BY GUY CARSON
Back in November, we wrote about inflation (see Inflation: Transitory or Here to Stay?). In that article we highlighted the two key causes, bottlenecks and monetary / fiscal stimulus. At the time, both factors were driving inflation up. Since then, a lot has happened. The war in the Ukraine broke out putting fear into the market around the supply of oil and also agricultural commodities such as wheat. This coupled with further lockdowns in China on the back of their zero Covid strategy, created a perfect storm in terms of inflation. In the US, Consumer prices have risen 9.1% over the last year driven by a 41.6% increase in energy prices. Core inflation which strips out energy and food is still running at an elevated 5.9% and the Federal Reserve’s preferred measure, Core Personal Consumer Expenditure (Core PCE) is running at 4.7%.
The core PCE measure is the clear focus for the Fed and after surging in 2021 and early 2022, there are signs that it is easing.
After peaking in March at 5.3%, the year-on-year rate has fallen to 4.7%. From the above chart, we can see the first clear signs of inflation began to emerge in April / May last year. Despite this, the Federal Reserve did not start hiking until March 2022. They were clearly behind the curve. However, whilst this is true, people can also significantly underestimate the impact that interest rate rises will have. This impact is due to the continuing rise of private debt in a low interest rate environment.
Private debt consists of household and corporate debt. It is different to Government debt because households and companies don’t have access to a printing press and can’t print their own money, they have to service it via income and need to have the means to pay it back. High debt levels don’t cause a problem on their own but they do make an economy vulnerable. With interest rates now on the rise, this vulnerability is being exposed. In 2008, the world entered a deleveraging cycle predominately in the household sector and a recession followed. The above debt chart is the reason why comparisons to the 1970s are misleading. Debt levels were significantly lower then and households could withstand interest rate rises. As we have seen over the last few decades, small interest rate rises now have a major impact.
One way to fix inflation is to weaken demand and that is what the Fed is doing via aggressively hiking interest rates. The question becomes whether they force the economy into recession as a consequence. When we look at bond markets, we can see that recession odds are on the rise. In fact, the most reliable recession indicator, the US treasury curve, has just started to indicate we are heading for one with the 10 year to 2 year spread turning negative. This indicator has successfully predicted every recession since 1980.
In addition, US GDP for the first quarter fell at an annualised rate of -1.6% and the Atlanta Fed’s GDPNow tracker is currently tracking at -1.2% annualised for the second quarter.
As well, as the warning signs above, commodities are starting to price this risk in. Copper is often referred to as “Dr Copper” because of its widespread industrial use and its ability to predict the economy. Currently “Dr Copper” is in freefall and is down nearly to pre-Covid levels.
Oil is also off its peak having fallen c. 20% despite the ongoing war in the Ukraine.
The issues with Oil and Gas supply are going to continue whilst the war is ongoing. It is important to watch this, most notably forced disruptions such as the shutdown of the Nord Stream 1 pipeline. It is also important to note that whilst Western Europe needs the gas, Russia also needs the income to finance its war so whilst they flex their muscles at times and cut supply, ultimately it is in their best interests to keep it running.
Any resolution to the war will likely lead to a decrease in energy prices, however that seems unlikely in the near future.
Going back to our article in November, there were two factors driving inflation – bottlenecks and monetary / fiscal stimulus. We have had a third factor thrown in there with the war in the Ukraine. At this point though, bottlenecks are easing and stimulus is reversing. The indicators are pointing to a slowdown in the economy and inflation forces easing. The extent of the slowdown to watch and unemployment will be the key variable, at this point it has held up well. The discussion is likely to switch from inflation to economic growth (or lack thereof) over the course of the rest of this year. If it wasn’t for the war in the Ukraine, we would most likely be pointing to a win for team transitory in the great inflation debate right now.
With regards to asset prices, back in November, we indicated that Cryptocurrencies, non-profitable technology and electric vehicle stocks were some of the most vulnerable sectors. That has played out and we continue to expect those sectors to struggle. The focus is firmly back on earnings for the first time in a long while. Value has started to shine and outperform growth for the first time in over a decade. Whilst we expect this to continue, we are now facing the prospect of earnings declining as the economy slows. This makes markets very challenging at present and suggests that the lows may not be in. Having said that, opportunities will appear as good companies fall with bad companies. These opportunities are likely coming and investors should be positioning themselves to take advantage.
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Disclaimer: The above contains the opinion of the author and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice