The Big Conversation
Episode 100: When will stocks react to inflation?
This week we look at the ongoing divergence between inflation and risk assets, especially bond yields, and the impact that this has had on the stock market. Will we finally see yields rise and value stocks outperform, or is the dollar starting one of those runs higher that can undermine risk assets? Regardless of which inflation camp you sit in, the lack of response to some startlingly higher inflation prints is quite remarkable.
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Roger [00:00:00] Welcome to this, the 100th episode of The Big Conversation, and we thank you for your three million views. Now over this time, the pandemic has dominated the narrative, and its repercussions will impact financial markets for a very long time. Perhaps the most enduring effect of the pandemic on the market has been the policy response and its impact on inflation, which has hit eye-watering levels in some regions. How far it can go and whether this will fully impact risk assets, well that still remains the biggest conversation today.
[00:00:36] Some of the recent prints in producer price inflation have been absolutely stunning. Spain and Sweden's PPI are at the highest levels in 40 years, comfortably outstripping all readings during this time period. Even in regions which have struggled to generate any meaningful inflation for decades, such as Germany and Japan, well, they've seen their levels of PPI shoot up as well. In many countries, this surge in PPI has not been matched by consumer prices. The differential between Chinese PPI and consumer prices has reached a record level, indicating one of the main problems for global corporates, which is margin compression. Chinese CPI is still under 2%, and whilst this consumer-facing data is no doubt massaged for the masses, it still reflects both the supply side policy response that has kept domestic demand in check, the ongoing rebalancing of the economy and a very different set of circumstances to those that have seen US consumer prices also surge to a three decade high of 6.2 percent. Now the US is focussed on demand. This saw a surge in durable goods that required significant inputs from raw materials, and JP Morgan has estimated that today demand for goods still remains about $700 billion above the trend, whilst demand for services is about 300 billion below trend. And this imbalance has put a significant pressure on supply chains at a time when they've been creaking under COVID. Now whilst Chinese corporate margins have been under pressure, in reality, much of that inflation was exported to the US as finished goods. The US has not experienced the same external demand for its own goods. US exports to the rest of the world are still below pre-pandemic levels because the rest of the world has not been as aggressive at stimulating demand. US inflation should, however, remain elevated for a few more months. The energy crisis is still playing out with crude oil at the top of the range and Europe still struggling to secure natural gas supplies, and in fact, Germany's regulator has not yet given the green light for the Nordstream pipe to come online. Europe has recently been experiencing warmer than usual weather, but a cold spell could again send and energy prices soaring further. Supply issues, especially ones due to under-investment or protracted geopolitical issues, they can remain in place for a significant period of time. Indeed, we've really experienced inflation as a result of policy rather than inflation caused by natural demand, though arguably inflation is always induced by policy. There is obviously a supply demand imbalance in the US, but this is almost entirely due to fiscal support provided by the government and not a natural rebound in activity. So has the US reached peak stay at home? And the answer to that is probably yes. But there are significant residual savings that could still support demand. 12 month rolling savings for US households are still over $1 trillion above the trend. Will this be spent in its entirety? Well it's unlikely though the expectation of constant bailouts does encourage people to spend with impunity. But the bubble in savings has now started to revert. The savings ratio is back at its former level. Once the current excess savings are drained, then the consumption surge will be over. Indeed, the rate of change of savings will have been declining for some time, and the economy is beginning to adapt to demand. The biggest issues for the US supply chain is within the auto sector, and this has been a drag on GDP because the affordability of autos has absolutely shot through the roof, as have second-hand car prices. Producers have seen their sales plummet, but for the economy, this will be a double-edged sword. Once the bottlenecks have been worked through, the auto industry will also start to normalise, and even though it remains only about three percent of the economy, this sector has an outsized impact because of the support industries. So if US consumers have put auto purchases on hold due to the affordability issues, then the excess of household savings may be earmarked for this sector once prices returned to sensible levels. Therefore, rather than ask whether the higher prices are transient or not, it may be better to ask how high inflation will actually go? If this spike is a one off? Or will corporates now start converting high input producer prices into even higher consumer prices in order to protect their margins and resulting in a shift high in that inflation? Now since the recovery last year, corporate profits have surged after many years of flat lining. Can US corporates maintain these profits in the face of surging prices? They'll try, and this should feed through to additional inflation, as the PPI vs. CPI gap closes. But if real wages continue to fall as they have, then demand will not fully recover. And so far, financial markets have generally acted as if inflation is a one-off spike, and that's distinct to inflation being transient. If the market was really concerned about inflation, then longer-dated yields should have moved significantly higher. Currently, all yields look incredibly subdued in the US, considering the spike in inflation. That certainly looks like a one-off surge rather than institutionalised