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Creating a balance between inflation and growth
Imagine you are making yourself a lemonade. You add one spoon of sugar to sweeten your drink, then add another one, and then one more…if you keep going like this, the sugar will stop dissolving in the water. This phenomenon is called the saturation point in chemistry. In the economy, the sugar that has stopped dissolving in the lemonade is the excess savings households have accumulated in the last two years. It is also easily comparable with the levels of debt governments have added to their balance sheets to save their respective economies from the brunt of the pandemic.
Now that economies have restarted, central banks have started to scale back the support by bringing forward the interest rate hikes and accelerating the taper of central bank asset purchases (i.e. ‘quantitative tightening’). Central banks are in an awkward position here: if rates are hiked too aggressively this would hamper growth and potentially tip into a recession, and if not hiked enough, then there is a risk that inflation gets out of control. Unlike in chemistry, there’s no hard science to this balancing act. In the past 12 months, we have seen the expectations on inflation moving from “transitory” to ‘expected to be transitory’ and now to be more persistent but short-lived. Time will tell.
Inflation Psychology
When inflation first appeared, it was deemed consistent with a rapidly growing global economy that was experiencing demand v supply imbalances (partly pandemic induced). But now, an element of inflation psychology has started to kick-in. In a recent consumer sentiment survey based in the US, consumers were asked about the most critical problem facing the economy, almost 90% cited inflation. The erosion in real living standards due to rising inflation was among the most common concerns among consumers.
“Economic events are substantially driven by contagious spread of oversimplified and easily transmitted variants of economic narratives.” – Robert Schiller
It is important to understand that while most consumers worry about inflation, they have only experienced low inflation with few short-lived spikes in oil prices. There is a big difference between being worried about inflation and not being able to afford basic living costs. But when consumers expect inflation, they become less resistant to paying higher prices, and employers become less resistant to paying higher wages until this self-fulfilling prophecy turns expected inflation into real inflation. Keynesian economists described inflation psychology as ‘animal spirits’, whereas behavioural economists pin this on our cognitive biases (towards expected outcomes).
Although the headline inflation numbers currently are large in size, they are still short in duration compared to previous episodes (such as the 1970’s). However, it is insightful to note that a ‘high inflation’ narrative has materialised in the past based around expectations and thus it becomes increasingly critical to incorporate some level of inflation risk within total portfolio construction (e.g. exposure to inflation linked assets, commodities, real assets).
Near-term outlook
The near-term outlook for global growth has weakened this year (but remained positive) as pent-up demand for goods wanes and central banks take away the crutches of ‘easy money’ policy support. The biggest distractions of the last two years – the COVID pandemic and ultra-loose monetary policy are now fading. The new challenge of creating a balance between inflation and growth has emerged in its place. If the problem has changed, the solution must change too and this is evidenced by ongoing market volatility and debate about what the solution could look like.
Markets are forward looking and presently pricing in an aggressive interest rate hiking cycle, which can provide a cushion for further surprises in any inflation readings. Removal of monetary support and mobility restrictions indicate that some previously affected industries will start to recover, such as travel, tourism and aerospace. For example, there has been an accelerated recovery in travel with carriers reporting strong demand across leisure, while corporate traffic is still improving.
Overall, the global economy is facing several headwinds such as ongoing supply disruptions, persistent inflation, and the unwinding of monetary stimulus. There is, however, a critical factor that has the potential to resume the upward momentum of the markets: the extra sugar from your lemonade. The consumer is one of the core forces that influence an economy and its growth trajectory, and in the US consumer spending makes up 70% of annual GDP. The US consumer is currently in strong financial shape by having 26% higher income and 33% lower debt than in 2008. This means the excess savings accumulated by households can act as a ‘shock absorber’ against additional market and financial shocks (e.g. higher oil prices) and thus support the further expansion of the economy – it just needs the consumer to remain confident of the future and this is the current difficult part.
Our focus
The market’s primary role is to try and price in all the publicly available information. Currently this means it is balancing ‘the war in Ukraine, supply chain issues and persistent inflation’ on one hand against ‘increasing productivity, consumer balance sheets, and low unemployment levels’ on the other. Similarly, portfolios need to strike a balance across various assets and sectors to navigate these ‘pushes and pulls’ and deal with an uncertain future as interest rates undergo some ‘rebalancing’. We continue to focus on appropriate levels of diversification across a range of strategies, including those which we think will have a low level of correlation with core markets. This means incorporating investments with more visibility on current cashflow generation rather than just future revenue growth. Ultimately, flexibility in portfolio positioning is a key here to better manage the risks and capture the opportunities as they evolve.
If you’d like to discuss how the market is performing, and what that means for your investments, please contact the team here at Crystal Wealth, who’ll be delighted to help.