Slowing growth, high inflation and rising interest rates fuel market volatility
9 June 2022
High levels of inflation globally and distressed supply chains continue to be the dominant discussion topic across investment specialists, media outlets and consumers. We are all feeling the pinch in terms of petrol prices and rising food costs while anyone building or renovating is feeling the impacts of increases in material prices. At this quarter’s Investment Committee meeting inflation again dominated discussions.
Summary of Views:
Inflation has been elevated and might remain so for an extended period.
Peak inflation may be nearing (or has already passed the peak) and highlight the importance of understanding the underlying components driving the numbers.
Central banks are in the process of tightening. Market expectations of rate hikes are aggressive and potentially won't be delivered.
Key questions around the state of economies post action by central banks to get inflation under control. Policy makers will be wary of recession given historical evidence around tightening cycles.
Australian households hold very high levels of debt, which means rate hikes will have significant impact on household spending and economic growth.
Australian market is pricing several rate rises, even compared to global peers.
Headline inflation is the raw inflation figure reported as the Consumer Price Index (CPI). CPI determines inflation by calculating the change in prices on a fixed basket of goods. Core inflation is a variation of CPI which removes the components that can exhibit large amounts of volatility (ups and downs) from month to month, namely food and energy.
The key contributors to the increase in core inflation have been goods, particularly used vehicles. This rise in goods prices has been primarily driven by supply chain issues and lockdowns which caused a shift in consumption from services to goods. Whilst supply chain issues are viewed as a temporary factor, the pain may linger, with the Ukraine/Russia war seemingly a long way from resolution and China continuing to enforce hard COVID-19 lockdowns.
In the US, Headline inflation has been severely impacted by energy and food prices, largely driven by the ongoing the Russia/Ukraine conflict.
US headline inflation – Year on year changes
Source: Goldman Sachs
Going forward, we expect normalisation in supply constrained sectors should continue to drag US inflation down toward the Fed’s target rate by the end of this year and into 2023. However, it is possible that we will remain in a higher inflationary environment for some time yet.
Putting the spotlight on used car prices as one of the key drivers of recent inflation helps show how inflation should settle looking forward.
Used car prices in the US flattened out toward the end of 2021 and have been declining since. In 2021, the contribution to inflation from used car prices was a massive 41%. If used car prices continue to fall as they have in recent months, this will turn to a deflationary drag on the one-year rolling inflation number.
For example, there was a short-term easing in car prices in mid-2021. This had a significant impact on inflation numbers at the time, with monthly inflation falling from 0.9%, 0.7%, 0.8%, to 0.3%, 0.2%, 0.3%. This illustrates the outsized impact a single component can have on headline inflation. It also highlights the importance of looking deeper into the data and assessing how temporary (or not) these changes will be.
The chart below from Deutsche Bank suggests that US inflation is nearing its peak and forecasts that it should normalise from here. Current inflationary pressures are supply/input driven with headline inflation racing away from core inflation, driven by the volatile moves in Energy and Food. The million-dollar question remains, will supply chains free up anytime soon and inflation normalise?
US inflation forecasts
Source: Deutsche Bank
The aggressive fiscal (Govt spending and tax cuts) and monetary (quantity of money available) stimulus rescued the global economy from a much deeper recession. However, this also propelled the ensuing inflationary spike. This has only been exacerbated by the Russia/Ukraine war and further Covid-19 related lockdowns in China. Stimulus is projected to contract rapidly on both counts, which will have a direct and substantial drag on economic growth and GDP.
From an Australian perspective, many homeowners took advantage of low rates in recent years and fixed their loans/mortgages at extremely low levels. There is a large wave of fixed rate expiries on the horizon from late 2022 into 2023. This will add an additional layer of tightening to the economy as these rates are reset at materially higher levels, meaning households have less money for other expenses, like discretionary spending.
Australia – fixed rate mortgage expiries
Source: Commonwealth Bank of Australia
On top of this, recall that Australian households are close to the most heavily indebted in the developed world. With a large majority of variable rate mortgages, the pass-through of rate hikes is almost immediate. Australian households are highly sensitive to rising rates which makes aggressive (large and fast) interest rate hikes difficult to enact without putting significant pressure on households.
