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Weekly investment update – The great inflation debate

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Nathalie Benatia
 

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This material is intended for Institutional Investors (as defined in the Securities and Futures Act, Chapter 289 of Singapore) only and is not suitable or intended for persons who do not qualify as such.

The pace of the rise in US consumer prices accelerated from 1.7% in February to 2.6% in March for the biggest year-on-year increase since August 2018. If the data is interpreted as the start of a new trend, it may sound like bad news. But in our view, a sharp acceleration in prices is unlikely. Nonetheless, the outlook for US inflation will be the main subject of debate this spring for investors and central bankers.

Why talk about inflation now? Because growth is picking up

The IMF has just revised upwards its forecasts and now expects global growth to reach 6% this year. That is the highest rate since 1980, when the IMF started tracking data on a comparable set of countries. Although the report warns of high uncertainty related to the path of the pandemic and focuses on assessing medium-term economic damage, it indicates that ‘a way out of this health and economic crisis is increasingly visible.’

Moreover, financial markets have taken in their stride recent announcements of delays in the distribution of vaccines, linked to manufacturing problems or a suspension of jabs to investigate possible side-effects. Reflecting the buoyant sentiment, the S&P 500 Index closed at a high on Tuesday, leaving it up by 4.2% since the end of March and by 10.3% so far this year.

The scenario of a cyclical recovery in the global economy in 2021 now appears to be firmly established. Many indicators underpin this view. Surveys have confirmed the improvement in activity as international trade accelerated and oil prices returned to early 2020 levels.

The recovery will likely remain uneven between the major geographical areas, with China and the US in the lead, but a revival of global demand is on track and should gain ground in the coming months when services can resume as vaccinations improve immunity.

Demand – Too strong?

This acceleration in global demand is both the source and the victim of supply problems. For many goods, production is failing to meet demand. This is either because pandemic-related restrictions still constrain activity, or ‘traffic jams’ are occurring as components are not available in large enough quantities, or investment fell short during the crisis. The resulting bottlenecks are disrupting production.

This phenomenon was apparent in a fall in German manufacturing output for the second consecutive month in February after business surveys had raised hopes of better data. Backlogs in orders have remained high although production is likely to move more into line with surveys in coming months. In the US, purchasing managers surveyed have reported shortages in most sectors, exacerbated by the extremely cold weather that struck Texas this winter.

These phenomena are transitory and production chains will adapt. However, they have driven a sharper-than-expected acceleration in producer prices. This was manifest in both China (+4.4% in March year-on-year, the highest since July 2018) as well as in the US (+4.2%, the highest since September 2011).

What is the path for inflation?

The answer is upwards. Is that a cause for alarm? No, but a few explanations are needed.

  • Firstly, the relationship between producer and consumer prices is rather tenuous. Since the upward pressure upstream in the production process should be temporary, it is unlikely that companies will pass these higher prices on to their customers.
  • Secondly, from a statistical perspective, measuring inflation has, for a variety of reasons, been difficult over the last year. During the lockdown, collecting data was simply not possible. The composition of consumption has also changed significantly (more food, fewer services).
  • Finally, the resumption of some activities is leading to price distortions.

Exhibit 1 - US inflation accelerated in March for the biggest YoY increase since March 2018, fanning a debate about the future course of inflation

In the US, the consumer price index (CPI) rose by 0.6% between February and March, or 0.3% excluding food and energy. Higher prices for hotel accommodation, airfares (transportation in general) and leisure partly explain the rise in inflation. Used car prices also rose surprising strongly. The cost of shelter (housing) contributed significantly to the acceleration in core inflation. Finally, the base effects on energy prices are beginning to be felt. The costs of all these items are likely to continue to rise in the coming months.

Against this background, the measure of inflation most closely monitored by the US Federal Reserve (core personal consumption expenditures (PCE) excluding the more volatile food and energy elements) is expected to show inflation exceeding 2% on a year-on-year basis in coming months (compared to 1.4% in February).

Such an outcome is consistent with the Fed’s forecasts (+2.2% for the fourth quarter of 2021). The question is whether there will be even stronger data in coming quarters that would force the central bank to tighten policy sooner than it wants under its flexible average inflation-targeting framework.

What does this mean for markets?

The message from policymakers at the Fed has not changed. Chair Jerome Powell has restated that ‘substantial progress’ towards the full employment and inflation targets, which are the necessary conditions to start normalising monetary policy, will need to be seen in reality and not just in forecasts. He has highlighted that temporary inflationary pressures are unlikely to change the psychology of economic agents and cause a permanent rise in inflation.

For the time being, investors seem to have been only partially convinced by the Fed’s commitment to ‘wait and see.’ Markets now anticipate the first interest rate hike in 2022.

Recent market developments do not, however, suggest a categorical rebuttal of the Fed’s prognosis. Upward pressure on US long-term interest rates has slowed after the rise of nearly 100 basis points since last November’s elections. On 13 April, the yield on the 10-year US Treasury bond was 1.61%, down from 1.74% at the end of March.

Furthermore, market-based expectations for the future rate of inflation as derived from the yields of inflation-linked bonds have ranged between 2.25% and 2.45% since the start of the year (they were 2.43% on 14 April for 5-year, 5-year forward inflation swaps). Expectations are therefore aligned with the Fed’s target for inflation.

A still favourable constellation for equities

Despite some more or less justified questioning of the outlook for inflation, monetary policy and rates should remain favourable for risky assets over the coming months. The prospect of a cyclical recovery is likely to support equities over the medium term, even though some technical configurations could raise concerns of short-term corrections.

Equity investors are of course also concerned about the inflation/reflation theme. As such, the upcoming first-quarter earnings season will put the spotlight on companies’ outlook statements. Particularly important will be comments as to whether coronavirus curbs, a computer chip shortage or other supply chain logjams may hinder future earnings growth. This will contribute to clues on the ability of companies to preserve their margins.


Also read:

Bond investors beware – US rates may rise sooner than thought


Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

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