? Central banks will need to hold their nerve and see through this near-term pressure. But if consumers’ inflation expectations start to pick up it will be difficult to argue that 0.1% is an appropriate policy rate in the UK. This leads to the question of why I am not more bearish on fixed rate bonds. To be clear, I think yields are going higher but that we are still in an environment of low interest rates. As Melanie Baker, RLAM’s Senior Economist pointed out to me, the UK is very sensitive to interest rate moves given high debt levels – so relatively small tweaks on the bank rate will impact the economy.
The private sector is not the only area that would be impacted by higher rates. Public sector finances have become a lot more sensitive to short-term interest rates thanks to QE: the buying of government bonds has been financed by the creation of central bank reserves that are paid the policy rate. Long maturity government debt has effectively been refinanced with short-term debt. The Office for Budget Responsibility estimates that a 30bps increase in the Bank of England’s policy interest rate would add £6.3 billion to the government’s interest bill. That’s an incentive to keep rates low.
Cash, government bonds and currencies
No real change in currency markets over the week with sterling staying towards its recent highs. Cash rates remained low with little movement in most markets.
Global bond yields fell again over the week, with 10-year US treasury yields moving back below 1.6%. In the UK yields ended the week below 0.8%. In the euro area there was a similar pattern with 10-year Italian yields, for example, declining to 0.8%, compared with 1% three weeks ago.
There were no significant changes in implied inflation – but this remained towards the highs for the year in all markets.
In the UK construction output rose further above pre-virus levels; the strength was broad based with each of the sub-indices of civil engineering, commercial and housing activity over 60, well above the no change benchmark of 50. Activity was strong despite increasing difficulty sourcing materials. The supplier’s delivery times balance deteriorated from 25.2 in April to 14.9 in May. Increases in the prices of steel and wood had already pushed up construction materials price inflation to 7.8%.
Investment grade credit spreads again went sidewards during the week but remain near YTD lows. There were several subordinated bank new issues which we bought – although initial price talk was more generous than actual printed terms, reflecting strong demand for these bonds. We remain overweight subordinated bank and insurance debt and feel there is further spread tightening to be had but remain aware of the greater volatility of the sector.
High yield bonds continued to perform well although spreads were broadly unchanged on the week.
The weekend comments by US Treasury Secretary Yellen reinforces the message that central banks should be in no hurry to raise rates and that a bit of inflation is a good thing. The problem for rate setters is that they just don’t know how the pandemic and its aftermath will play out. Our best estimate is that inflation will moderate later in the year but there is certainly a danger that government bond markets are too complacent here.
Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are the author’s own and do not constitute investment advice.