Steven Blitz, chief US economist at consultancy firm TS Lombard, believes a sharp reduction in inflation and a recession loom for the US economy.
US inflation has been coming down steadily and many market participants believe this could lead to a “soft landing” scenario where economic growth continues, boosting investment returns. But Blitz says the nature and reasons for the drop in inflation are such that a recession is more likely.
He says the recent inflation should be divided into two categories: the inflation caused directly by the imbalances resulting from the restrictions of the pandemic era, such as damage to supply chains, and the inflation that is more embedded.
As a result, the decline in inflation needs to be divided into similar categories, he said.
The principal measure used by the US Federal Reserve to understand the different types of inflation is “Services Ex Rent” and Blitz says inflation in this area has been declining since the third quarter of last year.
This measure may be one which excludes the more temporary pandemic induced issued in the economy, because the services sector should be less vulnerable to supply chain issues.
Blitz says: "There is disinflation from Covid-related distortions and there is disinflation signalling weak growth. The Fed, at this point, is indifferent and will hold off hiking in June – their long-awaited passive widening of funds to inflation has begun.
"This is a particularly critical point in the cycle because the long lag between inflation and growth pins the low for inflation from last year’s negative first half for GDP around now. In other words, if there is a reacceleration of growth, we could be in and around the low point for inflation until perhaps August or September. My bias, however, remains with recession beginning sometime mid-year and, in turn, pulling inflation down from these levels over time."
The other factor Blitz believes will contribute to the swift decline in economic growth and inflation is the recent regional banking crisis in the US.
His view is this will make banks more cautious on lending, and this reduces both the supply and the velocity of money in the economy, which would usually reduce the level of both inflation and growth.
Roger Aliaga-Díaz, chief economist for the Americas at Vanguard, says investors and central banks are in a stand-off about the direction of interest rates, but even if it proves to be the market that is wrong, there are returns to be made.
Rock and a hard place?
Aliaga-Diaz says investors have “for months” been “sending central banks the message: You’re going to cut interest rates in 2023. The Federal Reserve and the European Central Bank have responded: Not so fast. Even as the Fed and the ECB have raised their interest rate targets steadily, investors, concerned about the prospects for recession, have priced in rate cuts by the end of 2023.”
Anthony Rayner, multi-asset investor at Premier Miton, is more inclined to the latter view, saying if the markets’ view that rates will be cut is predicated on there being a downturn forcing policy makers hands, but he feels that inflation may stay higher than central banks want, and they will avoid raising rates.
Despite market expectations, both the European Central Bank and the US Federal Reserve have continued to raise rates.
His view is that central banks globally will have to keep putting rates up, as inflation is likely to persist at above the 2 per cent target rate.
Inflation in the US, UK and Eurozone still at more than twice the 2 per cent target level. Aliaga-Diaz notes that the persistent inflation in those areas now seems to be driven by the services sector rather than the goods sector, supply chain issues had driven goods shortages and that contributed to the first wave of inflation.
Much of the reasons for the stand-off is that investors believe central banks will stop raising rates if the recession Blitz is expecting happens, as inflation is likely to fall anyway.
But as many of those economic conditions receded, they were replaced, according to Aliaga-Diaz, by services sector inflation, the levels of which he believes tends to be a more reliable long-term indicator of the future normalised level of inflation than the headline rate at any one time.
Colin Finlayson, fixed income investment manager at Aegon, is another who believes that markets may be wrong to anticipate rate cuts from here, but he does believe a “pause” in rates is likely.
The reckoning
Gilles Moec, chief economist at Axa Investment Managers, believes the dominant consideration for investors is one outcome of the present US debt ceiling negotiations is likely that government spending has to be cut in order to make a deal happen, and such a reduction, which he believes could be quite sharp, would be expected to negatively impact the US growth rate for this year, and may also mean that monetary policy doesn’t need to be as tight as would have otherwise been the case.
Concerns around the impact of the debt ceiling negotiations have also been on the mind of Rupert Thompson, but he says that more generally, he prefers Asian equities right now because the economic outlook is more positive for the region, compared with the US.
Of the consequences of the debt ceiling negotiations, he says: “If there were a temporary default, equities would undoubtedly be hit. As for the dollar and US Treasuries, the impact is harder to judge but somewhat paradoxically, the ensuing flight to safe havens might well lead to a strengthening in the US currency and a fall in US yields.”
He says the economic growth spurt that resulted from the re-opening of the Chinese economy may now be on the wain, something which may be disinflationary for the rest of the world.
But despite that, he says: “Chinese equities have now unwound a good part of their large gains around the turn of the year, but China and Asia more generally remain two of our favourite equity regions. Although the economic rebound may not be quite as strong as hoped, growth still looks set to be considerably higher than anywhere else over the coming year. Valuations also remain cheap and supportive, unlike in the US."
david.thorpe@ft.com
