The latest US Consumer Price Index was released on October 13, at a spectacular +8.2 percent year-on-year. Markets immediately fell, but strongly rebounded a few hours later – in an unexpected and frankly irrational move. Regardless, inflation is currently the single most important driver for all assets. Let’s have a look.
How did we get there?
Just as a reminder, such a level was unseen in major economies since the 1980s. This is not business as usual. The current episode started with the pandemic. Central banks injected immense amounts of virtually free money into the system, so that governments could provide massive financial support to their populations.
The result was a high demand for goods – services such as restaurants were simply unavailable – at a time when factories and supply chains were disrupted. Too many dollars chasing too few items: goods prices spiked, but most observers, including central banks, had reasons to believe it was temporary. Markets believed it, with a buoyant 2021. But it escalated – dramatically.
China, the factory of the world, struggled with the virus and its “zero-covid policy”: the supply chain glut didn’t vanish. Elsewhere, economies were booming, with a sharp rebound in services, still funded by excess savings. Jobs followed: from record levels of unemployment to a lack of applicants for millions of vacant positions. Inflation broadened: from goods to services, to wages.
If it wasn’t enough, Russia’s special military operation in Ukraine and the following sanctions shocked commodities, especially energy and food, boosting their prices. In 2022, inflation is neither limited nor transitory anymore.
The difficult task of central banks
Inflation is an economic poison when it’s either too low, paralysing everything, or too high, spiralling from prices to wages into chaos. It’s about the purchasing power of money, and as Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon”. Hence the role of central banks.
Their first, often only, statutory mission is price stability, usually with a target (commonly 2 percent for “core” inflation, which excludes energy and food). To achieve it, central banks play on the primary cost of borrowing: their policy rate is the one at which banks transact with them.
There is supposed to be a “neutral” level; they are restrictive above, and accommodative below. The great financial crisis also brought another policy, then deemed “unconventional”: central banks directly using their balance sheet to buy financial instruments. While the latter impacts market valuations, the former affects economic activity.
Obviously, high-interest rates are a drag on borrowing and reciprocally. Economic growth is not directly part of the mandates of central banks, but it obviously matters. The Fed’s missions typically include full employment and most central banks care about financial stability, which is easier when growth is positive than in times of depression.
With anemic inflation for four decades, central banks were doing a lot on the rest: Helping growth, solving financial crisis, through cheap and abundant money (actually, debt). Now that inflation is back, the goals are conflicting. Central banks made it clear that inflation is absolute priority, which means that growth and even financial stability will bear a cost (“there will be pain”, as the Fed chairman Jerome Powell put it).
This is an issue for governments: the UK is currently perfectly illustrating a diametrical opposition between the government’s objective (supporting growth and employment), the central bank’s mission (fighting against inflation), and the markets’ reality (borrowing more in times of inflation has a cost). The result is chaos, with no easy way out, and this may spill over to other countries.
Why is it a global issue?
We mentioned regional nuances, but they combine in a financially globalised world. Let’s start with the US. Inflation is broadening from prices to wages, due to a booming job market. Demand is too strong. The Fed is thus right to hike interest rates to cool it down, it should work.
Any hope for them to stop before mission is accomplished is, we think, premature if not delusional. Europe is different: a large part of their inflation issue is about energy, they are already on the brink of recession, and governments are highly indebted.
Hiking interest rates will not magically provide natural gas, so why doing it? Well, if they don’t, their currencies will fall further, and inflation will skyrocket from their imports – including energy. Japan or China do not have a burning inflation issue for the time being, but they face the same peril.
How does it impact my investments?
It’s not good news, I’m afraid. As inflation snowballs, so do correlations between asset classes. With both rising interest rates and slowing growth, both bonds and stocks are down by -20/-30 percent so far in 2022.
To be brutally honest: there is no quick solution. It’s a slow-moving shock, and markets have to forget the comfortable pattern of the recent decades when central banks were always jumping in to fix any serious market concern.
This means that volatility should remain extreme, until the market starts to put a high probability on an imminent pause from the US Fed, which is clearly the single most important factor. It’s not easy to anticipate, but we think the US job market is the key there. Our own scenario is that the policy inflexion could happen around mid-2023.
However, we do not exclude a positive scenario, which would be that inflation is brought down before the world’s largest economy comes into a recession. We may also see a rebound in the second largest, China. It may boost energy demand, but output from their factories is disinflationary.
The good news for investors is that safe bonds are investable again – the monstrosity of negative nominal interest rates is over, and that equity valuations are now much more reasonable. While short-term speculation and leverage remain hazardous, there remain opportunities for the medium-term for patient investors.