Like any good investor, we are always challenging our assumptions and through potentially structurally higher energy prices, “camp transitory” is being challenged. Elevated energy prices will only go to exacerbate and lengthen supply shortages. There is ongoing evidence of energy prices starting to bite such as the CO₂ shortage, German factory shutdowns because the cost of energy has made producing goods uneconomical, and power rationing in certain areas of China forcing factories on to a two day week. We now need to ask ourselves if we are entering a phase of persistent supply disruption and the ramifications this has for markets. Indeed, markets are this week in the process of waking up to the possibility this could be the case, with higher prices having the potential to erode company margins and put a dampener on global growth.

Central banks will attempt to shift policy to address the supply demand imbalance but it isn’t going to be straightforward.

Since the 90s, central bankers have been highly adept at keeping markets happy by stoking demand with promises of plentiful cheap money. They’ve been aided in this regard by ever more efficient supply chains, plentiful cheap labour and benign energy markets which has helped them increase demand without stoking inflation. But we are now in the situation whereby a lack of demand isn’t the problem, it’s a lack of supply. In response to this central bankers can only seek to reduce demand, they cannot increase supply, so if growth slows as a result of high energy prices and ongoing supply disruption then applying stimulus at that point only serves to make the problem worse – it creates more demand which will stoke more inflation.

At this juncture, central bankers feel positive enough about their economies to attempt to decrease demand to meet supply by tapering bond purchases and increasing rates. Many emerging markets are well into this cycle, but developed markets are just getting started. However, once the US Fed starts they are likely to realise that financial markets will find this far too difficult to stomach. And if supply constraints cause slowing growth at the same time, they will reach for the central bank put once again and in the process stoke further inflation. Everyone then gets squeezed by lower real incomes.

A necessary adjustment to save the planet

If we are to rapidly adjust to a lower carbon world, then higher prices for fossil fuels will force through the necessary changes more quickly. The adjustment is clearly painful in the short-term, especially for those developing countries that are heavily reliant on hydrocarbons for power, such as India. Having said that there is a bright light at the end of tunnel, an energy nirvana, when the infrastructure is in place to capture and importantly store enough renewable energy. The end game is most definitely deflationary, with clean, cheap energy that doesn’t ruin the planet. But the path to nirvana is a going to be a bumpy one and will last for years if we are lucky and decades if we are not.