Higher Food and Energy Prices Spell Danger Ahead

Summary

• Food and energy prices have risen sharply of late
• Upward pressure on global manufacturing costs is a likely result
• US breakevens have risen but by much less than headline CPI

Market Implications

• Breakevens present asymmetric upside given these developments, offering an attractive risk/reward
• Rising yields may put upward pressure on risk-premia and downward pressure on equity valuations. Caution is warranted

Although highly volatile of late, energy prices have risen above their H2 2020 ranges. Now back over $55/bbl, Brent crude is its most expensive since Q1 last year, notwithstanding that much of the world remains mired in various stages of partial lockdown, reducing mobility (Chart 1). Assuming that demand for commuting and leisure travel recover somewhat during the year, then higher energy prices are almost certainly on the cards. This is the first step towards my recent ‘Grey Swan’ scenario of sharply higher food and energy price inflation in 2021, perhaps to above target in several major economies.

Food prices, meanwhile, have continued to rise on average from last year’s already elevated levels. Soyabeans, arguably the world’s most important single source of protein, have led the way. The near contract is now trading above $1400, the highest level in over five years and a ~50% increase over the past year. The other major grains have also risen sharply, if not by as much (Chart 2).

Food prices comprise only a small portion of the overall CPI baskets for most developed economies. But considering that emerging market manufacturing workers spend much of their disposable income on food, the potential upward pressure of higher global food prices on wages and, consequently, on manufacturing costs generally can be large over time. Adding energy into the mix has the potential to result in even higher all-in manufacturing costs.

Amid weak final demand in developed economies, such a cost supply shock might have little impact on the overall price level. But with all manner of Covid-related fiscal stimulus still working its way through the system, the overall mix is one of higher input costs on the one hand and relatively stable overall demand on the other. Should even more stimulus arrive in 2021, as seems likely in the US if not most major developed economies, then the overall impact on the price level could be all the greater.

Indeed, at least in the US, headline CPI has already been running hot since July (Chart 3). The six-month seasonally adjusted annualised rate has risen to around 4%. The core figure has been held down by the owners’ equivalent rent component, the somewhat controversial way in which the US estimates the costs of housing. Core rates of CPI have also remained low in China, Japan and Europe, as my colleague Bilal Hafeez has pointed out in a recent note downplaying inflation concerns. While that has indeed been the case so far, history provides examples of multi-quarter leads and lags within and between headline and core inflation components and across countries. The jury, in my opinion, is still out.

As the Fed made clear last year, they would welcome a period of higher CPI. As such, the near-term outlook for policy rates is that they remain unchanged for now. But the bond market is beginning to smell out some possible trouble. Yields have been rising, including inflation breakevens, although not by a comparable level of magnitude. That could begin to change.

If so, then it is highly likely that stretched equity and other risk-asset valuations are due a correction. They are where they are largely because of the previous low-yield environment. Should price pressures keep building and a general reassessment for persistently higher inflation occur, the overall impact on risk premia, earnings multiples and consequently on prices could be dramatic. Higher investor caution would therefore now appear warranted.