Australia and G10 – Household debt to GDP (%)
Unfortunately, history tells us that Central banks do not have a great record in terms of achieving a ‘soft landing’. Of the last 14 US rate hiking cycles, 11 have resulted in a recession implying that the US Reserve Bank tends to tighten too much, which results in recession.
The pace and magnitude of rate hikes expected currently (relative to the starting point of 0) is beyond anything we have ever experienced in recent times. As such, we continue to position the portfolios in a diversified manner, allowing for a range of outcomes such as the possibility that markets may have been too aggressive in predicting rate rises, Governments realising rate hikes won’t mend supply chains (they impact demand) and that headline inflation may be more persistent than previously anticipated.
Long bonds generally sell off ahead of rate hikes. This depresses bond prices and elevates their yield. As rate hikes are delivered, the yield curve flattens as the market prices in tightening conditions and the risk of recession.
The market has already priced in a large number of rate hikes. The implied policy rate in Australia is more than 2%, and in the US more than 2.75%, by the end of the calendar year.
Expectations would need to become even more hawkish than this to drive further weakness in bond markets. We think it is unlikely what is currently priced in will eventuate, let alone further deteriorate, hence we remain conservatively positioned in Fixed Income portfolios.
We feel that pricing of interest rates in Australia looks aggressive, particularly compared to other G10 (group of 11 nations with similar economic interests) peers.
Summary Asset Allocation Views
Global growth is expected to slow from an estimated 6.1% in 2021 to 3.6% in 2022 and 2023 (World Bank). These new estimates are 0.8% (for 2022) and 0.2% (for 2023) lower than projections in January. The World Bank cited the economic damage from the war as the reason for this reduction.
Inflation is proving to be more persistent than expected. The conflict in Europe has pushed back expectations for moderation in prices. Continued higher commodity prices, supply chain disruptions and an extension of China’s zero-COVID policy present an upside risk to prices in 2022.
Expect central banks to continue to raise rates in the near-term in line with their guidance leading to a meaningful tightening of monetary policy. US Markets are fully priced with a Fed Funds rate of 2.50-2.75% being priced by the end of the year and a terminal Fed Funds rate of 3.1% by Q3 2023.
In Australia, NAB expects the cash target to be 1.35% by year-end. NAB sees three further increases in 2023, followed by two in 2024, bringing the cash rate target to 2.6%. Notably, the markets are pricing a much more aggressive hike cycle with the cash rate peaking at 3.5% by 2023.
Recession risks have increased with the heightened global uncertainty. Recently the U.S. 2y/10y yield curve inverted (though only for a short period of time). Historically, this has proven a relatively reliable lead indicator for recession. However, the 3month/10y yield curve remains positive and has not flashed a similar warning.
Our base case remains ‘Positive’. There are still many tailwinds supporting the global economy including strong balance sheets, resilient margins/earnings (notably in the U.S.), historically low unemployment rates, and the release of post-pandemic pent-up demand. Within Australia, the economy should continue to benefit from the higher exposure to commodities and financials.
We believe inflation will peak later this year followed by a slow and gradual decline in 2023. While short-term inflation expectations have moved up, long-term expectations have been more stable. At the beginning of May, the U.S. 5-Year Forward Inflation Expectation Rate stood at ~2.4% down from a peak of 2.67% in April.
In our view, market pricing for the increase in cash rates is too aggressive (especially in Australia). Central banks may not be able to reach those levels without causing significant damage to the economy. The bulk of the rise in bond yields may be behind us.
Overall sentiment about the economy remains largely positive, but it continues to trend downward. We acknowledge the reality of slower growth and note that volatility might remain elevated, fuelled by slowing growth, high inflation, and rising rates. However, we remain positive on growth assets relative to defensive assets.
In a volatile investment environment, working with a team of experts, who each have their own area of deep specialisation, is in the best interests of any investor looking to generate genuine returns over the long-term.
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9 June 2022