Its on: the fight against inflation

Key Points: 

• Stay overweight growth assets. It’s too early to position for a recessionary global equity market drawdown. Equity market Investors need to accept that returns will be more modest they have been over the past couple of years and that volatility will increase. It’s also too early to buy government bonds or credit. Yields have further to rise and spreads have further to widen. We’ll update our TAA outlook next month, but our preference for a modest overweight position in growth assets is unlikely to change.
• The gloves are off in the fight against inflation. Central banks spent most of the 1990s and the first decade of the new millennium preemptively fighting inflation. The pandemic has changed that – inflation is out of the blocks and the chase is on. In the US, inflation has its biggest head start since the 1980s and this matters for markets. The Fed doesn’t have the tools to deal with the supply-side issues, but a miscalibration in slowing demand will cause havoc in markets.
• There are now signs of better news in one part of the inflation story. Data shows supply chain pressures in the US are easing and shipping rates are falling rapidly. However, data for December shows cost pressures on imported goods into the US from Europe and Asia. It will take some time for shipping rates to affect landed input prices.
• Labour markets are key. Central banks may be willing to wait for the positive developments in global supply chains to ease inflation, but it’s not possible to ignore recent developments in the labour market. In the US, the participation rate is still well short of its pre-COVD-19 recession level. The participation rate has increased in the past few months, but needs to rise further to moderate inflationary pressures in the labour market. Furthermore, unit labour costs have risen rapidly and were trending up even prior to the COVID-19 recession and appear to be stuck on an upward trajectory and this is the concern for central banks.
• The Fed is about to take out some insurance that will achieve its target. We think 4 or 5 increases in the Fed funds rate target to around 1.00% – 1.25% this year is likely. A 50bp increase in the Fed funds rate can’t be ruled out in March, but we think 25bp is more likely. If the Fed does more than 125bp of tightening this year then recessionary risks will become elevated. The RBA will take out some insurance as well from around the middle of the year and 3-4*25bp increases in the cash rate seem likely by year-end. There is less pressure on the ECB or the BOJ this year. Central banks such as the BoE and RBNZ are further progressed but probably need to do some more tightening this year.