This note was written on 25 November 2021, before the Omicron variant was reported on widely.
· Inflation reaches 30-year highs, but has been a complex and evolving process
· The Fed’s asset purchase tapering looks likely to be accelerated
· Growth equity is under pressure as the outlook becomes uncertain
US headline and core inflation reached 30-year highs in October. A surge in commodity prices drove much of the month-on-month gains in the headline CPI. The global energy crunch has driven up prices of oil and natural gas, and supply constraints show no signs of ending any time soon.
With hindsight, it is easy to make the statement that a high rate of inflation was always going to persist until the new year. But we argue that this argument downplays what has been a complex and evolving process over the last 8 months. When headline CPI printed a shock 4.15% in April, dispersion between contributing areas was high. “Return to normal” sectors like hotels, airfares and care hire drove much of the steep increase in prices. From May through September, we observed a decelerating month-on-month trend in increasing price levels. The rate at which prices were climbing every month, was slowing. Many of the culprit areas from earlier in the year were seeing sharp decreases in prices. This lead many to believe, including us, that the sharp rise in price levels would soon moderate.
This all changed in October. Energy/commodity prices began to contribute strongly, after being relatively subdued since April. Despite this, dispersion between sectors stayed low, indicating that price level increases were much more widespread across the economy. We have seen a similar story reflected in the core PCE deflator this week, the Fed’s preferred measure of inflation. Worryingly, the labour market looks to be tighter than expected – with the lowest level of weekly initial jobless claims reported since 1969 this week. The Quits rate, a good measure of employee bargaining power and labour market tightness, is also at decade highs. Wages appear to be increasing in lockstep with this measure. These factors, coupled with the recent increase in shelter costs, make us fear that inflation has become significantly more durable and persistent.
Much has been made about whether we are seeing persistent or transitory inflation. We feel a lot of the confusion comes down to the definition of “transitory” and the ambiguity around timeframes from the Fed. Our base case is that high year-over-year inflation will persist until supply/demand imbalances in the energy and broad commodity sectors blow over. Sticky factors such as wages and shelter will extend this high inflation period. Yearly base effects and supply coming online next year should lower the inflation rate. However, we feel that we will most likely normalise into a higher inflation regime than before, with annual headline CPI growth of around 3%.
As expected, the Fed began the process of tapering asset purchases this month. Taking into account the pace of tapering, the purchasing program was on course to wrap up in June 2022. But following upside surprises in the October employment and inflation reports, it seems increasingly likely that they will accelerate this pace. If the Fed decides to double the current pace (opting to buy $20bn & $10bn less treasury bonds and mortgage-backed securities per month respectively), the tapering program will come to an end by March 2022.
This has major implications for the timeline for future policy tightening, as it allows the fed to raise the federal funds rate as early as Q2 next year. A speed up in the tapering process could also be used to send a clear message to the market, lowering inflation expectations if they rise to uncomfortable levels. The US 10-year breakeven rate, derived from Treasury Inflation Protected Securities (TIPS), is currently at 2.6%. Inflation expectations have recently moderated, after sharply rising in October. Fed funds futures and Eurodollar calendar spreads, which can be used to estimate the market’s expectation for future rate hikes, are pricing in almost 3 hikes by end 2022.
With the inflation target for interest rate lift-off clearly met, attention turns to full employment. Newly re-nominated Jerome Powell has already indicated that the Fed is carefully watching secondary indicators such as job openings, wages and the quits rate to gauge where we stand vs maximum employment. As mentioned in the previous section, these measures show a tightness in the labour market not seen in the unemployment and participation rate.
Growth equity has potentially begun to price in the harsh environment expected next year. We will most likely see a net fiscal and monetary drag in many global economies, after a few years of very easy conditions. GDP and earnings growth is also likely to slow from the record rates seen in 2020 and 2021. Many of the high-flying names that investors piled into coming out of the pandemic have sold off dramatically in recent months. Companies like Zoom, Teladoc and Virgin Galactic have all lost more than half of their market value as measured by their recent all-time highs. This is despite the broader Nasdaq 100 trading near all-time highs. This is a stark reminder to investors that over the long term, fundamentals tend have the final say.
Global Economic Data Highlights
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