Falling inflation – what does it mean for investors?
By Robert Wright /February 16,2024/
- Inflation is in retreat thanks to improved supply and cooling demand. A further fall is likely this year.
- Australian inflation remains relatively high – but this mainly reflects lags rather than a more inflation prone economy.
- Profit gouging or wages were not the cause of high inflation.
- The main risks relate to the conflict in the Middle East escalating and adding to supply costs; a surprise rebound in economic activity and sticky services inflation; and floods, the port dispute and poor productivity in Australia.
- Lower inflation should be positive for investors via lower interest rates, although this benefit may come with a lag.
- The world is now a bit more inflation prone so don’t expect a return to near zero interest rates anytime soon.
The surge in inflation coming out of the pandemic and its subsequent fall has been the dominant driver of investment markets over the last two years – first depressing shares and bonds in 2022 and then enabling them to rebound. But what’s driving the fall, what are the risks and what does it mean for interest rates and investors? This article looks at the key issues.
Inflation is in retreat
Inflation appears to be falling almost as quickly as it went up. In major developed countries it peaked around 8% to 11% in 2022 and has since fallen to around 3% to 4%. It’s also fallen in emerging countries.
Source: Bloomberg, AMP
What’s driving the fall in inflation?
The rise in inflation got underway in 2021 and reflected a combination of massive monetary and fiscal stimulus that was pumped into economies to protect them through the pandemic lockdowns that was unleashed as spending (first on goods then services) at a time when supply chains were still disrupted. So it was a classic case of too much money (or demand) chasing too few goods and services. Its reversal since 2022 reflects the reversal of policy stimulus as pandemic support measures ended, pent up or excess savings has been run down by key spending groups, monetary policy has gone from easy to tight and supply chain pressures have eased. In particular, global money supply growth which surged in the pandemic has now collapsed.
Why is Australian inflation higher than other countries?
While there has been some angst about Australian inflation (at 4.3% year on year in November) being higher than that in the US (3.4%), Canada (3.1%), UK (3.9%) and Europe (2.9%), this mainly reflects the fact that it lagged on the way up and lagged by around 3 to 6 months at the top. The lag partly reflects the slower reopening from the pandemic in Australia and the slower pass through of higher electricity prices. So we saw inflation peak in December 2022, whereas the US, for instance, peaked in June 2022. But just as it lagged on the way up it’s still following other countries down with roughly the same lag. In fact, with a very high 1.5% month on month implied rise in the Monthly CPI Indicator to drop out from December last year, monthly CPI inflation is likely to have dropped to around 3.3% to 3.7% year on year in December last year, which is more in line with other countries.
Source: Bloomberg, AMP
What about profit gouging?
There has been some concern that the surge in prices is due to “price gouging” with “billion dollar profits” cited as evidence. In fact, the Australian Government has set up an inquiry into supermarket pricing. There are several points to note in relation to this. First, it’s perfectly normal for any business to respond to an increase in demand relative to supply by raising prices. Even workers do this (e.g. asking for a pay rise and leaving if they don’t get one when they are getting lots of calls from headhunters). It’s the way the price mechanism works in allocating scarce resources. Second, national accounts data don’t show any underlying surge in the profit share of national income, outside of the mining sector. Finally, blaming either business or labour (with wages growth picking up) risks focusing on the symptoms of high inflation not the fundamental cause, which was the pandemic driven policy stimulus and supply disruption. This is not to say that corporate competition can’t be improved.
Source: ABS, RBA, AMP
What is the outlook for inflation?
Our US and Australian Pipeline Inflation Indicators continue to point to a further fall in inflation ahead.
Source: Bloomberg, AMP
This is consistent with easing supply pressures, lower commodity prices and slowing demand. It’s not assuming recession, but it is a high risk and if that occurred it would likely result in inflation falling below central bank targets. Out of interest, the six month annualised rate of core private final consumption inflation in the US, which is what the Fed targets, has fallen below its 2% inflation target. In Australia, it’s expected that the quarterly CPI inflation to have fallen to around 3% year on year by year end. The return to the top of the 2% to 3% target is expected to come around one year ahead of the RBA’s latest forecasts.
What are the risks?
