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The Inflation Puzzle

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By Peter Lindahl – Evli: Last year, strong global economic growth resulted in high inflation, particularly in the US. The whitewash explanation for higher prices relied on the word “transitory.” The main narrative was that inflation wasn’t here to stay and was expected to fade away in 2022. However, supply-chain issues seemed to linger, and the new corona waves entailed further bottlenecks, such as labor shortages. Wages skyrocketed, especially in low-income service sectors.

Fed, the American central bank, realized in late 2021 that they had let the party go on for a bit too long. Fed chief Powell & Co. now appear to be somewhat in a hurry to remove the party punch bowl, meaning that the Fed is trying to turn around its monetary policy from an ultra-stimulative mode towards a tighter one. The US jobs market is booming as the economy is at full employment. For example, there are almost two job openings for every unemployed person.

The war in Ukraine adds to further inflation risk

The Russian invasion of Ukraine in late February was a shock for Europe and the Western world. What’s more, it has resulted in an inflationary shock stemming from higher energy and gas prices. Consumers are getting hurt at the gas pump – households and companies – due to higher energy costs. Inflationary pressures have risen even further in early 2022 and the word “transitory” is long forgotten. Eurozone inflation hit 7.5% in March of this year.

Simultaneously, as the inflationary shock blows through the economies, the fear of a recession has been on the rise, particularly in Europe. We believe that recessionary expectations are premature, even though a popular recession gauge, the difference between 10- and 2-year bond yields turned negative recently. We will likely see a growth slowdown in almost every region, but an economic recession in the next 12 months seems unlikely. However, if the war in Ukraine was to escalate much further, it would increase the risk of a recession specifically in Europe.

The global economy is in “mid-cycle”

Inflationary pressures could derail the economic cycle, or in an optimistic scenario even prolong the cycle. Although it appears that the US economy has already entered a ”late-cycle” period, the global economy as a whole is not as far ahead. Europe and Asia are more likely somewhere in a middle of their cycles.

The war in Ukraine is resulting in slower economic growth in 2022, which may cool off the overheated sectors of the economy and possibly trigger a so-called classic mid-cycle slowdown. In turn, this could extend the global economic cycle further out, as the global economy catches some new tailwinds down the road, especially if the Fed and other central banks succeed in taming high inflation.

The good news for investors

Historically, periods of monetary tightening have not meant negative equity returns. No, the Fed tightens because of a strong economy and inflationary risks. Currently we observe both.

This is usually positive for equity returns because healthy economic growth means positive profit growth. As long as the economy doesn’t head into a recession, equities have been able to do well despite slower economic growth. The Fed is now trying to contain inflation and cool down the overheated job market. Will they be able to accomplish such a “soft landing” remains to be seen. The main risk is that permanently high inflation above three percent could turn into a headwind for both the economy and equity markets.

Another positive outcome over the past year is that equity markets have become more attractively valued as absolute valuations levels are low, especially in regions outside America. Even credit markets look attractive amid wider credit spreads and higher yield levels.

As one might expect, the atrocities of the Russian invasion and the difficult ramifications in the geopolitical environment will result in various aftershocks to the world order. At least in the past, geopolitical crises and wars have often had short-lived negative impacts on global equity markets.

The outlook for the remainder of 2022

Indeed, the outlook for equity markets is not as distressing despite the horrendous war. Recession risks remain low, and earnings growth should reach positive levels in 2022. However, near-term uncertainty on the next phase of the war, or how large the negative impact on the economy could be, might keep markets volatile over the next few weeks. Nevertheless, equities are now cheaper and should do well on a 6–12-month horizon.

 

This article was initially published here.

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Guest Contributor
Guest Contributor
This article was written by a third party as guest contribution. The content represents the views of the author(s). It was submitted and edited under HedgeNordic´s guidelines, but is not a product of HedgeNordic´s regular editorial team.”

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