YOUR MONEY MATTERS: The Bite Of Inflation & What To Do About It

Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies, and interest rates.

Understanding inflation is crucial to investing because it can reduce the value of investment returns. With inflation rising recently to its highest level in four decades, investors should understand the factors driving inflation, the impact on their portfolios, and steps to consider as the investment landscape changes.

At the moment, the world and especially the US are battling with increasing inflation. In December 2019, the US reported 2.3% Inflation, compared to 8.2% in August 2022. Origin of the recent increase is the covid pandemic and the stimulations, which the governments and their central banks made to strengthen the economy. The Federal Reserve printed $3.3 trillion in 2020 alone, which equals 20% of all US dollars in circulation in the same year. In 2021, $13 trillion was printed by the FED, of which 65% were because of Covid and infrastructure measures. According to various studies, inflation needs about 9 to 18 months to kick in, which explains why inflation is increasing since the middle of 2021 till now. The CPI (Consumer Price Index) gives a good indication about inflation and shows with the help of the CPI Basket, which sectors impact inflation the most. Break evens and economists predict a steep renormalization toward the FED’s 2.0% target over the next 12-18 months. While Services make up the majority of the CPI basket, Goods and Commodities are having a greater impact. Futures indicate that Food and Energy prices should fall -5.7% and -11.8% by the end of 2023.

How to protect investment portfolios from inflation

There is a good chance inflation will decrease over the next 18 months. Investors should be aware of the origin of the problem and should consider futures of CPI sectors, which indicate a decrease in the near-term future. Investors, who want to invest as safe as possible, should consider commodities and precious metals as well as real estate investments like REITS. These asset classes are seen as the best inflation hedge and can still provide good yields and returns. Investors who want to profit from a rebound, which will definitely occur in the future, should follow the sector futures of the CPI basket and invest more in stocks and bonds, to be prepared when the market goes up again.

In the U.S., the CPI for August came in higher than expected, rising 8.3% y/y compared to expectations for 8.1% y/y. On a month over month basis, the print showed a fairly muted increase (0.12% following a -0.02% decline in July), much lower than the average 0.67% m/m increase in 2021 and 2022. Plummeting gasoline prices of -10.6% were the main reason for this softness, holding down the overall index even as core prices increased solidly. Costs were driven by larger increases in food, shelter and medical care services, which offset the declines in energy. The 12-month change in core CPI inflation also moved up from 5.9% in July to 6.3% in August. But broadly, the share of the CPI basket rising more than 4% on an annualized basis fell further to 70.1% from 71.8% in July and June’s high of 74.8%, confirming the beginning of the downtrend that started in July.

As economies recover post pandemic, consumer spending is shifting away from goods to services, with prices for items such as electronics down 20% and PPI data also showing a downtrend. But as services represent a higher weight than goods in CPI (about 60%), this shift is also putting pressure on inflation, despite improving supply chain dynamics for goods. Spending on rents (shelter) rose by 0.7% in August and this explains around half of the overall rise in core CPI.

This report leaves the Fed with more pressure to keep their hawkish policy path. The CPI print has now settled the odds for a September Fed hike at 75bps and the futures show even a 1/3 chance of a 100bps hike. The market is pricing at least a further 50bps for the November and 25bps for the December meetings. As a result of the increased rate expectations, the 2-yr treasury yield has moved above the 3.7% level. The 10-yr however has only edged marginally higher to USD to 3.44%, still reflecting that the market expects inflation to eventually cool down. This year’s high on the 10-yr yield was at 3.5% and we don’t expect it to move much above that top. On the equities side, the print does not mark a material change in the underlying economic drivers. However, a sustained rally will only happen with enough monthly prints and evidence that inflation is slowing. Consequently, we see the S&P to continue evolving in its current trading range in the short term but likely to gain traction above its short-term moving average of 4050 in the next few weeks as sentiment becomes more positive. Furthermore, the 20- and 30- year US treasuries, i.e. the long end of the fixed income markets remain largely unaffected by the recent inflation prints suggesting, once again, the transitory nature of rising prices.

The picture for the underlying US economy remains strong and it should avoid a hard landing. The property market also continues to be resilient while the US consumer spending is holding up, having risen over the summer months. The labor market is also robust, still creating above 300k jobs per month and latest surveys showing companies are still struggling to find workers. We believe that the Fed will eventually be successful in slowing inflation and the job market, although it may take a couple more months than expected of weaker inflation and job data.

Elsewhere, the biggest unknown remains for the European economy, where the situation could become critical heading into winter, if Russia keeps the taps of the Nord Stream 1 closed and shuts further pipelines. The Eurozone economy is likely to experience recession, with both consumer and business confidence falling with growing concerns about energy security and rationing during the winter. The European Commission is struggling to implement emergency measures aimed at stemming soaring energy prices for consumers and companies. Meanwhile, talks between Russia and Ukraine continue about an exports deal “and its extension as well its possible expansion”. A two-part agreement — allowing both the flow of Ukraine’s grain exports blocked by the war and Russia’s food and fertilizer exports — was brokered by the UN and Turkey in July and is scheduled to last 120 days.  A discussion about the possibility of Russian ammonia exports through the Black Sea emerged over the last few days, offering glimpse of hope that further deals up to a cease fire are possible, particularly as pressure is exerted with the arrival of winter.

