Everything seems to hang on the outlook for inflation. The Fed has been clear that interest rate policy will depend on inflation coming back towards its target. The Fed is raising rates aggressively and as a consequence, the US dollar is strong in response to relative interest rate differentials. This feeds through to all other assets, such as currencies, commodities, equities and bonds. At its most basic the Fed’s policy is exporting the impact of domestic inflation overseas through the strong dollar and weak asset prices, making inflation and economic pressure stronger in foreign markets than at home. This is an example of the exorbitant privilege of being the world’s reserve currency.

The outlook for US inflation over the coming months is critical for all investment markets. While we can have some insight into the future direction of inflation it is arguably safer to look at whether market expectations are likely to be undershot or exceeded. At present, market expectations (as implied by the breakeven inflation rate) are that US inflation falls back to close to 2% over 2023, while market forecasts are around 3.7%. We can take that as a range in which the market’s real view sits. Basically, inflation falling rapidly towards historic norms at least in the US.

The chart shows the market breakeven (2 year) inflation rate over the last 12 months (this is the rate of annual inflation over the subsequent 2 year period as calculated by the difference in yields between index-linked and straight treasury bonds). This is widely regarded as future inflation expectations as a buyer would make the same return if he bought either bond if inflation turns out to be that level.

Market Breakeven (2 year) Inflation Rate

Source: Bloomberg, 21.09.2021 – 21.09.2022.

The million-dollar question is how plausible is this rapid fall in inflation. The first thing to say is that this rapid fall in inflation, if correct, is likely to be as a consequence of a rapid contraction in economic activity. Inflation on one level, can be seen as demand for goods and services exceeding supply, so prices go up. This will persist until either supply improves or demand declines. At present, supply is constrained in a large number of the factors of production, most especially energy. Demand is supported by fiscal support for incomes and strong consumer balance sheets.

If we assume that energy prices are flat from here, then energy might become a disinflationary force come next spring. However, oil prices are very much a political issue. Longer term the market can be argued to be tight, but short term a recession might mean demand falls beneath supply. However, OPEC has the ability, particularly now the Western world has turned against new exploration, to set the price through supply adjustments. OPEC has indicated that current prices are at or around their desired level. Any disinflationary impact from energy may be relatively short lived.

The next big swing factor must be wages. In the 1970’s the big story was of a wage price spiral. Workers tried to maintain their real incomes against rapidly rising prices, but the process provided further inflationary stimulus. Despite a very strong labour market, real weekly earnings have fallen over 10% since their peak in 2020 and continue to fall. They are currently below pre-pandemic levels. It is hard to imagine that wages won’t start to catch up with the price level, given the supposed tightness of the labour market.

The other major factor at play is the disruption to large parts of the world economy as a result of politics. Here we can include Chinese zero COVID policy, the Ukraine situation, energy shortages in Europe and of course inflation support measures from various governments. All these events and policies will ultimately prove inflationary.

While it is evident that inflation may be falling near term, this is likely to be as a result of a significantly weakening economy. Longer term, the structural inflationary forces look set to remain. Once the genie is out the bottle, behaviour at an individual and institutional level changes to take into account the rising price level.

It seems there are two possible paths: either inflation persists higher for longer, or we are facing a severe economic contraction to bring it back down. Either scenario is a troubling one to negotiate in markets, as either interest rates and equity valuations need to adjust for the higher long-term inflation, or we need to adjust earnings expectations for the forthcoming recession. We think the most likely scenario is a blend of the two. Inflation remaining higher for longer and weaker economies. Hence we remain very conservative in portfolio positioning in the near term until the outcomes become clearer.