Inflation is temporary but the rotation is not

In the latest instalment of Simply Put, where we make macro calls with a multi-asset perspective, we explain why higher inflation will be temporary and why this should further fuel the rotation from value into growth.

 

Need to know Higher inflation will be transient as negative real wage growth and central bank hikes start to tame demand. With that, real rates will continue to creep up. We believe higher real rates are the reason behind the current rotation from growth into value stocks and we expect this to continue.

 

The “transient” or “temporary” nature of the current inflation shock, seemingly prevalent in 2021, is now being challenged from several angles. First, the numbers themselves: inflation is high and persistently so.  Second, market pricing and economists’ forecasts show only a slow decline in inflation during the quarters to come. Third, it is now a political issue. This is most notable in the US. During the Senate hearing regarding Lael Brainard becoming a member of the Federal Reserve’s (Fed) board, the Fed’s inaction was repeatedly labelled a “mistake”. As detailed in last week’s edition, the current inflation surge reflects fiscal policy: so in the case of the US the arsonists are simply blaming the firefighters. Now, against a backdrop of a market rotation to value from growth, this question seems to be even more crucial. In our view, inflation will be temporary but the rotation is set to continue.

Inflation will be temporary, but it is just a bit more persistent than initially thought. Many economists suggested inflation would be temporary because it reflected a disruption of the supply chain caused by pandemic-induced lockdowns and health measures. Today, cargo shipment data mostly show levels never seen before: producers and delivery systems are working at full steam with full capacities. Yet, inflation remains stubbornly high: (as discussed last week) today inflation empirically reflects the intensity of economic growth. If not, how can we explain why price growth for comparable products is so different between the US, the Eurozone, Switzerland and China? Local demand determines local inflation, while inputs costs are the same for everybody – with a caveat for the impact of forex. Demand is now in the driving seat as far as inflation is concerned.

 

Chart 1: Rebased evolution of US disposable income (left) and US savings as a ratio to GDP (right)

Source: Bloomberg, LOIM

 

Two factors typically make demand tick: income and wealth:

• Wealth remains high, particularly in the AngloSaxon world. It has been driven by fiscal spending and the skyrocketing stock market. Despite these factors, savings in the US have stopped outpacing GDP growth as shown in chart 1 (right-hand chart). The ratio is now lower than it was in June 2020. The current decline in the stock market should add to this phenomenon as “retail money” is predominantly invested in the tech sector.
• Meanwhile, wage growth has increased worldwide and has not kept pace with inflation. This has led real wages to contract. As illustrated by chart 1 (lefthand chart), since the fiscal stimulus of Q2 2021, real disposable income (one of many proxies for real wage growth) has declined each quarter. In total, real wages are now just 2.6% above their pre-pandemic level. This means inflation has normalised the action undertaken by governments and eaten into wages and wealth quite rapidly. With another year of inflation exceeding wages by 2% in the US, consumers will have to dip into their savings to maintain their standards of living. We will be keeping an eye on bank deposits to see how quickly they melt away.

Adding these factors to the tighter monetary policy, which has now become a political necessity, and you can see a combination of factors that will slow world growth, particularly for the US economy. This should extinguish the sparks of inflation in the fire. In other words, farewell demand.

This could be essential to understanding the sector rotation currently at play in equities. As shown in chart 2, the relative performance between value and growth stocks (using the MSCI World indices) almost perfectly tracks the evolution of the US 10-year real rate. If inflation slows more rapidly than expected in 2022, will the ongoing rotation from growth to value end? We do not think so. Real rates have declined for two reasons: first, and foremost, due to the large amount of savings accumulated during the pandemic and second because of central banks’ accommodative policies. There is little doubt that this second factor has now turned. However, the first factor is also starting to change course. Inflation and the recent decline in growth stocks will hit savings further, fuelling the normalisation in real rates which should let the value rotation unfold.

 

Chart 2 – MSCI value versus MSCI growth versus US 10-year real rates

Source: Bloomberg, LOIM

 

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.

These indicators currently point to:

• Solid growth worldwide, with stronger momentum in the Eurozone, while China lags. US growth momentum is showing tremors of moderation.
• Inflation surprises are more likely to be positive but could also lose momentum across the three zones. The pace of inflation pressure moderation has gained momentum lately.
• Monetary policy is set to remain on the hawkish side, except in China. Our nowcasting indicator for the US and the Eurozone remains in high territory.

 

World growth nowcaster

World inflation nowcaster

World monetary policy nowcaster

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).

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