inflation. The move that we've had at the front end of the curve, such as the 2-year, well that was a repricing of interest rate policy rather than a repricing of inflation, although we could argue that they are the same thing, and it was a tougher stance from some central bankers due to ongoing inflation that presaged this move in the first place. But it still remains notable that the US 10-year yield has still not broken the year's highs, despite the print of five and six percent in CPI. Yields appear to be comfortable with higher inflation, therefore, bond markets probably need a technical rather than an inflationary shock in order to significantly reprice higher. And in the absence of an explicit yield curve control, yields could surge higher before policymakers have a chance to respond. And so far, markets have been comfortable with a certain amount of continuity from the FOMC. There was a hawkish tilt at the June meeting, but it wasn't sufficient to cause long yields to reprice. In September there were hints that interest rate hikes might be coming sooner than expected, and that certainly moved the dial. But that was mainly the front end where yields had remained conspicuously subdued for some time. So therefore, what could cause a shift in policy expectations? Well, according to President Biden, a decision on the Fed chairman nomination is expected in the next few days, and it could even happen whilst we're filming this. The official announcement was supposed to be in December. Markets love stability. A change in the Fed should not send shockwaves through the market. But if Lael Brainard is appointed, then the FOMC would accelerate its dovish leaning. A shift like that could prolong QE and maintain a much shallower pace of rate hikes. And even if Powell remains, there will have been discussions about more accommodation otherwise Brainard wouldn't have been in the running in the first place. Recently, inflation expectations have already broken out and they should rise further. Long end yields such as the 10-year may finally start to retest their highs. And we should expect spot CPI to reach even higher levels if US consumption is given another boost. Now, not much of this is actually that new. Many analysts have been holding out for signs of economic reflation rather than just inflation. So regardless of who takes the helm of the Fed, there are expectations that value stocks will start to outperform growth, like we saw at the beginning of the year. Small caps are expected to make new highs. The Russell 2000 has recently broken out of a consolidation pattern, and tech stocks could wobble in relative terms. But it's a very brave person who bets against the ongoing pension and corporate flows into those names. So if technical factors, whether it's a VAR shock or change at the Fed, cause long dated yields to suddenly rise, then risk assets may come under pressure across the board. We saw that at the end of 2018. Bond yields soon fell again and tech stocks caught a bid. It's hard to bet against tech unless you think regulatory change is imminent or the market structure is about to change. Now, some institutions are hedging themselves against a surprise surge in long-dated yields through buying the puts on the long end of the curve. If we did see higher long dated yields, then banks can be expected to outperform the S&P, continuing a pattern that has held for a number of years. We would also need to look at the dollar. The dollar has also been breaking out. The outperformance is mainly versus the euro, a mirror image. Indeed, most of the weakness over the last year was against the euro in the first place. So this is very much a reversal of that. Lower yielding regions such as the Eurozone, Switzerland and Japan are expected to keep their rates on hold, so if the Fed does become more dovish, then U.S. policy will converge on those other major regions. And that might allow the dollar to drift a bit lower. However, a dovish turn, regardless of who is at the helm of the FOMC, would help boost consumption and growth expectations. Over the last 12 months, the euro has been following the spread between economic expectations between the two regions. Currently, Europe is again struggling with another COVID outbreak, and the US is toying with more stimulus or dovish pressure on the central bank. Now, that could boost expectations on the US in terms of growth versus the eurozone again, and that would favour more dollar strength. Furthermore, a misstep by the existing Fed chair or the repricing for a new one, could see a risk off bid return to the dollar. The dollar index has already broken out of a reversal formation, but any wobbles in the market could fuel a surge. So far, strength in commodity currencies has kept the rise in the dollar in check. But as we've seen with renewed weakness in some of the less well received pairs like the Turkish lira, the natural direction of the dollar at the moment appears to be higher. A strengthening of the dollar would tighten financial conditions. These have actually already hit a new low held by in no small part, the aggressive interventions of global central banks, but a dollar surge would tighten those conditions. But we are starting off with a very low base. It remains one of the key risks of a policy misstep. But overall, the market expects a year end momentum in equities to remain healthy. Markets love continuity, and stability in the FOMC should benefit that outlook. A dovish shift in the Fed could lead to a positive repricing of risk, but it also creates an opportunity for inflation expectations and higher yields in particular to catch investors by surprise. And these are the biggest risks as they've been all year. Policymakers don't want volatility, but a sudden surge in yields and a sudden surge in the dollar remain an increasing possibility if they drop the ball. The move in the dollar has started to gain momentum, whilst the move in yields has not. Both are, however, being actively hedged by investors as a source of protection rather than buying equity index put options that remain expensive when compared to the performance of the underlying equity market. If you have any questions about this episode, financial markets or the economy, please put them in the comments section or send them to TBC at Refinitiv dot com.