Risks to growth require a “light” policy on inflation
The global economic shutdown we experienced in mid-2020 was unique in recent history for its ability to disrupt the flow of goods, services and labor around the world. Since then, regionalised shutdowns in response to the resurgence of Covid-19 infections have been implemented periodically, often with very little warning.
Global supply chains have been hit hard by this uncertainty, struggling to cope with the rapid recovery in demand for goods in 2021. This disproportionate demand is linked to healthy balance sheets for consumers and businesses, aided by monetary policies. and generous taxes.
As a result, we have seen inflation rise sharply in both developed and emerging markets (ME), raising concern among policymakers, businesses and investors. US core inflation (excluding energy and food) stood at 4.9% on an annualized basis in November, well above the long-term target announced by the US Federal Reserve (Fed).
Base effects increased that number, but it has been high over the past eight months. Similar dynamics have been observed in the UK, Canada, the euro area and a number of emerging countries.
Normally, numbers like these would be enough to trigger concerted monetary policy action designed to cool the economy. Yet major central banks have so far taken a more thoughtful approach, influenced by the upheavals associated with the Ccovid-19 pandemic.
Keeping inflation under control is the main goal, but policymakers need to frame their decisions against the background of declining growth and recovering labor markets, which could be further affected by the arrival of a new variant of the coronavirus.
Against this backdrop, we believe global inflation is likely to continue to rise until the end of 2021, as demand remains high throughout the holiday season and continued disruption in supply chains maintains pressure on the prices of inputs and products.
However, we expect inflation to peak before the middle of 2022, as economic growth normalizes, demand slows, and supply issues begin to dissipate. The reduction in backlogs and the gradual increase in stocks of finished products are already proof of this. The ongoing transition to a service-based economy is also expected to minimize the effect of cross-border pressures on the supply chain.
Although we believe that inflation will soon exceed its peak, we do not expect it to return to normal levels until the end of 2022. In addition, inflation may stabilize at a level higher than one we experienced in a pre-Covid-19 world where low inflation was taken for granted.
In our view, a range between 2.0% and 2.5% is more likely for several reasons, including wage growth and a more flexible approach to inflation policy. Wages are unlikely to rise uncontrollably, but we could see continued upward pressure on wages in all sectors if participation rates continue to slow. Higher productivity levels may act to cool unit labor costs, but inflation is likely to remain slightly higher than pre-pandemic levels for some time.
While the normalization of inflation next year is our baseline forecast, it is possible that certain risks will materialize in concert and act to keep inflation high through 2022 and into 2023. In our opinion, this scenario is less likely, but it must be recognized given the effect it could have on financial markets.
Most importantly, households have benefited from the pandemic stimulus, while restrictions on movement and travel have helped boost savings and purchasing power. This could lead to persistent above-trend demand, which we believe is the main contributor to inflation. Unforeseen supply issues linked to labor shortages, global production, new Covid-19 lockdowns and energy shortages can also exacerbate inflation further.
Elsewhere, upcoming fiscal stimulus, such as US President Biden’s $ 1 trillion infrastructure program, could inadvertently add inflationary pressures while supporting economic growth through major new construction projects.
A sustainable recovery depends on a cautious approach by policymakers
We expect the major central banks to take somewhat different approaches to monetary policy in 2022 while sticking to their carefully communicated normalization plans. The Bank of Japan and the European Central Bank have been optimistic in their approach. Yet the Fed, alongside the Bank of Canada and others, has been more aggressive, initiating asset purchases by gradually lowering expected interest rate hikes.
The Fed’s asset purchase reduction program, which began in November, is expected to end in early 2022, while the federal funds rate will also have fallen from a very low level by the end of 2022 according to current projections. .
This kind of constant progress towards normalization should allow inflation to dissipate naturally, in our opinion, without the need for a sudden intervention. Further measures to control inflation could precipitate a decline in equity markets, given current high valuations and growth which remains above trend but slowing. The Fed’s latest projections show that the real gross domestic product of the United States was already declining after a post-pandemic peak in 2021.
There is also a risk that a too rapid reduction in liquidity will slow growth to critical levels, weakening business confidence and corporate investment to such an extent that central banks will be forced to turn around to re-inflate funds. economies and markets. Premature tightening could also undermine investor and consumer confidence, making any retrospective easing less effective.
In the United States, the appointment of Fed Chairman Jerome Powell for a second term creates welcome continuity for financial markets and should reduce fears about stable monetary policy. However, a reconfiguration of the Fed’s board could increase the chances of a more hawkish approach, depending on the persistence of inflation and the influence of political factors such as fiscal policy.
Implications for the multi-asset investment strategy
We continue to favor equities over bonds through 2022 as corporate earnings generally remain healthy, indicating that companies can maintain profitability by passing higher input costs on to customers. This was facilitated by strong demand and demonstrates how some inflation doesn’t necessarily have to be bad for stocks.
If margins remain strong through 2022, equity markets could strengthen further as inflation normalizes. On the other hand, valuations high compared to historical levels could be put under pressure if high expectations for earnings performance are not met.
The continued threat of newer variants of Covid-19 is a risk that could no doubt wipe out profits, especially if governments choose to act with caution. Blockages and travel restrictions of varying severity will all serve to disrupt business activity and affect consumer sentiment.
An interesting consideration is how inflation has had a different impact on industrial sectors, especially around wage growth, in an environment where wage increases reduce earnings per share.
We have observed that rising wages have a greater impact on businesses with lower paid workforces, such as transportation and food retailing, so we will factor this data into our decisions. investment in shares during 2022.
Elsewhere, the US Treasury yield curve is no longer steep, which is a good indicator that the bond market is anticipating peak inflation. We believe this confirms our preference for equities. Given the risks associated with the persistence of inflation, we will keep most of our bond holdings in short-term bonds less sensitive to interest rates.
Such a position means that a significant return is difficult to achieve. However, this can be solved, in our view, by investing in high yield corporate bonds that offer a large carry over to US Treasuries with an attractive risk / return profile. Cash and short-term US Treasuries also play an important role in our investment strategy, providing protection against the high volatility expected due to the normalization of monetary policy.
Ed Perks is the Director of Investments at Franklin Templeton Investment Solutions.