Global inflation has been the key theme of the past 12 months. Whilst inflation has increased in almost all major economies, there are some differences in the degree of inflation that countries face, the underlying causes and the steps central banks are willing to take to combat it. As central banks globally are determined to cut inflation, it is evident that this will be achieved at the cost of economic weakness and/or a recession.
Last week brought better news on inflation, following the new CPI (Consumer Price Inflation) release data in the US. Headline US inflation rate was flat in July resulting in the year-over-year rate dropping to 8.5% from 9.1% in the previous month.
The inflation problem undoubtedly started from the supply disruptions of the pandemic followed by the aggressive fiscal stimulus aimed at middle and lower-income households, who increased their consumption of goods. Many years of easy money also contributed to a boom in home prices, which account for approximately 30% of headline CPI. The low US unemployment rate pre-pandemic has led to a gradual increase in wages. Furthermore, the labour force growth continues to slow due to the retirement of the baby boomers and a sharp drop in immigration. Therefore, it is natural for wage growth to accelerate as the economy recovered from the pandemic. Finally, the impact of Russia’s invasion of Ukraine and China’s disruptive effects to suppress the virus have added extra pressures on global energy and food prices.
Much of the fall in inflation was due to the drop in gasoline prices, which fell 7.7% over the month. Other categories such as airfares, used cars, trucks and apparel declined significantly as well.
This was of course good news and the stock market surged higher in response; however, inflation is still higher than it has been in any other month over the past 40 years. Despite the selloff in some commodities, natural gas could reach new highs and that has the potential of reinforcing the inflation narrative. Tail risks have certainly not diminished as economic data continues to be mixed. Whilst weekly claims are up, the labour market is still generally tight and labour shortages continue to add to inflationary risk and suggest that inflation in the US may be stickier. Housing starts and building permits are beginning to show that higher mortgage rates are starting to bite.
Predicting the direction of the economy
Predicting the direction of the economy at this juncture can be tricky and one thing we believe is important to watch is the hiring plans of companies. We have seen some layoffs in the US over the last few months, but job openings are still high by historic standards. However, major PMI (Purchasing Managers Index, which measures the prevailing direction of manufacturing and services sectors) indices have started to roll over, which indicates that recessionary risks are still high despite the recent market rally. At the same time, we had some positive news for the US economy yesterday. Industrial production rose more than expected in July at a time when concerns are rising over the US manufacturing sector. Despite the Federal Reserve (‘Fed’, the US central bank) hiking rates, we may well have seen the market bottom for the S&P 500 in June. That said, the resilience of production may not last for long.
Given that prices have fallen, despite a strong July jobs report, there is a good chance that US inflation has now peaked. The US economy has lost momentum and its real GDP declined during the first two quarters of this year. As I pointed out in my previous market update this counts as a technical recession by European standards. A drop in fiscal stimulus will depress growth and inflation together with a stronger US dollar will have a negative impact on trade as will the higher mortgage rates on housing. Chairman Jerome Powell acknowledged at the last Federal Open Market Committee press conference that the last two Fed rate hikes of 75bps were aggressive, but they were data dependent and could continue to be aggressive at the next September meeting, if warranted by data. However, it is debatable whether the data will continue to support these aggressive rate hikes in the next meeting, and this is something that we monitor closely.
Inflationary challenge in Europe
While there are signs that inflation has peaked in the US, the story is less certain in Europe. Europe managed to contain the spike in unemployment during the pandemic better than the US, but they achieved this with less stimulus which limited the pace of economic recovery and the lower unemployment led to higher inflation. The biggest inflationary challenge Europe currently faces is to do with boosted energy prices, caused by the war in Ukraine. In addition, the effects of a strong dollar have exacerbated the inflationary surge for European consumers as global commodities are usually priced in dollars.
