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The fear of rising inflation has caused market volatility to spike. Kim Parlee speaks with Hafiz Noordin, Portfolio Manager, Global Fixed Income, TD Asset Management, about the seriousness of the inflation threat and implications for markets and investments.
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[AUDIO LOGO]
- Hafiz, the title of your piece that you just put out on inflation is called, "Is it just smoke and mirrors or the next big risk?" So that is the question-- which is it?
- Well, thanks for having me, Kim. And, yeah, certainly inflation has been top of mind, and a lot of people are asking that question and having that debate. Ultimately, where we land is that we do think inflation is transitory, despite all the noise. And on its own, inflation won't derail the markets. But it will be a source of volatility.
And for consumers, it's certainly a reality that we all have to deal with. Thinking back to last summer, and I, along with many others were going to do some home renovation projects, and I remember for one of the projects, between the time that I first spoke to a contractor and then having them start the work, which was maybe only a couple months, our quote for lumber prices doubled.
And fast forward to today, lumber prices are now four times what they were prior to the crisis. So broadly speaking, what's going on? Well, despite being in a global pandemic, consumption across the globe is still very strong. People are still buying a lot of stuff-- and in some cases buying more than they did prior to the pandemic.
Home improvement's one area, but also think of consumer electronics. Everybody wants devices while we're stuck at home, or buying more food and cooking at home, rather than going out to eat. And fueling all of this is a massive amount of government stimulus to support household spending.
And for suppliers, the challenge has been that it's been really tough to keep up. Inventories have been low and are getting lower. And there's labor shortages, both in terms of production and distribution. So you've got strong demand, and then you've got low supply, and that combination leads to higher prices.
Up to now, producers have been mostly eating these costs and absorbing them and were seeing reduced margins. Now what we're hearing is that companies are going to be passing on some of these cost pressures to consumers.
- Hafiz, it's a great explanation, I think, as to why we're seeing the inflation we're seeing. And again, for those who are building decks, it's not the best time. But tell me why you just think it's transitory and why it's not going to last.
- Right, well, everything I've talked about is really around goods inflation. And goods make up about 40% of our consumption, on average. And historically, when we look and study goods-related inflation, it tends to be volatile. And it tends to be more transitory, especially when supply issues are part of the equation.
The other 60% of our consumption is services. And when we look at the data around services inflation, it's been recovering. But it's still looking pretty sluggish right now. And it kind of makes sense with all of the ongoing shutdowns.
So looking forward, we can expect services inflation to continue recovering, as we all get vaccinated and as the economy more fully reopens. But even when we get to that point, to see persistent inflation, what we really need is wage growth in the economy. And to get wage growth, we really need the economy to be running at full capacity.
Or in other words, we need to recover all the jobs that have been lost over the past year to get to a point of full employment. And when we get to that, that's when workers have the bargaining power to demand higher wages. And once those higher wages are in the system, that then feeds in more broadly to not only goods inflation, but also to services inflation. And that's when you see that persistent inflation pressures.
Given the number of jobs left to recover, from what we see, we think we're still a ways away from seeing that wage-related inflation pressures.
KIM PARLEE: So let me ask you-- I've got about a minute left, Hafiz-- but just if, given that it's transitory-- and again, you're not so concerned with the wage growth you see coming longer term-- what does this mean for people, in terms of implication for equities, fixed income, other asset classes? What should we be watching for?
- Well, certainly from a longer-term perspective, if we're right about inflation staying low and stable, then that's great for equity returns. 1% to 3% inflation has been typically the sweet spot for equity returns. But even if we get into an unexpected bout of inflation, equities can still do well. But you just have to be invested more in companies that have the ability and pricing power to pass on those costs, so whether it's due to a strong brand or a competitive advantage to protect their margins.
Fixed income returns I think will be more challenging in that kind of environment, where inflation and interest rates are more volatile. And so to protect purchasing power in a broadly diversified portfolio, you would really look to not only equities, but alternative asset classes-- think real estate, infrastructure, commodities. These have all historically exhibited inflation hedging characteristics.
So I think the main message I would have around that is that asset management, both at an asset class level as well as at a security selection level, will be very important.
