The days of 2% inflation are behind us

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

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.

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.

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

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.

The US economy will likely avoid a recession.

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.

Unless we get another lockdown, we do not believe there will be another bounce back in tech stocks. 

This weakness is reflected in the S&P 500, which is overweighted towards large, multi-national goods providers, but is not a reflection of the strength of the significant service sector and wider US economy. 

Over the next few months it is likely that job vacancies will come down while unemployment will remain low.

This is a far-cry from a recessionary environment where unemployment rises and vacancies collapse.

Companies have devoted a lot of resource to hiring new staff over the past few months and so are unlikely to cut significant amounts of jobs in the short term. 

We therefore expect the Federal Reserve to acknowledge this situation and pivot on its rate hiking cycle early next year. 

Portfolio allocation implications

We are currently overweight consumer discretionary, materials and financials, and underweight technology and consumer staples.  

In our view, the tech bubble peaked in February, and the average Nasdaq stock has come down significantly since.

This speculative bubble was driven largely by quantitative easing, and multiples will come down as interest rates continue to rise.

Unless we get another lockdown, we do not believe there will be another bounce back in tech stocks. 

This is not a safe place for investors to be.

Short-duration domestically-focused stocks are doing well however, while large-cap internationally focused stocks are likely to suffer.

The five largest stocks within the S&P 500 are all tech stocks, heavily reliant on international exports.

This alone reveals that the S&P 500 is not the US economy, and there is huge concentration risk within the S&P 500.

This is not a safe place for investors to be, despite the continued health of the US economy.

Hugh Grieves is manager of the Premier Miton US Opportunities Fund at Premier Miton Investors