A shortened version of this piece appeared in the Sunday Times on 11th September 2022
September 2022
Stubbornly high inflation continues to be headache for central bankers and financial markets. Last year, when COVID-related supply side disruptions pushed up prices of goods like used cars and semiconductors many policymakers expected inflation to be transitory. However, as those price pressures eased, the inflationary impulse broadened out to other parts of the economy as wage growth picked up.
This year inflation has continued to climb driven by soaring energy prices, forcing central banks to raise interest rates. That has provided a difficult backdrop for financial markets; global equities declined by over 20% between Jan and mid-June, while government bonds had their worst start to the year in decades. However, during the summer, equities rebounded on hopes that the worst of the current inflation surge may be behind us.
Much of that optimism centred around developments in the US. Although July’s inflation rate was 8.5%, that marked a decline from 9.1% in June. Encouragingly, the month-on-month change was flat. Recent declines in food and oil prices were key contributors but even allowing for those the trajectory of inflation improved.
However, there is a suspicion in markets that the optimism may be misplaced, and the summer equity rally may just be a temporary reprieve. In particular, the economic and inflation outlook outside the US continues to look challenging. Although oil prices have declined, natural gas and wholesale electricity prices across Europe have surged meaning that headline inflation levels look likely to rise further in the months ahead. Whereas the stagflation of the 1970s was attributed to the two oil crises, the unfolding gas crisis in Europe may well drive stagflation in the 2020s.
It’s not just the direct impact of higher gas prices that is a concern. Rising gas prices raise industrial production costs and push up fertilizer prices which in turn raise food prices. Workers demand higher wages in response to higher prices generating what economists call a wage-price spiral. Research from the Bank for International Settlements recently highlighted that when an inflationary regime becomes established these spill-over effects can be very significant and difficult to reverse.
In August the Bank of England raised rates 0.5% and forecast that inflation would peak at 13% this October and that the economy would likely endure a 15-month recession. In Germany, the Bundesbank expects German inflation to rise above 10% this autumn, the highest level since 1951 driven by soaring energy prices. The hot summer weather has compounded the problems for the German economy, reducing water levels on the Rhine and disrupting trade and the distribution of coal. Business confidence data have already fallen to levels associated with recession.
Governments across Europe are rolling out measures to ease the burden of high energy prices on consumers and businesses. However, unlike during COVID, when the ECB was effectively underwriting the European debt market and governments could borrow at zero interest rates, bond yields have risen sharply in recent months increasing borrowing costs and providing a constraint on spending.
The unpalatable choice facing the ECB and most other central banks is either (a) raise interest rates further and risk compound an economic downturn or (b) hold off on rate rises and risk losing credibility if inflation remains stubbornly high. In July the ECB started the tightening cycle raising interest rates 0.5%; this week they raised rates a further 0.75%.
The problem for the ECB is that in Europe, at least, inflation has largely been driven by a supply shock while the tools at its disposal influence demand. A slowdown in demand means lower economic growth and ultimately a rise in unemployment. Currently, with unemployment still low there is little political pushback for higher interest rates but if the major economies go into recession and unemployment rises expect to hear more debate on the perceived trade-off between inflation and unemployment.
In the 1970s, central bankers, particularly in the US, struggled to contain inflation as political pressure resulted in repeated cycles of tightening and easing of monetary policy. Policy makers are acutely aware of the risk of repeating that mistake but that doesn’t make the policy choices any easier.
One difference with the 1970s is back then weakness in the US dollar was a key driver of US inflation. This time Europe is in the eye of the storm given the greater dependency in Germany, in particular, on natural gas. The US dollar has risen by about 12% this year, with the euro falling below parity for the first time since 2002. While euro zone exports and tourism will benefit from a weak euro, import prices will rise complicating the inflation challenge for the ECB.
During the last decade, markets and investors became accustomed to an environment of moderate economic growth, low inflation and accommodative monetary policy which was favourable for financial assets like equities and bonds. Stagflation would present a very different economic backdrop for investors.
Although equities are seen as a hedge against inflation over the long term, in the short term, rising interest rates reduce the present value of future cashflows justifying lower equity valuations. That’s the main reason why equities have already fallen this year. If economic growth was now to disappoint it would be an additional downside risk for equity markets in the near term.
Government bonds look less unattractive than a year ago as yields have risen from below zero to above 2% in the case of Irish government bonds. Government bonds could still be vulnerable to downside risk amid rising ECB rates particularly if a eurozone recession prompts investors to test the ECB’s resolve in supporting peripheral eurozone bond markets.
On the plus side, higher interest rates will mean savers will earn a modest return on deposits. Although real returns are negative, having cash to take advantage of market volatility could be attractive in the current environment. Investors have often turned to gold in times of stress and gold was a strong performer in the stagflation of the 1970s. This year gold has declined in USD terms but has still delivered positive returns to euro-based investors because of the weakness of the euro.
Commodities have also been strong performers in the last two years and historically have performed well in inflationary periods. However, even in the 1970s commodities were subject to significant volatility so there may be a case for investing in commodities via an actively managed rather than passive fund. More generally, greater volatility in financial markets may create opportunities for more active strategies; indeed, some hedge funds have been performing positively this year given the heightened volatility.
In sum, a changed macro picture may well translate into more volatile financial and commodity markets in the coming years and being diversified across asset classes and investment strategies seems even more important when considering asset allocation at the current juncture.