High inflation doesn’t scare the market anymore
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Good morning. Yesterday’s release of the Consumer Price Index proved quite interesting, as did the market reaction. Whoever put out that fake CPI report wasn’t dreaming big enough: Their made-up inflation rate of 10.2 percent was barely bigger than the real figure of 9.1 percent. Send your fabricated economic data our way: email@example.com and firstname.lastname@example.org.
Hot inflation, cold markets
There’s no getting around it: June inflation data was bad. And the details of the CPI report were no better. A brief overview of the horror:
Energy prices up 7.5 percent (month-on-month, seasonally adjusted)
Core inflation (excluding food and energy) remained high at 0.7 percent, with more sticky components such as core services (0.7), rent (0.8) and owner-equivalent rent (0.7) all hot
Categories that many thought would moderate soon refused to do so. Durable goods prices rose 0.7 percent, used cars and trucks increased 1.6 percent and transportation services 2.1
You can’t drink your problems away either: Alcoholic drinks were up 0.4 percent, driving a 6 percent year-over-year increase in the first half of the year (H/T Omair Sharif at Inflation Insights)
Futures markets reacted. The peak rate for fed funds is now expected to be 3.65 percent in January, up from 3.4 percent yesterday.
The really interesting point, though, is that stocks took the news with equanimity — indifference, almost. The S&P 500 ended a touchdown and the Nasdaq was flat. The Treasury market also remained cool. Two-year bond yields had to rise (about 10 basis points) to meet Fed expectations. But 10- and 30-year yields fell a bit, suggesting that markets still don’t believe inflation will remain entrenched. Market prices still in the Federal Reserve to cut interest rates next year.
One possibility is that markets are less focused on CPI than other data that suggests we are on the brink of an inflation-killing recession. Dom White of Absolute Strategy Research points to four areas where the data points to a recession: the bullwhip effect that is lowering spending on manufactured goods, falling commodity prices, a rapidly cooling housing market and slowing wage growth. He broke down this wage growth chart: Twitter on Monday:
A disinflationary recession is a fair bet. But the dominant market narrative is based on a tightly timed sequence of events: rate hikes, triggering a recession that lowers inflation enough for rate cuts to follow, perhaps as early as the Fed’s first meeting in 2023. Oh, and this recession must be like this. superficially, stocks don’t take another big step down from here and the yield curve doesn’t invert further. All of that is possible, but it feels like a lot to hope for. Inflation is a slow moving variable. Recessions are not all superficial. And the Fed could be wrong.
In a sense, the Fed’s job is now an easy one. Inflation is very high and unemployment is very low. What it needs to do – raise rates, quickly – is clear. But imagine a scenario where inflation is still way too high, say 5 percent, and falling. At the same time, imagine that unemployment is higher, say again almost 5 percent, and rising. So what does the Fed do? And why is it under political pressure? Already, with inflation over 8 percent and unemployment below 4, some senators are telling Fed Chair Jay Powell things Like it this one:
Right now, the Fed cannot control the main drivers of rising prices, but the Fed can slow demand by firing many people and making families poorer.
You know what’s worse than high inflation and low unemployment? It’s high inflation and a recession with millions of people out of work. And I hope you think about that before you drive this economy off a cliff.
How many politicians will say something similar in six months, when we are on 5 and 5? †Ethan Wue†
Fin de siècle, or just a cycle?
The big debate about the current inflationary period is how long it will last. But another debate, years from now, may seem much more important. After this period of acute inflation is over, will we return to something like the pre-pandemic status quo? Or will the pandemic spell the end of a 40-year regime of low inflation that, while punctuated by crises, delivered long steady spells of high returns for both bonds and equities?
The BlackRock Investment Institute, the research arm of the world’s largest asset manager, has joined forces with its team fin de siecle† In its semi-annual investment outlookwrites the BII team that since the mid-1980s:
We were in a demand-driven economy with a steadily growing supply. Borrowing money caused overheating, while collapsing spending caused recessions. Central banks could mitigate both by raising or lowering interest rates. † † The policy response involved no trade-offs; there was no conflict between stabilizing the two. † † That period has ended.
The end of the “great moderation” will be the result of a cabal of factors. Geopolitical fragmentation – particularly a split between China and the US – will make the labor shortages that characterized the pandemic years a permanent feature of the global economy. There will also be supply disruptions in energy and materials due to a rocky transition to net zero. The economic effects of these supply constraints will be magnified by the high global debt burden, making the fiscal and economic impact of higher interest rates more dramatic. A BII chart shows how interest payments could drive GDP:
Central banks will try to control the resulting volatility, but will alternate between undershoot and overshoot. Meanwhile, political polarization will block sensible policy solutions. “The result? Sustained inflation amid sharp and short-term swings in economic activity.”
Higher volatility means higher bond term premiums and higher equity risk premiums for stocks. Ultimately, despite political pressure and slowing growth, central bankers will be forced to tolerate permanently higher inflation. Continued tension between growth and inflation will mean that bonds and stocks will never enjoy simultaneous sustained bull markets.
If this story is known, it is because other versions of it have already been told. Charles Goodhart and Manoj Pradhan narrate it, emphasizing how demographics will lead to labor shortages, which, combined with a shift in the savings/investment balance, will drive inflation. Nouriel Roubini highlights the causal role of high debt in his own apocalyptic stagflation vision† Albert Edwards of SocGen modified his “ice age” thesis to include the beginnings of an unlimited fiscal and monetary surplus. Of the Fin de sieclists, Bank of America’s Michael Hartnett most succinctly summed up the statement, as we quoted earlier:
Deflation to inflation, globalization to isolationism, monetary to fiscal surplus, capitalism to populism, inequality to inclusion, lowering the US dollar. † † long-term returns >4 percent against ’24
So BlackRock’s argument stands out less for its originality than for the fact that the world’s greatest money manager has jumped on a fast-growing bandwagon.
A prominent voice following a different line from the new era theorists is Larry Summers. Here’s our friend James Mackintosh to describe Summers’s opinion in the WSJ (Mackintosh disagrees with Summers, by the way):
“It’s 60-40 that we’re going back to something that’s kind of secular stagnation,” [Summers says]† As in the aftermath of the recession of 2008-2009, interest rates will remain low due to increased savings due to aging population and the uncertainty that arises after a crisis. Rapid technological development will once again keep the cost of capital goods low. More saving and less investment mean that lower interest rates after inflation are needed to rebalance the economy.
On balance we are at Summers. We agree with him that the imbalance between saving and investing contrary Goodhart and Pradhan, ready to push through. We also think that the deflationary effects of globalization have room to work, especially as they extend from goods to services, a point urged us by Barings’ Christopher Smart. As Smart says, if you can do your work from home, someone else from all over the world can do it — for a lot less.
A good read
The UK’s total lack of seriousness with regard to public policy did not start with Boris Johnson.