It is probable for inflation in Europe to become more persistent if Euro weakness persists and the war in Ukraine continues to disrupt energy prices, however slower economic growth, monetary tightening and losing supply constraints are likely to shift inflation down. The European Central Bank increased rates in July and brought the deposit rate back to zero following eight years of negative rates. They also signalled a further increase in the next meeting. In an environment where Europe continues with its rate hikes, if the Fed takes a more dovish stance (i.e., Less aggressive), this could reverse the weakness of the Euro vs the US dollar, and thus combat at least one source of inflation.
Bigger inflation challenges in the UK
In the UK we face even bigger inflation challenges as the outlook is further complicated by the current Conservative Party leadership race. Both candidates are promising fiscal stimulus to shield customers from the negative effects of higher utility bills. This extra deficit spending should reduce the risk of recession however it would further worsen the public finances in the UK and could pressure the Bank of England into more aggressive tightening.
The Bank of England is now forecasting that inflation will peak at over 13% in the fourth quarter of this year. The latest inflation data from this morning, as measured by the CPI index (Consumer Price Index) indicates that UK inflation accelerated to 10.1% year-over-year in July versus consensus estimates of 9.8%. Core inflation, which strips out volatile food and energy prices also moved up to 6.2% versus consensus estimates of 5.9%. As a result of the latest inflation figures, the 10-year UK yield curve has moved up this morning whilst in the short term it remains inverted highlighting the challenges for the UK economy. The latest upward contribution to headline inflation came from electricity, gas, fuel, food and non-alcoholic beverages. Sterling, has also sharply fallen relative to the dollar, contributing to higher imported inflation. Real wages have been falling as wage rises fail to keep pace with the rate of inflation, and households are further impacted by the increased percentage of income being spent on energy bills. Producer prices also showed manufacturers passing on higher costs to customers and the pressure will increase on the Bank of England to take more assertive action in the months ahead and increase the scrutiny on government policy.
Inflation in China is likely to remain subdued
In contrast, inflation in China will likely remain relatively subdued in the near term largely because of slowing demand. The government’s attempt to prevent a major Omicron outbreak is likely to hamper economic growth. The housing sector continues to struggle with oversupply and China’s huge export industries are being threatened by a global slowdown. Looking ahead it is more likely to have monetary easing rather than monetary tightening in China. On Friday the five largest Chinese state-owned enterprises traded on US markets announced their voluntary delisting from the New York Stock Exchange. This has further worsened the relationship between the US and China on the back of US House Speaker Nancy Pelosi’s visit to Taiwan and China’s threats in response. If the two countries do not engage in dialogue this may escalate existing geopolitical tensions over Taiwan.
In Japan, although above pre-pandemic levels, inflation remains low in absolute terms. This is despite the collapse in the exchange rate and the same supply disruptions that exist elsewhere. Deflationary psychology is deeply embedded in Japan and even though the Bank of Japan raised its inflation forecast in July it expects core inflation to hit 1.4% in fiscal 2023. This is probably correct as growth is likely to slow in the 3rd quarter as a new wave of Omicron infections appears to create weakness in both manufacturing output and services demand. Wage growth has recently picked up in Japan which should allow Japan to avoid outright deflation. In this regard Japan remains an outlier and whilst the world sees high inflation as a problem, Japan would love some inflation.
What are the implications for portfolio construction? Whilst financial markets have started to buy into the idea of a soft landing, central bank policy remains a risk. The question is, could we have a prolonged recession if major global central banks overdo their tightening policy? Despite the present challenges we believe the global economy should return to an environment of steady growth in 2023 and beyond, with lower inflation and interest rates. Both long term bonds and global equities should benefit from this trend, although market volatility is likely to remain until then as central banks continue to battle inflation. We continue to favour investments that look attractive from a valuation perspective and are fundamentally strong, whilst reducing risk and maximising return by diversifying exposure to asset classes.
As always, your financial adviser or investment manager is on hand to answer any questions you may have about your portfolio or current market conditions.
Until next time stay well.