Surging inflation is leading to fears the world economy could be heading towards recession. While there are diverging views on whether we are entering a new era of stagflation, the medium-term growth-inflation trade off looks set to worsen with big implication for asset prices, argue Michael Grady and Peter Fitzgerald.
Read this article to understand:
- Why we may have entered a new inflation environment
- Why the response will differ from one central bank to another
- What this means for a range of asset prices
With the US Federal Reserve (Fed) and many other central banks in the process of tightening monetary policy rapidly to combat searing inflation, concern the world economy is heading for trouble is mounting.
Two ex-Fed officials recently warned US interest rates will have to rise more than expected and the outcome could be a recession. Richard Clarida, who until January served as one of Fed Chair Jerome Powell's top lieutenants, said the central bank will need to raise interest rates well into "restrictive territory" to slow economic growth and curb inflation. Days earlier, Randal Quarles, who oversaw banking supervision at the Fed to the end of last year, said a recession was now “likely”.1
The remarks came less than a month after the International Monetary Fund said a prolonged slowdown in China would have substantial global spill overs. The warning came as it slashed its growth forecast for the world’s second biggest economy this year to 4.4 per cent, well below Beijing's target of around 5.5 per cent, as its ‘zero-COVID’ policy forces much of the country into lockdown, disrupting factory production and curbing household consumption.2
In Europe too, the risk of recession appears to be growing as surging energy and food bills hammer household budgets, even if policymakers in the region are under less pressure to hike rates. “We see a big recession in the making,” said Stefan Hartung, CEO of German engineering group Bosch, on May 5.3
Little surprise then that a growing chorus of newspaper headlines is going as far as to warn stagflation, a long-lost economic phenomenon, is about to make an unwanted return. However, even if there is no universally accepted definition as to what is meant by the term, Micheal Grady, head of investment strategy and chief economist at Aviva Investors, says articles suggesting leading economies are likely to witness the return of persistent double-digit inflation alongside economic stagnation or recession are alarmist.
A low-probability event
“It's not impossible, but it's a very low-probability event, even if the prospect is for weaker economic growth and higher inflation than seemed likely at the start of the year,” he says.
He points out the combination of weaker output and sharply rising prices is highly unusual and has only occurred once before, in the 1970s, when two separate oil price shocks in 1973 and 1979 led to soaring inflation. Each time they ultimately tipped the US economy, and with it much of the world, into recession.
The recent surge in inflation has been driven by a series of supply shocks
As with these episodes, the recent surge in inflation has been driven by a series of supply shocks, caused first by the pandemic, and more recently by the war in Ukraine and China’s zero-COVID policy. However, unless the world experiences further supply shocks such as these, Grady believes inflation will prove far less persistent than in the 1970s.
Over the past four decades, labour markets in most advanced economies have become much more flexible as the clout of trade unions waned. And while globalisation may be in retreat, the threat of jobs being shipped abroad or automated has not gone away. That means there is far less scope for wages to continue rising in the face of slacker economic activity.
The fact central banks have gained greater independence since the 1970s is another reason to doubt inflation will become entrenched. While some central banks, most notably the Fed, have been slow to respond to the threat of inflation, it is reasonable to expect they will do what is necessary to bring it under control.
None of this is to deny inflation is a growing menace that is placing central banks in an unenviable position. The dilemma for them is that soaring inflation is simultaneously hitting real disposable incomes hard. That will ultimately weaken consumer demand and lead to softer economic growth.
Walking a tightrope
As Bank of England Governor Andrew Bailey said in April: “We are now walking a very tight line between tackling inflation… and the risk that could create a recession”.4
The response from policymakers will not be uniform
While few nations are being spared rising inflation, headline numbers mask big differences in the underlying backdrop. That in turn means the response from policymakers will not be uniform.
Among advanced economies, monetary policy needs to tighten fastest in the US where the economy looks to be operating at, or close to, full capacity. Rapid job creation over the past two years has pushed the number of unemployed people per job opening to a record low, as seen in Figure 1.
Figure 1: Number of unemployed persons per job opening, seasonally adjusted
Source: US Bureau of Labour Statistics. Data as of May 10, 2022
Tight labour market conditions are enabling workers to respond to surging inflation by bidding up the price of their labour, with the US Employment Cost Index rising at its fastest pace since records began, as Figure 2 shows.
Figure 2: US labour costs rising sharply
Note: Annual rate of change in monthly Employment Cost Index.
Source: US Bureau of Labour Statistics. Data as of May 10, 2022
All of this helps to explain why the drivers of inflation are widespread in the US. But this is not a pattern that is being replicated elsewhere. In Europe, for example, with economies still operating some way from capacity, there is very little evidence of inflation beyond energy and food prices, which have both been surging, as seen in Figure 3.
