global perspectives

    Inflation - defying gravity

    Inflation - defying gravity
    Florian Ielpo - Head of Macro, Multi Asset

    Florian Ielpo

    Head of Macro, Multi Asset

    In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we examine the recent US inflation data to ascertain whether the first signs of moderation may prompt the Federal Reserve to alter its hawkish stance. 

     

    Need to know:

    • When compared to its fundamentals (oil, wages and the saturation of productive capacity), US inflation remains too high despite its recent slight moderation
    • Such a disconnect between inflation and its level predicted by economic theory is rare historically but not unprecedented, and seems to occur when commodities rise rapidly (such as in 1980 and 2008)
    • Our nowcasting indicators continue to place the Fed in the hawkish central bank camp, pending a moderation in the housing and employment markets: this is where investors' attention should be focused

     

    The good and bad news in US CPI

    Financial markets were again anxiously awaiting the latest US inflation report to answer the burning question of whether we have passed an "inflation peak", i.e. the moment when inflation may still be high but has commenced a welcome decline. Inflation has been a prominent concern during 2022: investors have probably never followed the news flow on this subject so carefully.

    On this occasion, the July inflation report contained both good and bad news. The good news was that despite expectations of a continued rise, the data showed its first decline. The decline was limited of course, inflation fell from 9.1% to 8.5%. However, it provided markets with some much-needed relief and interrupted a long sequence of positive surprises that were beginning to make many market participants uneasy.

    Now for the bad news: inflation remains high, and its normalisation will require time and above all further rate hikes. Inflation may be beginning to moderate, but the Federal Reserve (Fed) will need to remain aggressive in order to purge the US economy of this disease. Here are some elements underpinning our current view of the situation: yes, inflation is moderating; no, central banks will not "pivot" from hiking rates in 2022.

     

    Inflation: stratospheric and widespread

    Inflation remains in the stratosphere. At above 8%, with core US inflation at around 6%, the situation is still more reflective of the 1970s than the 2000s. Core inflation previously reached these levels in 1969, 1974 and 1978, which is enough to worry central bankers. Furthermore, while inflation may not be a global problem, it has affected a large number of countries since Covid's exit: the US, the Eurozone and the UK – wherever excessive demand stimulation took place between 2020 and 2021. 

    What remains worrying about this latest inflation report is that, despite its apparent moderation, inflation remains high and appears to be disconnected from its usual fundamentals: energy costs, wage growth and capacity saturation. Over the long term, economic theory agrees that these are the three forces that shape changes in price levels – leaving money supply aside, as its relationship to inflation remains complex to demonstrate empirically.

    Figure 1 shows the long-term evolution of US inflation from 1970-2022 and a standard regression model based on these three factors highlighting what should be expected from "theoretical" inflation. While July's inflation stands at over 8%, its core was just over 3%: a considerable gap representing the difference between a Fed that is just starting to pivot and a Fed that is continuing its fight against inflation. Such a gap between "theoretical" and actual inflation has happened twice before: in 2008 when oil prices exploded to USD140 and in 1980, during the aftermath of the second oil shock.

     

    Figure 1. Fundamental modelling of US inflation based on oil, wages and capacity utilisation 

    Chart 01.svg

    Source: Bloomberg, LOIM

     

    Fed's hawkish stance to stick

    It is likely that the Fed itself is surprised by the persistence of inflation and is concerned about these historical benchmarks. This surprise should gradually turn to annoyance, and this annoyance to further rate hikes. A 75bps hike at its next meeting may not be buried so quickly by markets for this reason.

    Figure 2 shows that our central bank rate surprise nowcasting indicator for the US gives a similar signal. Such indicators do betray a moderation in the Fed's tone going forward, but also a need for the Fed to maintain its hawkish stance for some time to come: our nowcaster remains above 50% (suggesting the Fed should remain hawkish) but is showing some pullback (the diffusion index is at 31%, with 69% of this data declining). When we look at the breakdown of the nowcaster (the bottom of figure 2), we can see that the labour and housing markets will remain worrying for the Fed, while consumption and prices are showing a welcome decline.

    In a nutshell, employment and housing should be the focus for markets, as it will be their moderation that might prompt a dovish pivot from the Fed.

     

    Figure 2. Monetary policy surprise nowcasting indicators: nowcaster, diffusion index and nowcaster decomposition (bottom)

    Chart 02c.svg Chart 02b.svg

     

    Chart 02.svg

     

    Source : Bloomberg, LOIM

     

    Simply put, the start of inflation moderation does not necessarily mean the Fed's fight against inflation will end. Any dovish pivot would only occur if the labour and housing markets show signs of moderation.

     



    Macro/Nowcasting Corner

    The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

    The main news last week was the US inflation report. Clearly, the report has been interpreted by markets as being rather reassuring, as it dropped to 8.5% against expectations of 8.7% and a previous reading at 9.1%. Looking at the details of the report, the more macro element of inflation – service inflation, which includes shelter costs – is still rising strongly. How we read the report is simple: it is true that inflation moderated, but this essentially reflects a decline in energy and transportation costs.  It is too early to call an end to this period of high inflation, but markets opted to see more in this number than what was actually there. 

    Other than the inflation report, the NFIB index showed another decline while PPI indices also retreated to lower levels. The first is bad news when it comes to growth while the second is good news for price pressures: a mixed bag of data globally. 

    Europe had light macro news flow over the week. The only point worth mentioning was industrial production, which is indicated as moving lower by our nowcasting indicators; the European growth situation looks better than many expected and industrial production numbers do not disagree with that. In yearly variations terms, it has risen by 2.4% vs. 1% expected and 1.6% last month. 

    Finally, in China, money mass is rising, reflecting the ongoing stimulation of the economy. M2 rose in July by 12% versus 11.4% expected and 11.4% the month before. Also, PPI variations are showing a decline – consistent with the US PPI – while CPI numbers are increasingly nearing 3%. This is a new phenomenon in China that is also shown by our nowcasting indicators.


    Our nowcasting indicators currently point to:

    •    Worldwide growth clearly declining. The US and Eurozone are showing signs of decelerating growth momentum 
    •    Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US
    •    Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected

    World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

    Multi-Asset-simply-put-Growth nowcaster.svg

     

    World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

    Multi-Asset-simply-put-Inflation nowcaster.svg

     

    World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

    Multi-Asset-simply-put-Monetary Policy nowcaster.svg

    Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy). For illustrative purposes only

    important information.

    For professional investor use only.
    This document is issued by Lombard Odier Asset Management (Europe) Limited, authorised and regulated by the Financial Conduct Authority (the “FCA”), and entered on the FCA register with registration number 515393.
    Lombard Odier Investment Managers (“LOIM”) is a trade name. This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.
    Any benchmarks/indices cited herein are provided for information purposes only. No benchmark/index is directly comparable to the investment objectives, strategy or universe of a fund. The performance of a benchmark shall not be indicative of past or future performance of any fund. It should not be assumed that the relevant fund will invest in any specific securities that comprise any index, nor should it be understood to mean that there is a correlation between such fund’s returns and any index returns.
    Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term “United States Person” shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
    Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
    Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources. Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
    No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Asset Management (Europe) Limited prior consent. In the United Kingdom, this material is a marketing material and has been approved by Lombard Odier Asset Management (Europe) Limited which is authorized and regulated by the FCA.
    ©2022 Lombard Odier IM. All rights reserved.