In China, the economy is already facing an economic slowdown and the country’s strict zero-covid policy is only accentuating the troubles as strict measures including lockdowns and mass testing put major cities into locked down for several weeks impacting consumer spending and business investments. As a result, major Chinese tech internet companies reported their weakest growth figures in history.  On October 16, China’s governing Chinese Communist Party (CCP) will begin its 20th party congress, during which Chinese President Xi Jinping is expected to secure an unprecedented third term, and consequently continue to “adopt more forceful measures to deliver the economic and social development goals for the whole year and minimize the impact of COVID-19”, as announced in late June of this year.

Why the inflation is low in Switzerland and why Switzerland and the Swiss Franc offer inflation protection?

Inflation has surged to levels not seen in decades due to supply chain bottlenecks, rising commodity/energy prices, and tight labor markets. These factors apply to most developed countries, but not to Switzerland where inflation remains low. The annual inflation rate in Switzerland unexpectedly was at 3.2 percent in August 2022.

The main reasons for this inflation gap are differences in the CPI basket and weights of the main expenditure items. These reflect the spending patterns of households in the different economies.

The main differences between Switzerland, the eurozone and the US concern the energy, food, housing excluding energy, and healthcare components.

In Switzerland, the lower weight of energy in the CPI basket, the contribution to inflation is 2.5 percentage points (pp) less than in the eurozone and 0.8 percentage points less than the US.

The change in food prices, which also impacts restaurant prices, was also smaller in Switzerland than elsewhere, reducing Swiss inflation by 1.1pp compared to the eurozone and 1.3pp compared to the US.

Overall, food and energy explain approximately 90% of the inflation gap between Switzerland and the eurozone – and about 40% of the gap with the US.

The evidence shows that energy prices are fundamental in explaining the differences in inflation, especially between Switzerland and the eurozone. This is almost totally due to differences in the price of electricity. In February and March, the price of electricity in Switzerland rose by only 2.4% year-on-year while in the eurozone it surged by 34.3% year-on-year.

This gap reflects the different technologies used to produce electricity. According to data from the International Energy Agency, less than 1% of the electricity consumed in Switzerland comes from oil and natural gas, while 58% originates from hydroelectric and 34% from nuclear power. By comparison, in the European Union (EU) over one fifth of the electricity supplied is produced with natural gas and over one eighth with coal.

The prices of these commodities, which the EU imports mostly from Russia, have surged over the past 12 months, pushing up electricity prices in the EU. The gap in energy producer prices inflation between Switzerland and the eurozone has widened to unprecedented levels. This is important because a shock to wholesale energy prices affects the production costs of goods and services in all sectors of the economy.

Swiss Franc Strength

The SNB is prepared to let the Swiss franc strengthen as part of its fight against inflation.

High inflation has transformed monetary policy worldwide. In common with most central banks, the Swiss National Bank (SNB) is countering rising prices with higher interest rates. Unlike other policymakers, it has signalled a willingness to intervene to keep the Swiss franc strong.

A strong currency is a logical response to keeping imports as cheap as possible and containing consumer prices. Inflation in Switzerland increased 3.4% in July compared with a year earlier. While that is less than half the 7.5% rise recorded in Germany in the same month, some of that is trickling into Switzerland’s small, open economy as it imports more expensive goods, including crude oil, and services from its neighbors. This means that the exchange rate is a large component of Swiss inflation.

The Swiss currency’s strength is not a story of a year or two but long-term appreciation. In nominal terms, the franc gained 40% against the euro since the common currency’s inception in 1999, and more than 30% against the US dollar over the same period. Currency movements are by definition relative changes, and the franc has appreciated in response to demand from investors for a haven currency. More recently, the franc has strengthened in response to the eurozone’s slowing economies, geopolitical exposure to the war in Ukraine and in particular, rapidly rising energy prices.

Still, while the franc has strengthened in nominal terms, it has not done so in real, inflation-adjusted terms. Compared with the highest euro-franc rates of early 2015 when the SNB abandoned its floor against the euro, or during the 2011 eurozone debt crisis, the Swiss currency has appreciated as much as 9% in nominal terms. However, when adjusted for inflation, it is about 12% weaker, and explains why the SNB can now afford to let the currency strengthen.

Switzerland’s corporations have had decades to adjust to a strong currency, and high costs, through innovation and efficiency improvements. That has also allowed many sectors to charge a premium for their exports. High value goods such as luxury watches and pharmaceuticals are especially unaffected by the strong franc, while sectors including industrial machinery and chemicals find it more difficult to remain competitive. Overall, Swiss industries should be able to mitigate the impact of the exchange rate on their exports and pass on higher costs to customers.

Swiss companies continue to warn that supply-chain pressures, rising costs, wage increases, high inflation and recession fears will affect demand. Many are necessarily more cautious about revenues for the second half of 2022 and into 2023. The healthcare sector may prove an exception as it remains more insulated from the macroeconomic environment with lower price elasticity.

Corporate earnings in the country have been stable, though slower than other regions historically. In a globally diversified portfolio, US stock markets offer higher, more expensive earnings growth. Still, the Swiss market offers an attractive way to add portfolio value. Whether investors are looking for higher, stable dividends or positions in leading industrial and technological stocks, Switzerland continues to provide bottom-up stock picking opportunities.