Bad, worse or just dandy

At some point, higher inflation could provoke a tightening of monetary policy that is beyond what is priced into markets. Real yields and risk premiums would rise, growth expectations would fall. That would be a challenge for investors. Whether that happens depends on how quickly the world economy deals with its supply-side issues. For now, I bet on continued growth and lower inflation in 2022.   

Most-likely-worst-case

With no probability attached, the most likely worse-case (MLWC) scenario for financial markets is the following. The accumulation of evidence of higher inflation becomes too uncomfortable for monetary policy makers, forcing them to adjust conditions more quickly and more aggressively than is currently priced in. This would provoke an increase in real interest rates and risk premiums, tightening financial conditions, and lowering growth and profit expectations. Given existing levels of debt, write-downs and losses would be part of the scenario leading to reluctance among credit providers to lend. It would be a classic inflation and interest rate led recession. It is not the consensus view, but it can’t be too many degrees away from the modal outcome.

Inflation key

The likelihood of this scenario depends on overlapping influences (the energy price impulse coming on top of the supply chain impulse). It is iterative and conditional on the data and what central bankers do. The key is inflation. This week’s data from the US was a bit more encouraging. Core consumer prices rose by 0.2% in September and in the last three months the annualised rate of core inflation was 2.4% - in line with the Federal Reserve’s (Fed’s) target and with long-term break-even inflation rates. That also marked a deceleration from the 10.4% annualised pace of the previous three months period. Producer price inflation was also lower – the core index increased by 0.2% in September, the lowest monthly increase since last December.   

Still some risks

Encouraging as these numbers are, we are not out of the woods yet on inflation. Energy prices are still rising. Brent crude oil is trading at a seven-year high. High energy prices are impacting on industrial production. Alongside that, supply chains remain stressed with much of the media focussing on delays loading and unloading containers at some of the world’s biggest ports. The demand is there for goods, but the supply is disrupted and that will affect prices and sales – although in the end it may be an inter-temporal effect more than anything. If all those goods that are sitting on ships outside Long Beach do get delivered, there will be a surge in stock and that could even put downward pressure on prices next year.

The consensus is more benign  

The MLWC scenario is not priced in. If we knew it was definitely going to transpire then a consistent strategy would involve short-term inflation linked bonds, low duration fixed income and value stocks. Arguably this is already playing out a little in markets but not in the context of a more risk-off environment. Indeed, a fully-fledged hedge against this would require reduced allocations to credit and equity. The MLWC scenario would mean a much worse outlook for earnings and a higher risk of negative returns from credit and equities. What we can observe at the moment is forecasts of slower earnings growth, some deterioration in earnings momentum and a more mixed picture on guidance going into the end of the year. We are not yet on the brink of an earnings recession, but equity markets might find some of the mixed messages challenging. 

In the bank

The cycle is the most difficult thing to invest in, especially if we try to be too macro and too detailed about it – the difficulty most observers have had in guessing where the US 10-year yield would go this year is a case in point. Trying to second guess the cycle generates angst and involves expending a lot of intellectual and emotional energy. It’s hard to take into account what can be competing information and avoid being drawn into particular narratives. The MLWC scenario should be something to consider but when the biggest bank in the US reports strong earnings and releases loan-loss provisions (again) the message may be not to be too gloomy. The first week of Q3 reporting also saw a large European luxury brands conglomerate report strong sales and no real signs of consumer spending, at the high-end of spending at least, coming off. Competing information is the challenge for investors, always.

It’s the recovery 

Short-term investment considerations are focused on the shape and the amplitude of this cycle and how it breaks-down between real growth and inflation. Where we are is totally defined by the effect of the pandemic and the recovery from that. In my opinion it is the logistics of recovering from the shutdown in 2020 that is driving wage and price developments, not quantitative easing. It’s important to remember that QE was designed to confront the challenge to monetary policy when interest rates hit zero and became necessary because of the deflationary forces generated by the balance sheet recession that followed the global financial crisis. Any decision to stop QE and normalise monetary policy should be based on an assessment of those longer-term structural themes (potential growth, underlying inflation) and not on pig iron prices or shortages of baristas. By that token I see limits to how far long-term yields can rise. Yes we will get tapering, but be careful not to conflate supply-squeeze driven price hikes with longer-term monetary policy decisions.

LLWC

The least-likely-worst-case scenario (LLWC) is stagflation. I may be wrong but current “regime-break” discussions seem to be making the mistake of long-term linear forecasts that are based on current short-term developments. There is a risk of recession under MLWC but a persistent shift-down in growth and shift-up in inflation looks to be a very low probability outcome. The consensus is for GDP growth of 4% in the US and the Euro Area next year. I’d rather bet on that and a moderation of inflation than a return to the 70s.