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Yesterday we looked at why the transitory argument for inflation, with a looming recession attached, made sense.
Today we're going to look at why it might be flawed.
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(We’re going to ignore the political drama in the UK for the moment because it’s not really having any significant effect on markets, although we will have a chat about what a new chancellor might mean, once we get an idea of what he’s likely to be able to achieve, if anything).
Even if “inflation is transitory”, we won’t go back to the same market stories
We talked about the “staying in” versus the “going out” economy yesterday. Long story short, “staying in” companies saw a boom during the pandemic, and “going out” companies saw a collapse.
They both acted as if this was semi-permanent. So “staying in” companies over-produced, over-ordered, and over-hired. “Going out” companies (which arguably includes much of the energy industry) did the opposite.
Combine all this with general supply-chain chaos and you have a recipe for an extended period of idiosyncratic shortages – in the labour market as well. As we get back to something approaching “normal” and all of this clears, we’ll see a sharp slowdown and maybe even a recession.
That’s why it’s risky for central banks to be too aggressive with interest rate rises, because “this too shall pass”, effectively.
In all, it’s an “inflation is transitory” argument, but with a longer period of “transition” than first expected. We’re about to get a recession, inflation is going to come under control as a result, and – believe it or not – we’ll go back to the prevailing world order of “growth” trumping “value” and ultra-low interest rates.
It’s a compelling argument (at least the first part is, if not the second). And it’s what markets appear to be starting to price in. Yesterday in particular saw energy prices and related stocks collapse, while the “long-duration” assets that came to be identified with the low interest rate bubble, enjoyed a major bounce (the poster ETF for this movement, ARKK, jumped by 9%).
So what’s the rebuttal?
Let’s take the easy bit first. Even if you think the US is heading for recession and that interest rates are going to come down as a result, the idea that aggressive, profit-free US growth stocks (which is what the ARKK is full of) are your best bet in a recession does not hold water.
And if interest rates stop rising but we don’t get a recession, then that’s an argument to back cyclical assets, because it’ll be inflationary.
Meanwhile if interest rates keep going up either way – well, that’s not going to be fun for the ARKKs of this world.
So as Gave puts it, the big swing yesterday looks more like it’s related to “short-term portfolio flows and rebalancing”. Put simply, growth went down a lot, value went up a lot, so you take profits in a bit of one and buy a bit of the other.
I think that’s a sensible point. But I’d also note that markets are clearly still stuck in the old “paradigm”. They’re thinking “rates down = buy US growth”. To me, that’s just more evidence that they haven’t really got to grips with the idea that we are moving away from the long disinflation period.
The key thing to understand here is that we can simultaneously have a snarled up supply chain which will get unsnarled over time – but that this can be happening against a longer-term backdrop where the big disinflationary trends have already ended.
In other words, even if we hadn’t had coronavirus, never mind the war in Ukraine, we’d still be facing a more inflationary world right now.
We’re already in a more inflationary world
Why is this?
I’d return to the basic points. Disinflation had little to do with central bank “credibility”. The era of disinflation coincided – or rather, was driven by – a vast swathe of the world opening up and joining the market economy. The supply of workers rocketed, driving down the price of labour (wages). The supply of “stuff” rocketed, driving down the price of consumer goods.
On top of that, you had remote technology (the internet) enabling and encouraging all this. Even when we were bumping up against energy constraints, fracking came along and created a new Saudi Arabia in the form of the US.
That’s all in the past now. Globalisation peaked a while ago; even if it doesn’t reverse as such, the sheer force of that disinflationary wave has gone. And you can create far more pessimistic scenarios if you feel so inclined.
The technological squeeze on consumer prices and competition is arguably similarly played out, while energy constraints are pinching badly again.
So the big disinflationary trends are gone. Covid and even the war in Ukraine might have accelerated some of the inflationary trends we’re seeing now, but this was always on the cards.
Vincent Deluard, an analyst at StoneX who has been on top of the inflationary argument since the very start, makes the good point that even something like the piling-up of inventories at the likes of Walmart and Target might not in fact be due to error. It might just “reflect the added cost of doing business in a de-globalising world characterised by higher risks and lower efficiency”. In short, we may or may not see a recession triggered by rising costs. It might even already be happening. But in the longer run, inflation is likely to be persistent in a way that it hasn’t been in the past. That implies in turn that central banks will have to be more wary of slashing rates and propping up markets as in the past.
And it certainly implies that the likes of ARKK are not good investments right now. If you feel like topping something up, I’d be keeping the energy and commodity stocks on your radar instead.
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