Despite the fact that the latest US inflation data confirmed that the price increase is still very much alive, the markets looked the other way and ended last week with a relatively positive tone.
This week, the situation doesn't look much different. On Monday, October 17, the stock markets rose strongly to the beat of bonds (their price rises and their profitability falls). It seems that there is some optimism in some segments of the investment world despite the list of endless risks that plague the economy and that can greatly complicate the scenario from one day to the next (Russia's nuclear option remains a risk). Are the markets underestimating what may be to come?
Deutsche Bank economists are very clear about this:
The markets are ignoring the inflationary shock and the impact it is likely to have on the real performance of stocks and bonds. Experts of the German bank believe that investors can face years of negative real returns (financial repression), and yet they are still invested or looking for opportunities to get in and out in an environment that does not bode well.
The markets usually quote the risks clearly, but today it does not seem that they are trading on the possibility that a Putin could resort to nuclear weapons or other options in response to NATO threats. It is true that stock markets have fallen and bond yields have risen, but these movements do not seem too in line for what could be the beginning of a global war or a stagflation with negative growth (recession) and rising interest rates.
"The markets are ignoring the fact that we are at increasing risk of returning to prolonged 1970s-style stagflationary dynamics, which would require an even greater interest rate response. If the experience of the 1970s is repeated, investors will find themselves with a prolonged period of negative real yields for both bonds and stocks," according to Henry Allen, a researcher and analyst at Deutsche Bank.
This expert stresses that "this is not just a warning (without foundation). Inflation has become increasingly widespread and persistent. The interest rates managed by the central bank remain deeply negative in real terms, even after all the adjustment made so far. And fiscal stimulus packages to deal with the energy shock are putting further upward pressure on inflation in the medium term."
Two trains at full speed:
Allen believes that these forces are like trains that are going to collide. On the one hand, the inflation train picks up speed with globally coordinated fiscal policies (more spending, aid, some tax cuts...), while interest rate hikes are another train coming head-on to try to curb inflation. In addition, the problem with rate hikes is that their real impact on the economy sometimes takes up to a year to be perceived, so, perhaps, rate hikes have already done a lot of damage, but as it has not yet been clearly seen, central banks will continue to raise interest rates (in highly indebted economies, with unproductive and vulnerable companies). The train wreck may end in a rare recession.
Six reasons to believe the markets are wrong:
In light of this troubling inflation dynamic, Allen and his colleagues at Deutsche Bank outline the reasons why markets should be much more concerned about inflation than they are
1. The risk of inflation expectations slipping is seriously underestimated:
One of the biggest determinants of inflation expectations is where inflation is at the moment. So the longer inflation stays high, the greater the risk that inflation expectations will also rise. For the moment, expectations have remained relatively, but there are worrying signs that this could be reversing, the Deutsche Bank report ensures.
2. Central bank interest rates remain deeply negative in real terms:
Both the Fed and the ECB have embarked on rapid tightening cycles and are moving at a rate of 75bp per meeting. Persistent inflation means that their policy rates remain deeply negative in real terms. In fact, in September, the real spot federal funds rate was still below -5%, which means that it is still a long way from the levels it reached during the inflationary decade of 1970.
For its part, in the Eurozone, the ECB's real rate (interest rate minus inflation) hit a record low in September, despite the 125 bps of rate increases that have been seen so far, because inflation has continued to increase. Moreover, even if the ECB only wanted to bring rates up to the neutral zone (around 2%), although it would still have several increases in the price of money, that in the most conservative scenario of rate hikes, since to stop inflation, the ECB will probably have to enter the contractionary terrain of monetary policy, as several members of the Governing Council have begun to point out.
"All this is still a long way from the strongly positive real rates that were used to control inflation under Paul Volcker as Fed chairman, and adds to the possibility that inflationary pressures will be stronger than expected in the coming months," warns the economist at Deutsche Bank.
3. Government policies continue to serve to boost inflationary pressures in the medium term:
"Currently, we are experiencing a globally synchronized cycle of rate hikes. But fiscal policy is pushing in the other direction. For example, Germany announced a major fiscal package at the end of September to limit gasoline prices, which was one of the factors that led our European economists to raise their benchmark expectations for the ECB's terminal rate," the German bank's report notes.
"The collective impact of these policies is pushing up inflation. In addition, political incentives remain in favour of further interventions, given the unusually large reduction in the cost of living faced by consumers, so there is an underestimated risk that fiscal policy measures will help inflation to remain structurally higher."
4. Inflation (and core inflation) remains widespread across the consumer price basket:
When the rise in inflation began in 2021, it could reasonably be attributed to some idiosyncratic factors, such as rising energy prices, second-hand cars... But in recent months, the explanation for inflation has changed." In the case of the Eurozone, a good part is still the fault of energy, the question is that it is still energy, this component does not seem to give respite to the Old Continent, rather the other way around, energy could become a structural factor of high inflation in the Eurozone.
In the US, inflation is also a reflection of the impact of housing, which is a lagging variable. But even if you look at the core CPI, excluding housing, then monthly inflation in September presented the very high growth (+0.45%). Meanwhile, "core inflation indicators, such as the trimmed average, reach multi-decade highs in both the US and the euro area. Therefore, we can no longer rely only on specific prices to normalize inflation so that it goes down, since it has spread much more," Allen argues.
5. Are the so-called 'sticky' prices are the ones that are still accelerating:
One of the most worrying details of last week's US inflation report was that monthly growth in the core CPI series reached its highest level since 1982, at +0.68%... "The fact that this series is not even stabilizing, but accelerating, is bad news and raises the possibility that inflation may not decrease as quickly as investors expect in the coming months."
6. As in the 1970s, seemingly transient shocks have merged to keep inflation high:
We can't rule out more happening. As with last year, consensus expectations are that inflation will recede over the next 12 months. But what would happen if a new shock added to the process of unwinding inflation expectations?.
Alejandro O. Asharabed Trucido
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