Friday Highlight  

The days of 2% inflation are behind us

The days of 2% inflation are behind us
(FT montage/Bloomberg)

There are good reasons to believe US inflation will come down relatively quickly and by more than widely expected. 

First, the US economy is currently suffering the side effects of fiscal and monetary overstimulation during the pandemic.

Covid-19 meant monetary and fiscal authorities pushed the economy into a deep freeze and they are now suffering the side effects of the thaw.

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Demand was pushed up but, with lockdown some way behind us, accumulated savings are now being spent and cash reserves are coming down. 

Second, supply chain disruptions have improved as China emerges from lockdown and factory construction, which was largely put on pause during the pandemic, boosting production capacity.

For example, the semiconductors supply shortage has been exacerbated by an absence of increases in production capacity during the pandemic, but this is now improving as new factories come online.

Third, fears of a wage-price spiral are misplaced to a large extent.

Large numbers of workers left the workforce and a lack of training of new workers during the pandemic have been two of the main drivers of labour shortages over the past two years.

But there is now evidence that people are returning to the workforce and resuming training for roles in many sectors.

Airlines, for example, which cut many jobs during the pandemic, are now beginning to rehire at pace to meet consumer demand.

We expect this trend to continue, meaning significant wage hikes are unlikely to materialise in the medium-term. 

Nonetheless, we believe we will never see 2 per cent inflation again.

The 30-year period prior to 2020 of roughly 2 per cent annual inflation was an aberration, largely caused by the mass-production globalisation impact of Chinese industrial prowess.

We see inflation instead landing around 3-4 per cent, meaning different asset classes will come into their own.

Interest-rate-sensitive long-duration assets are now far less appealing than they were over the previous decade, and investors' attention will instead turn to shorter duration assets that are able to deliver income now. 

The US economy will likely avoid a recession.

Now is not the point in the economic cycle where recessions usually start.

One major signifier of recession is defaults on mortgages and consumer credit arrangements. There is currently very little evidence of this in the US.

Consumers have enjoyed access to cheap debt for years and have strong cash reserves.

The availability of 30-year mortgages in the US means that default risk is low, even with interest rate rises, and the US housing market should remain solid. 

While retailers are seeing weakness, this is mainly driven by the overreach they experienced during the pandemic, when lockdowns changed consumer preferences towards goods.

Now lockdowns are behind us, consumers are spending more on services.