Inflation has continued to run high in recent months, pretty much wherever you look: the financial press is covered in headlines like “highest inflation for 30 years”. Increasingly we are seeing influential commentators calling for central banks to accelerate rate hiking plans. Indeed, while the US Federal Reserve and the European Central Bank have remained firmly dovish so far, New Zealand’s central bank has panicked into tightening, and the Bank of England’s contradictory actions suggest a level of worry in the UK central bank.
My analysis remains that much of the inflation we are seeing today is driven by transitory factors to do with reopening the world after Covid. Supply chain complications caused by the pandemic are proving a lot more difficult to resolve than I and many others imagined, and they can continue into the new year, but they won’t be with us forever. Similarly, Covid has caused disruption to labour, which has driven some wage inflation at the top level. Again, peeling back the surface, the average cost of labour per unit of output hasn’t actually increased. I expect to see wage pressures tail off as more and more people come back to work. In fact, in the U.S., broadly speaking, productivity has been comfortably outpacing real compensation per hour.
Policy is becoming a headwind to growth
I see a number of headwinds to growth as we head into next year, and there is a real risk that inflation fears force central banks to increase the pace of tightening just as the global economy slows down. This could cause a setback to recovery next year.
While monetary policy may remain loose by any historical standard, the pace of central bank balance sheet expansion has pretty much stalled out. Also, money supply growth has rolled over in all major economies. China’s M2 money supply growth is basically back to record lows at just above 8% year on year.
In addition, one of the key drivers of the recovery has been incredible levels of fiscal stimulus, particularly in the US. In 2022, the US is expected to experience significant fiscal tightening. In fact, across the G4 economies we are about to see monetary and fiscal tightening to the tune of $5 to $7 trillion, which is equivalent to Japan’s GDP. Also, it’s worth bearing in mind that the recently announced US infrastructure package will be spread over many years and given the parlous state of US infrastructure, this sum of spending is not going to have a material impact on forward looking GDP expectations, in our opinion. Furthermore, we would argue that governments struggle to allocate capital efficiently and sadly, delays, cost overruns and leakages in some shape or form tend to be a regular feature.
One of the impacts of higher prices we have seen this year is it has had a material impact on consumer confidence: US consumer surveys on durable goods spending show buying conditions have plummeted to levels not seen since the early 1980s. Also, spending on durable goods rocketed during the pandemic as consumers spent the money they saved staying at home on white goods and home improvements. That spending surge is exhausted, and while we expect higher spending on services, the $800bn service sector can’t compensate for the somewhat inflated $2tn durable goods sector.
China: canary in the coal mine?
So far volatility in Chinese real estate has been confined to China: we’ve seen at least six defaults, and over 40% of China high yield bonds are trading below 50 cents on the dollar. The Chinese government is actively trying to reduce over-indebtedness in its overleveraged property sector, and we think this volatility can keep going for some time. Why does this matter? The sector, at approximately $60tn, is by some measures the world’s largest asset class. More importantly, 80% of Chinese household wealth is concentrated in real estate, compared with just 15% in the US, and 60% in Japan at the heights before the Japan property crash in the late 1980s.
I expect this real estate crisis to ripple out across the rest of the world. Chinese import demand is already suffering as Chinese divert earnings into building up lost savings. I’m also seeing incipient signs of a slowdown in eastern Europe, which is a bellwether of Chinese demand because much of western European industrial production is concentrated in that region. In fact, we are also seeing early signs of a slowdown unfolding in Germany. Currently it is hard to gauge if this is due to renewed Covid problems or the China slowdown. This needs to be watched closely.
Tightening into a slowdown?
Looking ahead into 2022, I see significant headwinds for the global economy as Chinese demand slows and some of the tailwinds of fiscal policy and pent-up demand that have sustained the economy since the pandemic start to fade. Central banks are at the same time under enormous pressure to normalise monetary policy, and this pressure is increasing as inflation numbers continue to come in ahead of target.
The recent flattening that we have seen in some areas of the bond market – meaning that while shorter term yields have been rising, longer term yields have been falling – indicated, in our opinion, that growth and inflation are likely to be subdued. In the US, the ongoing inversion in the breakeven curve (longer dated inflation expectations are lower than shorter dated) also points to inflation not being persistent longer term. In my opinion, bond markets are getting a scent of economic difficulty emanating from China and are worried that central banks risk committing a policy error by tightening into the teeth of a slowdown and peak inflation and may well end up having to ease at some point next year.
In portfolios, this means that at these levels we think developed market government bond yields in places like Australia and the US are attractive and have room to come back down in the medium term. They also act as a good ballast to risk in the portfolio. I’m still finding interesting opportunities to put capital to work in the credit market, relying on bottom-up fundamental credit analysis, but I am reducing credit risk and prefer shorter maturity bonds. I’m cautious on emerging markets given the situation in China, but I do see an opportunity for Chinese government bonds, which I expect to rise in value as China is eventually forced to ease policy.