This year has begun with most of the developed world in or approaching recession. This state of affairs has been induced by a reduction in real incomes, courtesy of higher prices and by tighter monetary policy, triggered by the increase in inflation.
Fortunately, the shocks to the price level are mostly in the past, and slower growth or recession should be enough to bring inflation back to target – that is Fathom’s central case. In most countries the recession will be short-lived, a ‘pause that refreshes’ – though the UK might be an exception here.
The risk is that inflation, now ignited, proves harder to extinguish than we might hope.The enormous monetary and fiscal stimulus of the Covid period secured the most rapid bounce back the world has ever seen, from the steepest recession it has ever seen. The current pause is to be expected, a ripple from that storm.
The risk is that inflation, now ignited, proves harder to extinguish than we might hope. The pandemic stimulus packages drove aggregate demand up, and it remains above long-run potential aggregate supply (still scarred by Covid) in many countries.
That excess demand has provided the kindling for higher inflation, and Russia’s invasion of Ukraine has poured petrol on the inflationary fire.
The combination of slowing growth and rising inflation is a harsh environment for financial assets. Markets were brutal during 2022, punishing holders of bonds and equities alike. And right now the signals remain negative. For example, the put/call ratio in US equity markets is, on the face of it, more bearish now than at any time since the great financial crisis.
The UK stands out to us as most vulnerable to an extended period of high or even rising inflation.However, things are not as bad as they might seem. The recent reversal in the put/call ratio coincided with US Federal Reserve chair Jerome Powell’s hawkish position on rates and quantitative easing, which was effectively a removal of the free put option that the Fed had issued to markets from the crisis of 2008-09 onwards.
With that removed, market participants now have to pay for the same option, and that is what they are doing. It is possible that they were equally as bearish before rates started to rise, but felt protected by the Fed put. And the spike in this ratio also reflects technical factors, so it is not really as bearish as it looks at first glance.
It is prudent to take this signal into account when thinking about your asset allocation, but the outlook for equities is probably not as bad as this signal alone might suggest.
For a start, it turns out that the bearishness apparent in that ratio is not consistent with the news on corporate profits, which remain robust, especially as a share of GDP.
And, for the US specifically, the worst of the news on energy prices (both wholesale prices and those paid by consumers) may already be in the past. The same is unfortunately not true in the euro area, the UK or Japan.
Looking further afield, food prices are still very high globally, though they have also come off their peaks. This level of food prices, if maintained, is likely to create stresses in many developing or less developed countries, as they did during the Arab Spring.
Food prices are extremely important in less developed economies, where they are a very good predictor of conflict and financial crisis, but less so in advanced economies like the US.
Meanwhile, other commodity prices such as base metals appear, on the whole, to have decisively passed their peak, at least for now. Much here hinges on the short-term outlook for China, which is slowing, although the outlook will be improved by the relaxation of Covid restrictions there.
The impacts of the initial round of price-level shocks will soon fade everywhere: but what about the second-round effects?There are exceptions to this generally encouraging picture in certain key commodities though; lithium prices, for example, have rocketed in line with demand for electric vehicles and they remain exceptionally high.
In the US and China inflationary pressure in the round appears to be waning, but it is still on the increase in the euro area, the UK and Japan, at least for now. The impacts of the initial round of price-level shocks will soon fade everywhere: but what about the second-round effects?
The UK stands out to us as most vulnerable to an extended period of high or even rising inflation. This is thanks to second-round effects, already in evidence in the labour market, where wage inflation is far higher than the rate that would be consistent with hitting the 2 per cent inflation target, even before the impact is felt of the wave of public sector strikes now under way.
If second-round effects take hold in the UK, it would imply further monetary tightening and a deeper, more prolonged recession. In fact, Fathom’s forecast for growth in the UK is less bearish than the Bank of England’s, because we see inflation running higher for longer than the BoE does.
The outlook for inflation in the US, EA and UK together is summarised in the fan chart below.
Our central forecast has inflation drifting slowly back down towards the target over the coming two to three years. But that is by no means a certainty, especially in the EA and the UK.
The UK line could be towards the higher end of the fan over the coming year or so at least, and there is still a significant risk in the UK of a return to 1970s-style inflation and growth outcomes for an extended period.
And the risk of such an outcome cannot be written off even in the US, as the chart below shows.
The experience of the 1970s showed that the flames of the first-round effects of higher energy prices can start to die down, to be stoked again by second-round effects through wages and other costs – aggravated in the 1970s by another energy price shock at the end of the decade.
The inflationary fire was only finally put out by the Paul Volcker period, and by the recession induced by the monetary tightening he oversaw.
It is too soon to be sure that Powell has yet doused the flames in the way that Volcker did. The same risk applies in the UK, to an even greater degree.
Erik Britton is managing director of Fathom Financial Consulting
