Inflation, recession or both?

Inflation has proved very sticky over 2022, rising higher and lasting longer than many would have expected. Central banks are widely considered to have been too slow to respond to inflation, in some cases, by their own admission. Now many investors are concerned that central banks will again be too slow, this time failing to respond to weakening growth and continuing to tighten into a recession, resulting in worse economic outcomes than may be necessary.

Inflation still a problem

Inflation has remained stubbornly high over 2022 despite many of the pressures of 2021 easing. To recap, last year’s inflation spike was largely a story of elevated government support to locked down households causing a spike in demand for goods right at the time when supply chain disruptions were limiting supply of goods. It was a story of Peloton bikes, Netflix and cars. While high energy prices were already pushing inflation higher in Europe last year, for the most part countries with elevated financial support for households and businesses experienced high inflation.

While the end of government support programs and reopening economies could have been expected to result in lower inflation, constrained supply chains were slower to improve than anticipated. New variants triggered further lock downs, particularly in China, where a zero covid policy remains in place.

The widely unexpected war in Ukraine, which in addition to being a terrible humanitarian crisis has been a salient reminder of geopolitical risks, has further exacerbated inflation pressures. This has been a particular challenge for countries that rely on food and energy imports, including Europe and many emerging market countries.

While households and corporates have remained in good financial shape and well placed to continue supporting an economic recovery, there are concerns that the duration of the recent high inflation period combined with tight labour markets will result in self-reinforcing, elevated inflation through wage price growth. As we wrote in February (click here to read), wages price growth is considered the primary mechanism for spiralling inflation as higher wages flow through to higher prices, higher prices then cause employees to demand higher wages, and so on.

After years of stagnation, 2022 has seen wages rise across many developed countries, with the latest US wage growth figures at 5.2% for the year to July. This has been less pronounced in Australia, where the latest annual wage data was just 2.6% to June 2022, albeit the highest result in eight years.

While wages have increased in nominal terms, they are negative in real terms, leaving employees worse off despite the apparent bounce in wages. Labour markets have changed significantly since the 1970s, with far lower levels of unionisation and less direct inflation linkage in wage agreements. This may limit the degree to which wages rise in real terms, however with tight labour markets, this remains a key watch point.

Potential Impact of Rising Rates

After years of exceptionally low interest rates, central banks have aggressively raised rates in recent months in the hope of curtailing inflation. While higher interest rates can’t directly resolve supply issues, imposing higher costs of financing on households and companies can reduce demand, which will ultimately result in lower prices. The degree of economic pain that must be weathered to deliver this outcome is uncertain, particularly as the trajectory of supply side drivers of high prices is also uncertain.

Inflation is a lagging indicator, and it will take time for the impact of higher interest rates to be reflected in inflation figures. Central bankers must make decisions without perfect foresight, and concerns about a ‘policy error’ are not without foundation.

What could this mean for investors?

The combination of rising inflation and rising interest rates are generally associated with the latter part of an economic cycle, where growth has already peaked. Inflation and interest rates typically peak when an economic downturn is already well underway. Add in the prospect of a more significant recession and you could have a very poor market environment for multi-asset investors.

In simple terms, higher input costs arising from inflation and higher financing costs combined with falling revenue that would be expected during a recessionary environment will reduce corporate profitability and would typically be negative for equity investors. The outlook for the traditional defensive bond asset class could also be challenged – higher inflation erodes the value of future debt repayments, while rising interest rates directly reduce the value of bonds.

Assets with direct or indirect inflation linkage, such as commodities, inflation linked bonds and real assets would be expected to perform better in an inflationary environment. However, these assets are also sensitive to rising interest rates. They also have varying levels of sensitivity to the economic environment – for example, commodities may perform well in an inflation shock but would be sensitive to an economic downturn.

JANA’s analysis of unlisted Infrastructure and Property¹ assets suggest that they will remain relatively resilient in a high inflation, rising interest rate environment. While real assets have historically been less sensitive to recessions than listed equities, the quantum and duration of the downturn and the nature of the assets can make a big difference to outcomes. Core infrastructure and high-grade property assets, especially those with longer weighted average lease expiries, would generally be expected to perform better, but would not be immune to a recession.

What is in the price?

Theory is one thing, predicting outcomes in practice another. The impact of the economic environment will depend on starting asset prices, and what future expectations are reflected in that price.

Equity markets have sustained losses over 2022 and could currently be characterised as pricing in a ‘soft landing’, where central banks will reduce inflation without causing a significant economic contraction.

On a global basis, earnings expectations have moderated but remain comfortably positive despite the high starting point, while Australian earnings expectations show a more significant levelling off in the coming years.

On the other hand, bond markets appear to be pricing in a recessionary environment. Many consider an ‘inverted’ yield curve, when the yield on 10-year bonds is lower than that of a 2-year bond, an indication that the bond market is pricing for a recession.

While credit markets have rallied in recent weeks, the additional yield for corporate bonds relative to government bonds, the ‘spread’, remains moderately elevated, implying more cautious outlook. This position has softened in recent weeks as market rhetoric around the likelihood of a soft landing has increased.

In conclusion

While there is a lot of focus on downside risk today, as the old adage says, economists have predicted nine out of the last five recessions. Just as there is the risk that central banks over-tighten and trigger a meaningful recession, there is also the potential that the equity market’s optimism proves correct, and the heat is taken out of inflation without serious economic repercussions.

Predicting the precise future path may not be possible, but it is possible to see where investment risks may be skewed to the up or downside and position your portfolio accordingly.