However, a number of leading indicators show the inflation environment is changing now although we are still some distance away from reaching the 2% level desired by policymakers. US money supply growth is collapsing, and three-month annualised declines of this magnitude have not been seen since the Great Depression.
US CPI has softened after touching a four-decade high of 9.1% in June as commodity, food and oil prices have fallen from their peak seen earlier in 2022. China’s producer prices have declined to the lowest levels in two years, which should provide relief for US CPI as well. It’s no longer a question of whether inflation will slow from here but rather a question of how quickly it will decrease and where will it ultimately settle.
The foremost question in investors’ mind right now is whether recession is a certainty, or whether soft landing is still a possibility. Soft landing implies slower growth and lower inflation without inflicting material spikes in unemployment, significant pain on the economy or further weakness in risk assets. Western central banks started raising rates only towards the end of the first quarter of 2022, but the hiking process has certainly been aggressive.
Typically, economies take anywhere between 12 and 24 months to digest a rate hike or cut, depending on how levered the economy is. If history is any guide, an immaculate transition from high inflation to normalised inflation while keeping growth steady is extremely unlikely. Central banks tend to overtighten under these conditions due to the long and variable lags of monetary policy. We are entering 2023 with policy already highly restrictive, with much of the historic tightening still to be digested and further hikes to come across many markets. In our view this will spur a sharp downturn in growth that is being picked up to some extent by the recent Purchasing Managers Index (PMI) data2 and many of our leading indicators are highlighting this will only deteriorate out into 2023.
A natural corollary of recession will be a steep fall in inflation. Analysis shows that over the past 100 years the US Consumer Price Index (CPI) declined on average 7% during recessions.
Housing prices also influence spending patterns, and ultimately impact the health of the overall economy. The rise in mortgage rates has dramatically reduced affordability, particularly in the US. Prices are falling in the UK, Hong Kong, Canada, New Zealand, Australia and Sweden. China’s property market is also going through a difficult time, which naturally has a bearing on global economic growth.
Finally, housing markets are also important for inflation. Shelter is roughly one-third of US CPI. In recent months shelter CPI has been catching up with the parabolic increase in house prices seen in the last years. Looking at more timely indicators such as rents asked in the market, we can already see a meaningful slowdown. In other words, weakness in the housing market will translate to lower shelter inflation going forward.
Overall, the growth backdrop should prompt central banks to pause and then reverse some of the policy actions of 2022. These could include stopping quantitative tightening (sale of bonds) or starting to cut rates, or a combination of the two. We think the US Federal Reserve is likely to pause rate hikes in the first half of 2023 and move to an easing cycle later in the year. That would be a fertile environment for very strong bond returns.
History shows the Fed pauses between four and six months before easing rates, but a cut could be hastened if unemployment spiked, or other economic indicators deteriorated in a particularly violent manner. Maintaining price stability is a key economic goal of the Fed along with “maximum employment”. Therefore, we would expect Fed action to avert any rapid deterioration in the job market.
The financial markets face other risks too. The Russia-Ukraine conflict is still ongoing, and uncertainty is elevated. We would avoid pinning down specific forecasts for crude oil or natural gas prices as these will essentially depend on unpredictable factors such as the end of the conflict or what kind of winter lies ahead of us. However, it is quite clear that commodities are no longer the main force behind inflation and we might expect some disinflation coming from there in the future as has already been witnessed in certain base metals.
2 The PMI is based on a survey of senior executives at companies to gauge economic trends including measures such as new orders and inventories.
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