Figure 3: Accounting for increase in CPI inflation since January 2021 (per cent)
Source: Aviva Investors, Macrobond. Data as of May 2022
As European Central Bank President Christine Lagarde said in April, although both the US and Europe may be struggling to contain inflation, they were also “facing a different beast”. Noting much of Europe’s inflation stemmed from surging energy costs, she said: “If I raise interest rates today, it is not going to bring the price of energy down.”5
Even if a repeat of the kind of stagflation experienced in the 1970s may be unlikely, Peter Fitzgerald, chief investment officer, multi-asset and macro, Aviva Investors, says there are strong grounds for believing average inflation around the world will be appreciably higher over the next ten years than in the decade that followed the Global Financial Crisis, and the one that preceded it. He argues investors need to adjust portfolios to account for inflation both higher and more volatile than they have grown accustomed to.
Geopolitical tensions could lead to further upheaval in global supply chains
Fitzgerald says geopolitical tensions are more likely to intensify than abate. That could lead to further upheaval in global supply chains and an ongoing scramble for increasingly scarce resources, putting upward pressure on prices and leading to greater inflation volatility. These inflationary forces will almost certainly be exacerbated by global efforts to transition away from burning carbon.
Witness the surge in the prices of nickel, lithium and cobalt – key raw materials for car batteries. With Russia accounting for 11 per cent of the world’s nickel, its war with Ukraine has sent prices skyrocketing. But the price of these metals was already rising sharply because of surging global demand and overstretched supply chains. The cost of these three metals required in a 60KWh battery had risen to more than $7,400 in early March, from $1,395 a year before, according to battery group Farasis Energy.6
“There is little doubt the energy transition, by curbing the supply of fossil fuels, is having an inflationary impact and we expect this to continue,” Fitzgerald says.
Higher inflation suggests the ‘neutral’ rate of interest – one which is consistent with full employment and stable inflation – could be appreciably higher, especially in the US, than investors are used to. Grady believes the neutral rate in the US could be as high as 3.5 per cent.
Fed loses the plot
While the US bond market is now factoring in a sharp rise in interest rates over the next 18 months, the likelihood is that yields will rise further given policy may need to be tightened even more aggressively than the Fed is indicating and the market is anticipating. In marked contrast to Clarida’s remark about the need for policy to be restrictive, the Fed’s latest ‘dot plot’ shows policymakers envisage rates peaking at around 2.8 per cent.7
Markets will have to contend with quantitative tightening
According to Fitzgerald, not only will interest rates potentially have to rise further than is priced in, markets will also have to contend with quantitative tightening. The Fed is poised to start shrinking its balance sheet as it withdraws some of the extraordinary pandemic-era stimulus. This is a largely experimental policy that threatens to heap further pressure on Treasury bonds.
The central bank said in May that from June it would allow up to $30 billion of Treasuries per month to roll off its balance sheet, rising to $60 billion per month by September. That would mark a sea change for a market that has grown accustomed to the central bank’s support. The Fed bought around $2.4 trillion of Treasuries in 2020 and a further $960 billion last year. Somewhat surprisingly, it even added to its collection in the first quarter of this year.8
Growth-inflation trade-off deteriorating
The likelihood is the growth-inflation trade-off for many advanced economies is deteriorating, which would have important ramifications for asset prices. Fitzgerald says Aviva Investors’ AIMS Target Return portfolio is looking to profit from a continued drop in US bond prices.
Although a further rise in US yields would be expected to negatively impact other developed government bond markets, the comparative weakness of the European economy suggests bond markets look less vulnerable.
As for equities, the combination of rapidly slowing growth, sustained high inflation and tighter monetary policy means the AIMS portfolio has little outright exposure to the asset class and is instead focused on relative-value trades.
Although US economic prospects look brighter compared to Europe, the technology sector is likely to hold the US market back
Fitzgerald says, while the US’s economic prospects look brighter compared to those of Europe, the heavy weighting of the technology sector is likely to hold the US market back. Given the investment team’s bearish view on the outlook for US rates, the portfolio has been tilted away from growth in favour of value stocks. For example, it is looking to profit from a view that energy stocks will continue to outperform the broader market. Fitzgerald also favours European banks and US healthcare companies relative to their respective broader indices.
Aside from its position in energy, the portfolio also has significant exposure to gold and various other commodities to provide exposure to further inflationary pressures.
“While a very quick and significant hiking cycle is now priced in, it is arguably not enough – particularly if you think the inflation risks remain tilted to the upside, which we do. The market then prices rate cuts in a couple of years ahead, which is hard to rationalise,” Fitzgerald says.