Of course, the decline in inflation is likely to be bumpy and some say that the “last mile” of returning it to target might be the hardest. There are five key risks to keep an eye on in terms of inflation:
- First, the escalating conflict in the Middle East has the potential to result in inflationary pressures. Disruption to Red Sea/Suez Canal shipping is already adding to container shipping rates due to extra time in travelling around Africa. So far this has seen only a partial reversal of the improvement in shipping costs seen since 2022 and commodity prices and the oil price remain down. The US and its allies are likely to secure the route relatively quickly such that any inflation boost is short lived. The real risk though, is if Iran is drawn directly into the conflict, threatening global oil supplies.
- Economic activity could surprise on the upside again keeping labour markets tight, fuelling prices and wages, and hence sticky services inflation.
- Central banks could ease before inflation has well and truly come under control in a re-run of the stop/go monetary policy of the 1970s.
- In Australia, recent flooding could boost food prices and delays associated with industrial disputes at ports could add to goods prices. At present though, the floods are not on the scale of those seen in 2022 and it’s expected that any impact from both to be modest (at say 0.2%).
- Finally, and also in Australia if productivity remains depressed, 4% wages growth won’t be consistent with the 2% to 3% inflation target.
What lower inflation means for investors?
High inflation tends to be bad for investment markets because it means higher interest rates; higher economic uncertainty; and for shares, a reduced quality of earnings. All of which means that shares tend to trade on lower price to earnings multiples when inflation is high, and growth assets trade on higher income yields. We saw this in 2022 with bond yields surging, share markets falling and other growth assets pressured.
Source: Bloomberg, AMP
So, with inflation falling, much of this goes in reverse as we started to see in the last few months. In particular:
- Interest rates will start to come down. The Fed is expected to start cutting in May and the European Central Bank (ECB) to start cutting around April, both with 5 cuts this year. There is some chance that both could start cutting in March. The RBA is expected to start cutting around June, with 3 cuts this year.
- Shares can potentially trade on higher price-to-earnings (PEs) than otherwise.
- Lower interest rates with a lag are likely to provide some support for real assets like property.
Of course, the main risk is if economies slide into recession, which will mean another leg down in share markets before they start to benefit from lower interest rates. This is not our base case but it’s a high risk.
Finally, while inflation is on the mend cyclically, it’s worth remembering that from a longer term perspective we have likely now entered a more inflation prone world than the one prior to the pandemic, reflecting bigger government; the reversal of globalisation; increasing defence spending; decarbonisation; less workers and more consumers as populations age. So short of a very deep recession, don’t expect interest rates to go back to anywhere near zero anytime soon.
Where is the Recession?
By Robert Wright /May 19,2023/
- A progress report on inflation: Inflation appears to have peaked, led by improvements in core goods prices and rate sensitive sectors like housing. The policy focus has shifted to labour market normalisation where early signs of progress are emerging.
- Is a soft landing in sight? The Fed remains committed to doing “whatever it takes” to bring inflation to the targeted level. Despite the aggressive tightening we’ve seen so far, alternative data indicators suggest that the economy remains on relatively solid footing.
- Equity market positioning: We are positioned for themes of continued high rates, improving sentiment outside the US and a potential soft economic landing. This is expressed with a preference for value particularly in cyclical sectors including capital goods, consumer durables, autos and airlines.
2022 was a year where extreme macroeconomic and geopolitical events shaped market behaviour. The US Consumer Price Index (CPI) peaked at 9.1%, the highest level in over 40 years. The subsequent policy response saw the US Federal Reserve (Fed) deliver 4.25% of rate hikes across only seven meetings. This was the fastest cycle of rate hikes since the early 1980s, a period of stubborn inflation and aggressive policy action that ultimately ended in a recession.
As we begin 2023, there’s a greater level of clarity around some of the questions that have driven markets over the last year. Recent inflationary data shows improvements in the trajectory of core goods prices and rate sensitive components. Now, the focus of policymakers has shifted towards restoring balance in the labour market and doing “whatever it takes” to bring inflation to the targeted level. As we enter a new phase of tightening beyond peak price pressures, what does alternative data reveal about the path of inflation and the recession that so many are expecting?
A progress report on inflation
In the final months of 2022, long awaited improvements in the trajectory of inflation began to surface. Figure 1 shows the widening gap between current reported inflation and where US CPI is expected to stand in six months based on a broad range of leading economic indicators and text mined commentary on inflation. Peak inflation seems to be behind us and a clearer path towards meeting central bank objectives has started to appear. As observed in the inflation GPS measure, the sentiment of corporate comments around cost pressures and the effects of inflation on margins hasn’t showed signs of deteriorating as the outlook improves.
