Written by Bill Blain, Strategist at Shard Capital
This week: The Market Commentariat think deflation will counter inflation, rates will fall, and recession will be limited. The world is more complex – supply side factors are more volatile. Stagflation is a more likely outcome than recession.
This week will be dominated by inflation. Just how sticky will US core inflation look when we get CPI tomorrow? The market risk is inflation across the West proves more persistent than the market bulls have been praying for. We might be headed for something different and much worse– recession and sticky prices in some economies; Stagflation!
Yesterday, I noted a number of banks quietly rowing back expectations. Central Banks are about to start reversing the recent run of rate hikes – putting cuts back to 2024. Macro hedge funds are shorting rate cuts. What do they know that we don’t? They’ve got a view on sticky inflation and how central banks will respond.
Deflation is a hope – not a reality.
The professional market commentariat of economists, analysts and guessors, are largely talking about deflation – that interest rates will shortly come down in line with inflation as a result of downwards pressure on prices. Reasons for them to think inflation will fall include the slowing economy, declining demand for goods and services as a result of crashing discretionary consumer spending, but also that recession will be limited by the reopening of the global economy and supply chains post-Covid (particularly in China), boosting the supply of cheap goods. There is a general expectation spikes in food and commodity prices will reverse in much the same way as energy prices. And, the collapse in “broad money” “M2” is seen by the monetary augurs as proof positive that prices must fall.
Conventional thinking for unconventional times.
Wishing for deflation to magic away the present raft of troublesome economic issues is not a good strategy. It falls into the same bucket of misplaced hopes as Central Banks telling us how “transitory” inflation would be last year. Conventional wisdom says inflation can only be addressed by higher rates.
To figure out what comes next in inflation and thus interest rates, we need to understand the current crises in supply and demand, and the fundamental causes of the current market instabilities and uncertainties. The market is full of contradictory signals.
US three month Treasury-bills hit 5.2% (a 20-years plus record level). That was partially a reflection of fears a US debt ceiling shutdown will hit as early as next month, but also the reality of an inverted curve presaging recession. Warren Buffet
told his audience at the annual Berkshire Hathaway jamboree a downturn is coming: “Get used to making less.” He has been selling stocks this year.
One analyst report informed me the collapse in container prices from Asia to Europe is profoundly deflationary, while another said it is normalising the volatility in shipping costs and a sign of a stabilising market. Taken in conjunction with the slower than expected pace of the Chinese economy, I humbly suggest it means less goods are being shipped. Global trade has changed – in line with changed geo-politics.
The economic reality of the last 25 years has been global deflation in the price of goods – primarily on the expansion of the Chinese and other Asian economies as cheapest-to-produce economies. Lower prices have had profound economic consequences on the West – pricing out domestic production in favour of imports.
China’s priorities have changed. It’s no longer about growth to expand the economy and create jobs through exports, but about directing the economy towards rising domestic consumption. The simple reality is China is no longer the default cheapest-to-deliver manufacturer – and it will take years for new supply chains to establish that foregone production elsewhere as cheaply.
What is inflation?
Inflation is a consequence of mismatched demand and supply.
We know what will be in demand – that’s why companies, banks and governments employ legions of researchers to measure and determine demand and thus what they produce and supply. The demand side of the economy changes slowly – in line with demographics. When we get a paradigm shift, as we are seeing in the switch from ICE to Electric vehicles, it has all kinds of complex economic consequences on supply chains and materials costs.
Supply is more volatile. It’s the cost of producing things that’s the primary variable in an economy. Key components in production costs include the price of labour and materials. A key factor in what we buy is its relative cost of production – the cheaper it is to make, the more will be sold. At present the global economy is still adapting to a succession of supply-side economic shocks:
· Supply Chains
· Energy Spike
Each of these factors triggered a host of ancillary consequences – such as workers leaving the market or switching out of one sector to another, or redefining supply-chains. These are not “transitory” – they have long-term effects how the supply side of the economy works.
Post-Covid we had a brief demand side inflation spike, fuelled by money not spent during lockdowns, and economies reopening. We are now into the supply side
inflation. Companies are being accused of artificially pushing up prices – but their material and energy costs have risen dramatically and become increasingly uncertain. Across industry I am hearing multiple supply chain issues that could take years to stabilise. For instance; in the aviation market the supply of parts is severely constrained, and combined with a shortage of engineers (many retired during Covid or left the industry), its taking months longer for planes to be serviced and maintained – thus pushing up costs.
At present the costs of labour remain elevated. We know that from both the resilient US employment reports – which keep surprising to the upside, and from the shortages of labour across all aspects of the economy in the UK. There is no downside pressure on wages from the slowing economy. As the current slew of strikes in the UK and across Europe highlight, workers are complaining they are not paid enough to meet basic needs.
What does it all mean: Deflation or Stagflation?
Strip it down to the basics and I doubt we are in a deflationary environment – that is just too simple a view of the complex global economy.
Global supply chain uncertainty and reinvention, shifting trade patterns, commodity volatility, and labour shortages will keep prices unstable for longer. I suspect inflation remains highly elevated for longer. Addressing it by cutting wages is not sustainable. Governments and central banks may need a rethink on wages – which will further fuel inflation. Therefore, in a slowing economy, when nations like the UK have stalled… Stagflation rather than deflation looks nailed on
Not an easy call..