Markets are being driven by two interrelated risks. The first is inflation, and its implications for consumers and producers. The second is the risk of a recession – specifically whether the Fed can succeed in squashing inflationary pressures without triggering a recession.
In the initial phase of the current inflationary surge, it was clear that a multitude of one-off factors coincided to push inflation upwards, including shortages due to supply chain constraints and the rise in energy prices. But it was also always clear that inflation can gain momentum given the scale of monetary expansion that is in the system. Inflation is always and everywhere a monetary phenomenon, as Milton Friedman famously said. It can be produced only by a more rapid increase in the quantity of money than the increase in output. The quantity of money has been increasing at an astronomic rate since the Covid crisis. The lessons of the 1970s were forgotten after decades of low inflation.
Inflationary pressures have reached a level where it is highly doubtful that the dissipation of “one off” factors can bring inflation back within the Fed’s target range. Expectations are changing, along with consumer behaviour. Wage pressures are rising. None of this can be reversed easily without a reduction demand and potentially a rise in unemployment. Economists can disagree about the scale of the rise of interest rates needed to achieve this outcome. They can also disagree about whether this will imply a recession needs to happen. But the inescapable reality is that whether an economy goes into recession may not matter to markets. For markets, the current environment means that costs are rising while demand will be cooling. This will lead to an earnings recession regardless of whether GDP registers more than one quarter of negative growth.
This cyclical scenario is already being priced into the markets. The more important question is what happens next? Will a mild recession be sufficient to reduce inflationary pressures? Will the Fed be able to pivot back to business-as-usual?
To answer this question, we need to look at both cyclical and secular factors that are at play. From a cyclical perspective, the Fed remains well behind the curve. Despite the interest rate hikes, interest rates remain low, and real interest rates are substantially negative. Negative interest rates are not conducive to price stability because they encourage consumption today over tomorrow. This is exactly the opposite of what the Fed needs to achieve price stability. Interest rates need to move to levels higher than anything we have seen since the global financial crisis of 2008.
From a secular perspective, many of the trends that underpinning the global economy argue for inflationary forces that are higher than we have seen in the past two decades. The first such trend is deglobalisation. The prioritisation of domestic production over reliance on global supply chains is not a phenomenon associated with the Covid crisis. Arguably, the election of Trump and the Brexit referendum in 2016 were the first signal in a series of developments in which governments are actively moving away from the principles of free global trade. These have dominated international economic policy since the early 1990s. The decoupling of the US and Chinese economies is a slow but steady moving process. Covid accelerated this trend by highlighting to companies the importance of “just in case” supply chains. Diversifying production away from the lowest cost suppliers entails higher costs.
The second trend that will impact future prices is the transition to greener energy. Technology has improved to the point where many alternative energy sources are cost effective. However, for industrial countries to achieve their stated carbon neutrality goals, the price of carbon needs to rise by multiples of where it is today. A rising cost of carbon emissions will automatically feed through to the cost of goods and services.
The third secular trend that argues for a higher level of inflation is demographic developments in all major economies. Europe, China, Japan, are ageing rapidly, while in the US, labour force growth barely keeps up with the growth in the number of retirees. Labour shortages in economies that are less open to outsourcing or immigration will tip the balance in favour of wages rising more rapidly than the past. This trend will be encouraged by governments, as reducing income inequality has become a central stated policy goal in most countries.
Taken together these trends suggest that we are not simply heading into a cyclical downturn. Rather, it is that the downturn is a turning point on the route towards a different economic landscape. The low interest rates we have seen in the past 15 years are unlikely to be repeated. This has important implications for investors.
An environment where inflation remains higher than it had been before the Covid crisis can be favourable for some equities. And overall, it would be more favourable for equities over bonds. Earnings can grow in line with inflation. But an environment where capital is scarcer isn’t one where companies can prioritise growth over profitability. Companies that can improve efficiencies to keep cost pressures under control will thrive.
To position for the environment we see ahead, we have rebalanced portfolios with three priorities in mind. The first is increasing exposure to companies with high free cash flows. The second is ensuring that our exposure to growth sectors are focused on those areas that are likely to lead the next investment cycle, such as investment in alternative energy. The third is to further reduce our exposure to emerging markets, where a more turbulent global environment is likely to increase balance of payments pressures.