Investors shouldn’t be surprised if inflation proves to be stubbornly high and continues to contribute to ongoing equity volatility well into 2023.
US equities markets have rallied over 10 per cent since a slightly better than expected US CPI print was released in the middle of October. Investors have quickly raced to the view that headline inflation has peaked, and central banks will pivot and slow the rate of increases. Some are even hoping that interest rate cuts start as early as 2023 and the recent bounce in equities is the first phase in a new bull market run.
As is often the case, the future path of equity markets will depend heavily on the reaction function of central banks – and markets appear to be underestimating how difficult it will be to fully squeeze inflation out of the system.
After rising rapidly in 2021, many input prices are now falling sharply. Base metals, lumber, and oil have fallen consistently over recent months. The Baltic Freight Index, which measures of the cost of shipping goods worldwide, has fallen from nearly 6000 in October 2021 to around 1300 in November 2022. Annual core inflation in China has fallen to 0.6 per cent, and there is a strong chance that as China relaxes its zero covid policy, the reopening of the economy will see China once again exporting deflation to much of the developed world.
But while goods prices are certainly rolling over, the risk is that inflationary forces are becoming more entrenched in the services side of the economy.
In the US, the Atlanta Federal Reserve produce a CPI measure of a basket of items that change price relatively slowly. This sticky-price consumer price index (CPI) is up 6.4 percent on a year-over-year basis and has been consistently rising through 2022. The Atlanta Fed’s measure of its flexible CPI—a weighted basket of items that change price relatively frequently—increased 11.6 per cent in October 2022. But this is down from a high of 20 per cent in March 2022. While the softening of the flexible series is welcomed and should lead to better inflation outcomes over coming months, the persistent rise of the sticky inflation series is likely to lead to higher inflation outcomes than the current market consensus.
While Covid disrupted supply chains, logistics were already being impacted before the virus arrived. The Trump tariffs of 2018 had begun a significant rewiring of global supply chains which the virus exacerbated. Thirty years of globalisation had delivered incredibly streamlined supply chains and continually lower unit labour costs. Specialisation of production, efficient logistics pathways and just in time inventory had created a super-efficient, but fragile, supply system. After the disruption created by Covid, combined with the rising geo-political tensions, we shouldn’t be surprised that an alternative to a system that took decades to perfect doesn’t simply reappear overnight.
The other curious feature of this cycle is the apparent shortage of labour in developed markets as economies reopen. A significant number of baby boomers have taken the option to retire and many people have simply got out of the habit of working, having being supported by significant government stimulus packages. It is estimated that around 10 million able workers in the US are reluctant to re-enter the market. Covid quarantine, along with a powerful move to working from home, has seen a lot of people out of the market and is a key driver behind business bidding up wages to attract talent. The labour shortage has surprised many, and with new variants of covid emerging and new waves continuing, it is likely that the labour supply disruption will continue well into 2023.
While markets are hoping that inflation can fall back towards central bank targets, the reality is that the goods inflation of 2021 has spilled over into “sticky” services inflation and rates will need to be held at more restrictive levels for longer than the market seems to be factoring in. After working hard to win back some much-needed credibility, central bank governors over recent weeks have been reminding markets not to get too carried away with the chance of easing in 2023. The Federal Reserve Governor Christopher Waller said in Sydney on November 13 that “the market seems to have gotten way out in front on this, over this one CPI report.”
So, while the next US interest rate increase might downshift to 50 basis points and the high in the cash rate for this cycle may well be 5 per cent, central banks will be very reluctant to reverse course and cut rates any time soon. Bankers know that squeezing sticky inflation out of the system will be painful, and are unlikely to wavier at the first hint of economic softness. Markets are conditioned to see rate cuts in times of economic weakness – but on this occasion – cash rates are likely to be defy gravity and remain elevated well into any economic slowdown.