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2022 was a year in which we saw one of the most aggressive policy responses by central banks in over four decades as they looked to bring inflation under control. As we transition into 2023, market pricing would suggest the hard work is largely done, and the inflation genie will be back in the bottle by year’s end. In this article, we consider why there is still more work to be done and, as a result, why a reversion to easier monetary policy may still be some time off. We also look at what this means for corporate profitability and market returns.
As it currently stands, short term market rates are pricing in a scenario of inflation reducing by year end, with expectations of additional rate rises over the next few months but falling rates by the end of the year.
Similarly, investor consensus would seem to have shifted from a reasonable likelihood of a meaningful economic downturn, to one where a soft landing can be achieved with little economic damage. While this is undeniably the desire of central banks, there are a number of factors at play which make this tightening cycle much more challenging than those of the past forty years. None more so than the volatility in economic conditions witnessed over the past three years, from the large economic drawdown during to covid to the huge post-covid rebound, which have made it much more challenging to understand where equilibrium is.
If we walk through the dynamics currently at play, it is much easier to paint a picture where economic conditions need to weaken more than is currently expected. The recent inflation problem has been driven by two factors – a breakdown in global supply chains and excess demand. In the case of the former, covid lockdowns created material supply chain blockages which reduced the availability of nearly every manufactured good. At the same time, governments responded to the pandemic by providing fiscal support at levels not seen in the post-WWII era. This stimulus was targeted at both businesses and households. These two factors, limited supply and increased demand, created the perfect environment for inflation to take root. One of the best examples of this dynamic was cars. Cars tend to be manufactured with parts sourced from multiple locations. As supply chains ceased to operate, the supply of cars globally fell materially. At the same time households had much higher levels of disposable income, driven by fiscal support and not being able to spend on things like travel. This created the perfect storm for car prices, particularly used car prices as shown below. However, also as shown, this trend has reversed more recently as the demand and supply pressures unwind.
While central banks were arguably late to recognise that many elements of the inflationary impulse were not transitory, they have since responded with gusto, undertaking monetary tightening at a pace not seen since the 1970/80s. But it is important to recognise that central banks can only influence one element of inflation, that being demand. Supply side constraints are clearly outside their sphere of influence and will resolve themselves, which they largely have, given sufficient time.
In relation to the demand side of the equation, the key challenge for central banks is to restrict economic growth sufficiently to reduce demand to a level where inflationary pressures begin to subside. Effectively, central banks want economies to move from a positive output gap to a negative gap. In addition to high inflation, tight labour markets are a key outcome of economies running above capacity, which has the second-round impact of elevated wage growth (i.e. workers have much more leverage in negotiating higher wages). Elevated wage growth is a problem because there is a greater risk of it becoming “sticky”, which is when central banks become more concerned. This is effectively where we are now.
The longer labour markets stay resilient (which they clearly are, as shown above), the more challenging it becomes for central banks to change policy direction. This heightens the risk of over tightening, leading to a more severe economic downturn than is effectively required. The other key challenge facing central banks is the lag between tighter policy and the actual impact on the economy. While there are signs of a slowdown at the margin, the signs are not suggesting a broad-based slowdown.
Further, it is important to remember this is not the usual business cycle of the past 40 years, where central banks are looking to dampen economic growth so as to avoid an overheating economy. This tightening cycle is singularly targeted at bringing inflation under control, with much less regard for the economic or market consequences – smaller short term pain vs material longer term pain. Simply put, inflation is a tax on everyone, while a weaker equity market is a tax on much fewer people. It would seem that central banks have learnt from the 1970/80s where they changed policy direction too quickly and then had to tighter much harder the second time around.
As a result of the above dynamic, this effectively means the quick transition from a tightening cycle to an easing cycle, which has been the approach of the past 30 years, is unlikely to happen this time around. Rather policy is likely to stay restrictive for longer as central banks wait for clear evidence that the inflation genie is back in the bottle.
So, what does this mean for markets? The tailwind of low interest rates and excessive market liquidity are clearly behind us in this cycle. In the main, developed market centrals banks have tightened monetary policy and have started unwinding their quantitative easing programmes. All things being equal, tighter financial conditions make it much more challenging for financial assets to deliver a return.
The catalysts for markets to move materially higher from the current starting point are hard to see. Until labour markets begin to weaken, central banks are unlikely to believe inflation is under control which means policy needs to remain tight. As a result of tighter policy, aggregate demand is expected to weaken and corporate earnings should fall (unless they can expand their margins from already elevated levels). At this stage markets are not pricing in this outcome, which we believe should lead investors to being cautious. This is basis for JANA’s current asset allocation advice.
However, this is clearly just one view of how the future environment may play out, and it is important to consider other scenarios for economic growth and markets. On the negative, we could experience a severe downturn if inflationary pressures do not ease and central banks tighten further than expected, leading to a stagflation environment. Nearly all asset classes, with the exception of cash and some direct inflation linked securities, would be expected to deliver negative returns. At the other end of the spectrum, if a soft landing does eventuate, as a result of inflation falling quickly, this would give central banks much greater policy flexibility and would be positive for risk assets. Corporate earnings would remain resilient, and equities could move higher on falling discount rates and potentially stronger future earnings.
Finally, it is important to understand what we don’t know yet. The following quote from Deutsche Bank highlights why the current market dynamics are potentially riskier than they have been for a long time.
“Every Fed hiking cycle in the fiat high debt era has led to some kind of financial crisis somewhere across the world. In this cycle with less of a “Fed put” it seems inconceivable we won’t have a big accident, especially after 10-15yrs of low/negative yields, more debt and surge of money into illiquids”.
While at JANA we don’t believe investors should panic, we do, however, believe it is sensible to be aware of building risks in financial markets and ensure liquidity is available to take advantage of any dislocations that do eventuate.
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