Figure 1: US Inflation GPS shows continued decline in the trajectory of consumer prices
Current US Inflation vs six month inflation expectations
Source: Refinitiv DataStream, chart by the BlackRock Investment Institute, December 2022. The BlackRock Inflation GPS shows where core (excluding food and energy) consumer price inflation may stand in six months’ time. The GPS models the relationship between rates of core inflation and a broad set of economic indicators including measures of slack, inflation expectations, and other inflation related data such as business surveys and wages. It also incorporates a proprietary Systematic Active Equity signal measured through text mining of commentary on inflation.
Core goods prices, where the initial surge in inflation was the most robust, are showing significant progress. This has continued to play out with the shift in spending from goods to services throughout the economic reopening and the healing of supply chain bottlenecks. Figure 2 shows average freight transportation costs which have fallen back to pre pandemic levels. These costs were previously 14 times greater during the peak of supply chain issues.
Figure 2: Global supply chains have mostly recovered with shipping costs returning to pre COVID levels
Average freight costs for shipping a 40ft container
Source: BlackRock, with data from Bloomberg, as of January 2023. All amounts in USD.
Shelter is another category where alternative data is pointing to a clear disinflationary trend throughout 2023. Shown in Figure 3, the growth rate of new online rental listings in the US has started to decline. The Owners’ Equivalent Rent (OER) component of CPI which captures both new and continuing leases tends to lag this alternative rental data by 6 to 9 months. This suggests that the trend we’re seeing in new leases will increasingly impact CPI data as the year goes on.
Figure 3: The growth rate of new rental leases has started to decline, a trend that will increasingly impact CPI data
Online new rental leases vs. Owners’ Equivalent Rent (OER)
Source: BlackRock, with data from Apartment List and Zillow, January 2023.
For the next phase of the tightening cycle, Fed officials have shifted their focus to labour markets. Wages have remained a persistent driver of broad-based services inflation since the economic reopening began. Historical periods of inflation have shown that reining in wage inflation is a critical step in restoring price stability and preventing long-run expectations from becoming unanchored. In early November, Fed Chairman Jerome Powell identified 3.5% wage growth as a targeted level that would be consistent with the Fed’s 2% inflation objective.
To monitor the trajectory of wage growth, we use online job postings in the US for a real time view of employment cost data ahead of official releases (Figure 4). Wage growth has started to moderate in recent months and shows signs that the labour market is finally beginning to cool. However, more progress is needed to reach the Fed’s target especially in the services sector where inflationary pressures remain the most stubborn.
Figure 4: Wage growth is showing signs of moderating, but more progress is needed
Year over year wage growth for goods vs services roles
Source: BlackRock, with data from Burning Glass Technologies, as of January 2023.
Is a soft landing in sight?
The likelihood of a soft vs hard landing depends on how healthy the economy remains as inflation continues to normalize and how policymakers react to ongoing developments. So what does the data tell us about where the economy is heading?
Let’s first examine the underlying drivers of the readjustment that’s taking place in labour markets. Following COVID-19, a labour shortage emerged as many individuals didn’t immediately return to the workforce. Simultaneously, the economic reopening drove robust demand for workers and a significant increase in job openings, many of which remained vacant due to labour supply constraints. As a result, the recent normalisation in labour markets and wages has mostly come from a decrease in job openings. This differs from past periods of inflation where monetary tightening caused severe job losses and high unemployment that ultimately ended in a recession.
Figure 5 shows the decline that we’ve seen in the number of online job postings as labour demand falls. Most of the pullback in job postings is concentrated in the technology sector. This is also the case for layoffs which remain extremely benign across the broader economy. Importantly, job openings remain elevated in aggregate relative to pre COVID, suggesting that the gap between labour demand and supply can continue to narrow through a decline in job openings rather than severe layoffs.
Figure 5: Falling labour demand has come through declines in job openings, not layoffs
Volume of online job postings normalised to 2020 levels
Source: BlackRock, with data from Indeed.com, as of January 2023.
Along with company behaviour, we’re closely monitoring consumer activity for signs of weakness. Figure 6 shows US inflation adjusted consumer spending in the services sector which remains relatively stable and above pre COVID levels despite starting to decline particularly for the lowest income cohort. How has this level of consumer activity been sustainable as savings rates have fallen to historical lows amid higher interest rates? The previous period of unprecedented fiscal stimulus throughout the pandemic has kept the total level of household savings in excess, even long after stimulus payments have tapered off. Furthermore, household interest payments remain well below the pre COVID trend with less debt on consumer balance sheets. The combination of sustained excess savings, lower debt levels, and muted layoff activity has allowed consumer spending to remain relatively resilient over the course of the Fed’s tightening cycle.
