Unpacking Inflation

Key Points: 

• Stay overweight growth assets. The global inflation scare isn’t yet a trigger for a global central bank tightening cycle that will bring to end to the equity market rally and risk asset outperformance. Inflationary pressures are more concerning in the US than other advanced economies. In EM, countries seeing inflationary pressures are generally those who struggled with it prior to the pandemic.
• Labour markets are key. In the US, the unemployment rate is still above pre-pandemic levels, but the rebound in labour market participation as the economy has opened up, is sluggish and a concern. In Australia, the unemployment rate is below the level seen just before the pandemic. Participation has bounced back, although the Sydney and Melbourne lockdowns are a temporary setback. In Japan the unemployment is still above pre-pandemic levels and participation is rising.
• The inflation is coming from goods and services most impacted by the pandemic and should ease as the pandemic fades. In Europe, the US and Australia inflationary pressures are occurring in items of the CPI such as restaurant meals and computing and AV equipment.
• Financial markets are siding with the central bank view. The term premium on the US 10-year note is below zero again after briefly rising to 50bp at the start of the pandemic. Indeed, there is no compensation on offer for holding the note through the current period of growth and inflation volatility. The level of the yield is also low given the pace of growth and inflation in the US. Furthermore, the US yield curve is still positive and suggesting we are still at mid-cycle.
• Inflation expectations are still well-anchored in the US, Australia and Europe, although they have risen recently. It’s important inflation expectations remained anchored at levels consistent with central bank targets.
• Despite our relatively positive assessment of the current bout of inflation, our lead indicators on the US business cycle suggest it is maturing. The New York Fed business survey and the Philly Fed survey suggests the US yield curve has peaked and will begin to flatten. However, it is likely to stay above zero over our investment horizon. The likelihood of a large recessionary equity market drawdown is still some way off.