KIM PARLEE: Hafiz, thanks so much for joining. Great to have you with us.
- My pleasure.
[AUDIO LOGO]
[MUSIC PLAYING]
- Hafiz, the title of your piece that you just put out on inflation is called, "Is it just smoke and mirrors or the next big risk?" So that is the question-- which is it?
- Well, thanks for having me, Kim. And, yeah, certainly inflation has been top of mind, and a lot of people are asking that question and having that debate. Ultimately, where we land is that we do think inflation is transitory, despite all the noise. And on its own, inflation won't derail the markets. But it will be a source of volatility.
And for consumers, it's certainly a reality that we all have to deal with. Thinking back to last summer, and I, along with many others were going to do some home renovation projects, and I remember for one of the projects, between the time that I first spoke to a contractor and then having them start the work, which was maybe only a couple months, our quote for lumber prices doubled.
And fast forward to today, lumber prices are now four times what they were prior to the crisis. So broadly speaking, what's going on? Well, despite being in a global pandemic, consumption across the globe is still very strong. People are still buying a lot of stuff-- and in some cases buying more than they did prior to the pandemic.
Home improvement's one area, but also think of consumer electronics. Everybody wants devices while we're stuck at home, or buying more food and cooking at home, rather than going out to eat. And fueling all of this is a massive amount of government stimulus to support household spending.
And for suppliers, the challenge has been that it's been really tough to keep up. Inventories have been low and are getting lower. And there's labor shortages, both in terms of production and distribution. So you've got strong demand, and then you've got low supply, and that combination leads to higher prices.
Up to now, producers have been mostly eating these costs and absorbing them and were seeing reduced margins. Now what we're hearing is that companies are going to be passing on some of these cost pressures to consumers.
- Hafiz, it's a great explanation, I think, as to why we're seeing the inflation we're seeing. And again, for those who are building decks, it's not the best time. But tell me why you just think it's transitory and why it's not going to last.
- Right, well, everything I've talked about is really around goods inflation. And goods make up about 40% of our consumption, on average. And historically, when we look and study goods-related inflation, it tends to be volatile. And it tends to be more transitory, especially when supply issues are part of the equation.
The other 60% of our consumption is services. And when we look at the data around services inflation, it's been recovering. But it's still looking pretty sluggish right now. And it kind of makes sense with all of the ongoing shutdowns.
So looking forward, we can expect services inflation to continue recovering, as we all get vaccinated and as the economy more fully reopens. But even when we get to that point, to see persistent inflation, what we really need is wage growth in the economy. And to get wage growth, we really need the economy to be running at full capacity.
Or in other words, we need to recover all the jobs that have been lost over the past year to get to a point of full employment. And when we get to that, that's when workers have the bargaining power to demand higher wages. And once those higher wages are in the system, that then feeds in more broadly to not only goods inflation, but also to services inflation. And that's when you see that persistent inflation pressures.
Given the number of jobs left to recover, from what we see, we think we're still a ways away from seeing that wage-related inflation pressures.
KIM PARLEE: So let me ask you-- I've got about a minute left, Hafiz-- but just if, given that it's transitory-- and again, you're not so concerned with the wage growth you see coming longer term-- what does this mean for people, in terms of implication for equities, fixed income, other asset classes? What should we be watching for?
- Well, certainly from a longer-term perspective, if we're right about inflation staying low and stable, then that's great for equity returns. 1% to 3% inflation has been typically the sweet spot for equity returns. But even if we get into an unexpected bout of inflation, equities can still do well. But you just have to be invested more in companies that have the ability and pricing power to pass on those costs, so whether it's due to a strong brand or a competitive advantage to protect their margins.
Fixed income returns I think will be more challenging in that kind of environment, where inflation and interest rates are more volatile. And so to protect purchasing power in a broadly diversified portfolio, you would really look to not only equities, but alternative asset classes-- think real estate, infrastructure, commodities. These have all historically exhibited inflation hedging characteristics.
So I think the main message I would have around that is that asset management, both at an asset class level as well as at a security selection level, will be very important.
KIM PARLEE: Hafiz, thanks so much for joining. Great to have you with us.
- My pleasure.
[AUDIO LOGO]
[MUSIC PLAYING]
