The inflation debate returns
Higher inflation for longer has won this round of the debate, but we would be naive not to assume markets take a very different view next month…
Following a strong performance in January, the global stock markets gave back some of their January gains, with a 1.5% fall in February. Data continues to show that the labour market remains extremely tight around the world: despite the massive tightening in financial conditions, unemployment levels are still at 50-year lows and this means higher inflation for longer.
As a result, interest rates have continued to rise, and the 10-year US Government Bond rate finished the month at 4% – a sharp increase from the 3.5% where they started the month. What’s more, for the first time in this cycle, markets are listening to central banks: market forecasts for the Fed Funds rate are broadly in line with the Fed expectations of a peak at 5.5% (currently the US Fed rate is at 4.75%).
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Given that the news is all the same, with inflation single-handedly dominating the discourse, this month we thought we would answer some key questions we’ve been recently asking ourselves.
1. Why is employment data so important in all of this?
People – they’re one of the largest fixed-capacity factors in an economy. At any given time, there are only so many people that can work in a country. So when unemployment is very low and it’s extremely hard to find a job, wages will rise until an equilibrium can be found.
Unfortunately, higher wages then get passed through in price increases, which end up being a key driver of inflation in its own right.
The combination of very strong economic growth and shrinking workforces has resulted in unemployment rates remaining at record lows across the developed world. And while typically rising interest rates tend to slow the employment market, as companies look to delay investment and consumers cut their spending, this cycle hasn’t seen any of this.
Of course, this is confusing economists and resulting in a fair amount of uncertainty trickling into the investment markets.
2. Where will interest rates go?
The globalisation of financial markets means that interest rate forecasts are highly coordinated around the world. At this stage, markets are expecting interest rates to continue to rise another 0.5- 1.0% through the course of 2023, with a view that they will begin to fall again in 2024 when higher interest rates finally cause a recession. This is why you have longer-term interest rates which are lower than short-term interest rates at the moment (an inverted yield curve).
The timing and extent of the fall will depend entirely on the state of the economy. A hard and deep recession will mean a big cut to interest rates, though a shallow recession (or no recession at all) might result in interest rates staying elevated for an extended period of time.
It’s interesting to note that economists have consistently been wrong in this cycle and have spent the past 12 months increasing their estimates for how high inflation will go, as well as the length of time that it will stay high for. I think it’s fair to say no one really has any idea on where interest rates will go.
Central banks have made it very clear they will do everything they can to control inflation, which could mean pushing interest rates higher than anyone expects (as they have already done). Alternatively, we could move into recession allowing central banks to quickly drop interest rates.
3. Can we actually crush inflation without a hard landing?
Hard landing, soft landing, or no landing? That is the question we continue to ask ourselves. Basically, it’s not clear whether continuing to increase interest rates to control inflation will result in a deep recession (hard landing), a shallow and short recession (soft landing), or no recession at all (no landing).
Traditional theory suggests that we have significant excess demand in the economy at the moment, and the only real way to take some of that demand out of the economy is through a recession. This is what most economists expect, though there is a massive debate around when it will hit and how deep that recession will be.
Having said all that, this cycle has been very different to anything we have ever seen on record, so who knows whether a recession will happen or not. In New Zealand, for example, we are starting to see a re-acceleration of the economy and improved confidence. But while this may allow us to avoid a recession altogether, it’s likely to have dire consequences for inflation and interest rates.
Back to the original question (Can we crush inflation without a hard landing), the short answer is no: we probably do need a hard landing – though politically that might not be a popular answer.
4. Interest rates have risen sharply in the past month: why have we not seen a corresponding fall in equity markets?
Interest rates rose by 0.5% in February and yet we only saw markets fall by 1-2%. Back in September 2022, when we experienced a similarly sharp move in interest rates, markets fell by almost 10%.
Again, the normal playbook no longer seems to be working. In fact, economists can’t agree on the impact that rising interest rates will have on the broader economy and therefore companies that operate in those companies and therefore their share prices.
To give you another example, before this tightening cycle, it had been widely anticipated that any normalisation of interest rates would be catastrophic for the broader economy. Sure, we have seen impacts on the housing market and a few other interest rate-sensitive industries, but most other industries have remained strong and have not really felt the impacts of interest rate hikes.
Where to from here? No one really knows. Hard landing or no landing, take your pick!
5. 12 months on from the Ukrainian invasion, how has that impacted markets?
Russia’s invasion of Ukraine has caused a huge amount of personal suffering and market turmoil, but at this stage it doesn’t not look as though it will have a long-term impact on global markets. Commodity prices have returned to pre-invasion levels and, as expected, cutting Russia off from the global financial system has not done much to the rest of the world. Russia had been slowly extricating itself from the system since its 2014 invasion of the Donbas.
Oil exports from Russia have largely continued, though oil is now sent to China and India via tanker rather than piped to Europe. Europe has been very lucky thanks to an unseasonably warm winter, which reduced their typical gas demand. This time has been critical for them to find new sources of gas and energy, and hopefully this will help them through the next winter.
6. Why is the crypto market performing so well?
The price of Bitcoin has risen by almost 40% since the start of the year. Unfortunately, there are no tangible reasons for this strong recovery, but there are a couple of important factors to take into account:
All high-risk assets have done well this year. Bitcoin has performed similar to other assets like Tesla (+60% year-to-date) or the innovation-focused Ark Innovation Fund (+40% year-to-date). These assets suffered significant falls in 2022, but they have seen a rebound this year as risk appetite has shifted and investors have returned to positivity.
Crypto is a small market and when investors become positive, they seem to get really positive. The market capitalisation of Bitcoin and Ethereum combined is only c.$700 billion of which a significant majority is tied up with long-term holders. To put this in context, large companies like Apple and Microsoft have market caps of over US$2 trillion, and largely open share registers. This lack of supply for crypto means that, when crowds race to invest, they can quickly push the prices up.
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