We are all hoping to see an end to the invasion of Ukraine, however we believe the reduction in geo-political risk is unlikely to materially change the inflation pressures in the global economy. US inflation is currently running at 8.5%, and this is before the full ramifications from Russia’s invasion of Ukraine are accounted for. We believe, though, that inflation is much bigger than any one factor, it is a multi-faceted and as-yet unchecked phenomena. One need only look at the current Federal Reserve policy rate of 0.5% to see just how much lower interest rates are compared to inflation. This is the case not just in the US but across the world, in fact the problem is arguably worse in Europe where interest rates are negative and Spanish inflation is running at ~10%.
The key worry for central banks is therefore that a wage-price spiral develops, and inflation expectations become de-anchored from the psychologically important 2% level. While growth has undoubtedly slowed in recent months, central banks will not be too worried. Don’t be fooled by the nominal yield curve and talk of a recession, the last batch of PMIs signalled robust growth and, with employment so strong, low consumer sentiment is likely to be giving a false negative, in our view.
Put simply, we think monetary policy is much too loose and policymakers need to start raising interest rates and fast. Real rates (bond yields minus inflation) remain well below zero, which is great for the Nasdaq, but not for lower income households who bear the brunt of higher prices.
Core inflation has surged
Cyclical inflation is rising too
Source: Bloomberg, as at 01.02.22.
One can only speculate on what deglobalisation could mean for future inflation. Global trade as a % of GDP peaked in 2008 and has been falling ever since. The fallout from Russia’s aggression feels symptomatic of this wider trend, indeed the US-China trade war remains ongoing. If the trend continues, then the onshoring of supply chains will become more prominent as countries look to reduce their dependency on others for energy, food and raw materials more broadly. The implications of this could be profound, higher costs of production, margin compression, higher capital investment, more wage pressure and ultimately more inflation. As for commodities, a commodity premium may start to build as Western governments look for a reliable supply of energy and commodities, with the price of those supplies being secondary. Without Russian commodities, this leaves the western world with difficult choices, a fact best exemplified by Biden’s bizarre decision to send a US delegation to Venezuela.
This is a very different world to the one pre-Covid, with more fiscal spending and investment. In our view, real interest rates will need to move higher as, quite simply, everyone can’t spend at the same time. If the US tries to re-industrialize in even a small way, with no spare labour capacity the macro implications will be huge. Either a US productivity miracle occurs, or inflation will stay high and pressing.
The problem for central banks is that inflation has risen so much but real rates haven’t kept pace. So, by doing very little, financial conditions are easing which is contrary to what all these hawkish central banks want. In the end it just means they need to raise nominal policy rates that much more to have an impact. We also question where the ‘neutral rate’ even is. Nobody, including the Fed, really knows. So as inflation and growth stay high we believe the market will attach a risk premium to front end rates until we get some clarity (falling inflation or growth coming in lower).
An inverted yield curve is to be expected in a high inflation environment. The real yield curve is a more accurate ‘recession indicator’ and it’s still upward sloping, suggesting that the central banks are still not doing enough. We see the yield curve talk as misleading, though, and the growth backdrop solid. The headwinds have been handled well so far, but we admit the next few months are a hurdle to get through for the global economy mostly due to the energy risks in Europe. We remain positive but mindful of risks.
For us, interest rates remain far too low in developed markets, especially in the US. For all the fearmongering about a US recession, the fact remains that the US has never entered a recession with negative real rates. Real rates are near record lows, and the US labour market is incredibly tight, making the prospect of a recession seem to us a distant prospect at best, at least until interest rates move substantially higher. In our view the recession that many are calling for is the wrong way to see things, as the world has now changed. A strong recovery and structural shifts have generated inflation alongside pockets of growth weakness. But it is higher interest rates, not lower, that are needed as the global economy transitions.
US real yields are at record lows
Source: Bloomberg, as at 01.03.22
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