Paraphrasing an old adage, a forecaster is a portfolio manager who never marks to market. There’s some truth in this. There’s a disincentive in rapidly shifting views back and forth – which is equal to not having a view. Investors sometimes contrast the stickiness of macro forecasts with the market consensus, which changes continuously. Markets are highly efficient when it comes to absorbing information – they’re great observers. But, because they overreact to the latest news and tend towards excess on either the positive or negative side (and oscillate between the two), they’re rarely good predictors – in the sense of figuring out how tomorrow may differ from today. A better approach is thinking of the cause-effect relationships in the economy, and their market implications, in terms of competing narratives and adjusting their probabilities based on clear signposts. Stimulus cheques, demand-supply imbalances – how do they impact the inflation spike vs spiral debate?
Inflation narrative #1 | Spiral here to stay: The first-ever recession by government decree triggered drastic actions by central banks and governments worldwide. They injected trillions of dollars of liquidity into the economy and capital markets: benefit payments and enhanced unemployment insurance to individuals; loans and grants to businesses; and large-scale asset buying. The stimulus cheques added more than USD 2 trillion to consumer balance sheets, with wealth effects from stock market gains and soaring house prices dwarfing the impact on household incomes. Above-trend income growth coincided with below-trend spending growth, as we couldn’t spend money on services such as travel, hospitality and leisure. Instead, we bought goods – at lot of them. Used car prices rose because of shortages of imported parts. Materials and component prices, from lumber to metals and semiconductors, picked up too. Smartphones were in short supply. Shipping costs skyrocketed. Labour shortages in the sectors most impacted by the virus outbreak boosted wage growth. This is resulting in a broadening inflation spike. A tail risk is that it could become a self-sustaining spiral.
Inflation narrative #2 | Spike to subside: Shortages and longer delivery times for finished goods and intermediate inputs have to do with restarting supply chains. But demand-supply imbalances will subside, and so will the inflation spike (our base case). Vaccination in emerging markets, where most goods are manufactured, should mitigate production shutdowns. Demand will slow: a given pool of extra money can’t generate ultra-strong growth forever. A spending rotation from goods to services – the price of which isn’t spiking – should help. The price of lumber, which rose by 540% between April 2020 and May 2021, is now much lower. Iron ore prices are down. The energy spike should drop out of the year-on-year comparison, even if oil and gas prices were to stay unchanged at today’s elevated levels. The Baltic Dry Index, at a 5-month low, suggests that freight costs are moderating. No more enhanced unemployment benefits should bring extra workers into the job market, reducing labour shortages and wage pressures. Pay growth for high-income earners, which are in abundant supply, isn’t spiking. Automation, demographic change and globalisation remain disinflationary forces.
Here’s why this matters:
Interest rates & central banks: If we’re right that the inflation spike, however enduring, is unlikely to turn into a self-sustaining spiral, then central banks should only lift interest rates from record lows gradually. The inflation spike looks like a ‘tax hike’, with the potential to hurt the economy. Raising rates aggressively would only make things worse: think of higher mortgage payments, how does that help cope with higher petrol prices and utility bills? We’re more dovish than markets on rate hikes. The current policy mix is still designed to cushion a deep recession, while things have improved. So slowing/ending central banks’ asset buying makes sense, just like a gradual rise in interest rates as labour markets tighten and wage pressures rise – not now, but eventually. Aggressive tightening isn’t the right (nor the most likely) response. While the Fed and the Bank of England are likely to continue to take steps towards rate normalisation, the ECB is more dovish, which is why we see the dollar strengthening and, to a lesser extent, sterling recovering versus the euro.
Equities & cost pressures: Our tactical asset allocation continues to overweight US equities. Corrections are the norm rather than the exception, and this turned out to be the case again in October and early November as markets shrugged off cost pressures and logistics concerns to again reach new all-time highs. The 2021 rally in US equities has been driven by strong earnings growth rather than rising valuations. Earnings growth has likely peaked and looks set to moderate going forward, but remains a tailwind given strong consumer demand, low funding costs and high profit margins. Companies’ earnings for the third quarter highlighted a number of pluses and minuses, but a bias to pluses. Cost pressures, notably energy and staff, have caused some angst, but not enough to stop forward earnings forecasts being revised higher. While the rate of surprise has moderated from previous quarters, it’s still significantly above its long-term average. Structural drivers support the all-important and very large tech sector, while defensive and cyclical sectors are roughly balanced.
Meanwhile, watch policy, politics and geopolitics…
Never a dull moment: The Fed (Wednesday) and ECB (Thursday) minutes should confirm central bank divergence: more hawkish in the US and more dovish in the euro area, so the recent USD appreciation versus the euro may have further to run. Germany’s energy regulator “temporarily suspended” the certification of the Russia-backed Nord Stream 2 gas pipeline, sparking a rise in gas prices. A possible release from the US Strategic Petroleum Reserve of at least 20-30 million barrels of oil is a near-term downside risk for oil prices, but not a big one. In Japan, the Kishida Administration announced a JPY 55.7 trillion fiscal package, far exceeding the JPY 40 trillion mark expected by media, and the largest ever made. Investors will likely scrunitise the purchasing managers’ indices (Tuesday) for the US, euro area, Germany, France, UK and Japan for signs of whether the bottlenecks are intensifying or easing. The German Ifo business climate (Wednesday) could be important too, although it won’t yet capture the recent Covid restrictions and Austria’s lockdown. US core PCE inflation (also Wednesday), the Fed’s preferred measure, should exceed 4%.
Daniele Antonucci | Chief Economist & Macro Strategist