Figure 6: US Services spending remains above 2019 levels despite signs of weakness
3Y Discretionary service consumption by income cohort adjusted for inflation
Source: BlackRock, Yodlee/ConsumerEdge, Earnest Research, as of December 2022.
Alternative data reveals an improving picture for inflation, orderly rebalancing of the labour market and a relatively healthy consumer – each currently more supportive of the case for a soft landing than a hard landing.
Market pricing has increasingly shifted towards the expectation for interest rate cuts by the end of 2023 (Figure 7). This can be supported by two opposing viewpoints: 1) the hard landing scenario which expects policymakers to overtighten and engineer a recession, or 2) a scenario where inflation swiftly returns to the 2% target and the Fed is able to begin easing financial conditions. In our view, both of these scenarios are unrealistic. Instead, we believe rates will remain higher for longer rather than a near term policy pivot. Today’s relatively stable economy may remain more resilient to high rates and policymakers are likely to delay easing financial conditions due to the lingering effects of two years of excessive inflation.
Figure 7: Market is currently pricing in rate cuts by the end of 2023
Market implied policy rates
Source: BlackRock, with data from Bloomberg, as of January 19, 2023.
Equity market positioning for Q1, 2023
After a challenging year for equity markets in 2022, the downward trajectory of inflation and continued economic stability point to a slightly more positive outlook in the coming months. How are these insights shaping our positioning across the global equity landscape?
An expanding global opportunity set
Like the US, the outlook for Europe has started to improve despite core inflation remaining at record highs. A warmer than expected winter has relieved some of the pressure from the energy crisis. Wage growth has also started to come down in Europe as labour markets normalise at an even faster pace than in the US. In China, the economic reopening has quickly taken off. Along with relaxed COVID-19 restrictions, there’s been an easing in common prosperity and antimonopoly regulations. This is an added tailwind to the improving sentiment towards Chinese assets, particularly in sectors like education, internet and real estate that were most impacted by these regulatory initiatives.
Sector positioning for a potential soft landing
Our global portfolios maintain a preference for value vs growth based on continued themes of high rates and inflation followed by a potential soft landing. Notably, we’ve seen a shift in the underlying sectors driving the top down leadership of value. What was previously led by the energy sector has shifted to favour cyclical sectors that have been heavily discounted over the last year, including capital goods, consumer durables, autos and airlines where we’re currently overweight. These are well positioned for a continued high interest rate environment where the economy ultimately avoids a deep recession.
As we enter the next phase in the fight against inflation, market focus has shifted to whether policymakers can achieve a durable decline in inflation without causing a recession. Using alternative data to cut through the noise of hard vs soft landing speculation, we see signs of progress in restoring price stability while maintaining economic strength. At the same time, macroeconomic uncertainty remains high and we expect market volatility to persist as conditions evolve. This makes a data centric investment approach crucial to navigating today’s complex environment, allowing us to remain nimble as investors during a time where dynamism matters most.
Five long term global trends and implications for markets
By Robert Wright /March 07,2023/
This article looks at some longer term structural trends in the economy and their impact on economic growth and investments.
1. A decline in routine based jobs
Fear of technology replacing jobs has been around for years, although concern around this risk appears to have waned in recent times, as impacts of the pandemic on labour markets has taken focus. New technology is constantly displacing some jobs but it is also creating new ones in its place. The jobs most at risk are routine based jobs, because this type of work can be replicated, learned and taught by machinery and automatic intelligence. In Australia, there has been a long term decline in manual and cognitive routine based jobs. In the late 1980s, routine manual jobs were 40% of the workforce and are now around 26% of the workforce while routine cognitive jobs were 26% of the workforce in the late 1980s and are now worth 19% (see chart). Similar medium term trends are evident across other developed countries. Non routine jobs (either manual or cognitive) are less at risk of being displaced by technology because they are harder to replicate and often need a human element (for example in jobs related to health, childcare or teaching). Problems in recent years with self driving cars also shows the difficulties associated with technology.
