Energy prices keep going up, feeding concern that the world is in for a prolonged period of inflation, or worst still, stagflation.

Just as the world appears to be returning to some sort of normality, consumers have been hit by an abnormally fast rise in commodities costs. Natural-gas prices, according to some European benchmarks, have more than quadrupled since the start of the year. Meanwhile crude oil and coal prices have risen by over 60%.

Analysts fear that once the winter chill sets in, and amid production and supply chain kinks, energy prices could rise even more steeply. Other non-energy commodities, including agricultural goods and industrial metals, have also seen price rises of around 20 percent - less dramatic than energy, but no less worrying.

Inflationary pressure

Granted, inflationary pressures had already been a feature of 2021 prior to these recent price hikes. But the situation has taken a turn for the worse. Now hovering at around 5.0% year-on-year, the US Consumer Price Index (CPI) is well above the 2.0% inflation rate targeted by the Fed.

The same is true of Europe. German consumer prices jumped to 4.1% in September, a level not seen for nearly 30 years. As a result, like the US, Eurozone’s headline inflation is at a 16-year high of 3.4%, and well in excess of the region’s 2.0% target.

But even while announcing an end to current liquidity levels, the Fed reiterated its view that this inflation was “transitory”. Many analysts and central bankers agreed. They reasoned that the commodity price rallies were largely due to a rapid post-pandemic economic re-awakening, so short term inflationary pressures were to be expected.

This view is supported by European Central Bank President Christine Lagarde, who said the region’s stronger economic growth and employment was giving rise to inflationary pressures. These would be expected to dissipate once supply chains adjusted to the new normal, although she accepted that energy prices would take longer to resolve.

Economic growth concerns

However as energy prices continue to surge, the consensus is starting to strain. Some markets watchers have started to fear that inflation may become more persistent than central banks are forecasting. The ripple effects of higher commodity prices is already flowing through into industrial production and post-pandemic consumer spending slowdowns. As a result, in October the International Monetary Fund (IMF) cut its 2021 US GDP growth forecast from 7% to 6%.

The IMF has urged regulators to stay on their toes. “Although central banks can generally look through transitory inflation pressures and avoid tightening until there is more clarity on underlying price dynamics, they should be prepared to act quickly if the recovery strengthens faster than expected or risks of rising inflation expectations become tangible, ” the IMF warned in their most recent World Economic Outlook report.

Perhaps even more worrying than inflation is stagflation. Not the kind of stagflation seen in 1970s US when inflation was in double digits, unemployment was close to 10% and the economy was in recession. Nevertheless, some analysts say we are facing the spectre of “modern day stagflation”. This is when inflation is driven by entrenched supply factors rather than strong economic output, and therefore matched by a minimal uplift in employment, wages and consumer confidence.

Reflationary trades

However, on close inspection of US growth forecasts, it would still appear that post-pandemic economies are more likely to surprise on the upside than the downside. Various US growth surprise indices have been improving since end-August (see chart).

Figure 1: Growth Surprise Indices: Jan – Sep 2021

Source: UOBAM Research, based on Bloomberg data

In the meantime, unlike the highly dovish stance taken by central banks in the recent past, there appears a growing willingness to limit liquidity in order to keep inflation under control. The market now expects the path of the US’s Treasury purchase programme and interest rate rises to be brought forward to 2021 and mid-2022. The EU is expected to follow suit at its policy meeting in December.

This causes us to argue that reflationary trades are more likely to unfold in the coming weeks and months. In contrast to stagflation, reflation occurs when economies emerge from a crisis and is returning to good growth and employment conditions, but amid rising inflation and in some cases, rising interest rates.

Under such conditions, last seen in late-2012 to 2013, late 2016, late-2017 to late-2018, US Treasury yields and the USD both rose. In this growth-driven environment, we would expect cyclical sectors such as energy, materials, industrial and financial sectors to outperform, especially those in Europe and Japan.

Similarly, smaller cap companies may offer better upside opportunities than larger ones. Research has shown that in a reflationary environment, large cap quality stocks tend to underperform the broader index by 1.5% – 3.0%. Technology and growth stocks also tend to perform less well.

Higher income-generating assets such as corporate bonds and real estate investment trusts (REITs) would be favoured over government bonds, although the rising rate environment would suggest a preference for shorter duration credits. While gold is typically used to hedge against inflation, this may not be the case given the expected rise in the USD and real yields.

The risks to these forecasts rests of course on how stubborn inflation will be. Should inflationary pressures remain high for an extended period, central banks may have to tighten more aggressively, and both business and consumer confidence may diminish. This would not bode well for economic growth, in which case a stagflation scenario may indeed come to bear.