Middle income households tend to be most susceptible to routine based jobs so this trend will increase inequality and could put downward pressure on wages growth in the long run. The OECD (Organisation for Economic Co-operation and Development) in a report done in 2018, estimated that around 14% of jobs (in the OECD) are at high risk from automation, with large variations across countries (countries at higher risk include Slovakia, Slovenia, Greece and Spain while the countries at the lowest risk include Norway, Australia, Finland and Sweden). The workforces that are more at risk tend to have a lower educated workforce, a weak tradeable services sector and have a low urbanisation rate. In Australia, around 7% of jobs are estimated to be at high risk of automation and in the US its slightly higher at 10%. The government has a role to play in ensuring that the transition to new types of employment for impacted employees is managed through training programs, appropriate university curriculum and ensuring that funding is targeting those areas at the highest risk of job losses due to automation.
2. An ageing population and an increase in the ‘dependency ratio’
The global population, especially in major developed countries, is ageing which has been a long term trend as the birth rate has declined. In Australia, the share of the prime working age population (those aged between 25-54) peaked at 44% of the population in 1999 and has been falling slowly since then, currently at around 41% and projected to be around 40% by the end of the decade. In contrast, the share of the population that is aged 65+ is expected to keep climbing to just under 20% by 2030, up from 17% now (see chart). An ageing population will put upwards pressure on the ‘dependency ratio’ (the sum of those aged under 15 and over 65 as a share of the whole population) which will detract from national savings (people who work increase savings while the very young and old drain savings) which is inflationary in the long term.
3. A decline in business investment as a share of GDP but a lift in intellectual property as a share of investment
In many developed countries, private business investment is declining as a share of the economy, in place of a rising services sector which is less investment intensive. In Australia, business investment often goes through cycles because of the dominance of the mining sector (at its peak mining investment reached 11% of GDP). After the last mining investment boom (which ended in 2012 after business investment was 19% of GDP), investment has been on a gradual decline and is now 9.4% of GDP (see chart). While there may be ups and downs in the cycle from the mining investment contribution and the usual wear and tear associated with depreciation, private business investment is likely to decline further as a share of GDP because of the changing nature of business investment. The typically large scale buildings and structures, machinery and equipment type of investment is being replaced with less ‘heavy’ types of investment, like intellectual property with the rising importance of the tech sector in all industries. A less capital intensive economy could weigh on long run productivity growth, although the impact is probably marginal as intellectual property investment should still boost productivity growth.
4. A multi polar world means more geopolitical risks
The US economy has been increasing in importance to the global economy since the end of the Second World War. The rising significance of the US economy to global trade, cultural influences, military presence and economic power has been increasingly consistent with a unipolar world, especially as the United Kingdom and the Eurozone have had challenging economic conditions in the past decade.
However, the balance of power has been shifting in recent years as the Chinese economy grows and becomes a larger share of the global economy (see chart). In purchasing power parity (PPP) terms (which adjusts individual country prices into a global comparison after accounting for exchange rates and purchasing power in each country which allows a better sense of living standard comparison) the Chinese economy is already the largest in the world (at 19% versus the US at 16%). If we also account for India then China and India make up 26% of the global economy compared to the US, UK and the Eurozone at 27% (in PPP terms). But we are currently at a crossroads, with China and India about to take over as a larger share of the global economy. On our estimates China and India will be 34% of the global economy by 2045, versus 22% for the US, UK and Eurozone (if growth rates continue at its current pace). As a result, the global economy is increasingly moving towards a multi-polar world as the balance of power shifts away from the US. This shift in the balance of power will keep geopolitical tensions and risks high over coming years as the US and China compete for global control, particularly in the technological space. Investors should be prepared for periodic inflammations in geopolitical tensions and heightened risks of conflict or war, keeping volatility in share markets high. Concerns over the growing Chinese economy are expected to again be a feature of both the Democratic and Republican party campaigns in the 2024 US Presidential election. However, in Australia, the relationship with China looks to be improving with a recent meeting between Australian PM Albanese and China’s President Xi Jinping seemingly the most positive in years.
5. Peak globalisation is inflationary
Globalisation looked to be reaching a peak before COVID-19 broke out, with global trade (the sum of exports and imports) declining as a share of GDP since the Global Financial Crisis in 2008 (the chart shows that global trade was 56% of GDP in 2019, below its peak of ~61% before the GFC), as countries decided to become more self-sufficient after seeing the contagion impacts of the GFC. COVID-19 dealt another blow to global trade as closed borders and transport delays led to a push towards bringing as much production onshore as possible, or at least to closer countries (‘nearshoring’ or ‘friendshoring’). Given that globalisation was disinflationary because production was transferred to countries to the most efficient producer (which most often ended up being the lowest cost producer) some reversal in the globalisation trend will be more inflationary for the global economy.