The final issue overhanging markets is the persistence of inflation, which is being exacerbated by the situation in China and Ukraine which we wrote about in our last two posts.  Taking a 20,000-foot view, inflation itself is not a bad thing. When the economy is running below capacity, inflation actually helps production. More dollars means more spending, increasing demand for goods and services. More demand, in turn, triggers more production to meet that demand. This cycle, is economic growth in its most basic form. All of the stimulus thrown at the global economy since the credit crisis in 2008 – 2009 was designed to create inflation and stave off the kind of deflation (persistently falling prices) that countries with stagnating economics like Japan have faced since the 1980s.  But central banks have a mandate to provide price stability, and that is clearly being tested by the jumps in energy and food prices over the past year.  They have only one lever to pull to combat this, which is to increase borrowing rates and slow down the economy.  When supply exceeds demand, prices fall.  How this will play out in the years ahead remains to be seen, but here’s our view of how the situation could evolve in the months ahead.

The near-term (1-3-month) view: the central banks were “behind the curve” in battling inflation in 2021, and it stands to reason that they will be slow to move rates lower until employment starts to soften and inflation turns meaningfully downward even as the broken supply chain, which triggered this, starts to heal (see the chart below).  Markets have adjusted valuations to reflect higher risk-free borrowing rates, but higher rates have a real impact on consumers and businesses alike, which is just being reflected in corporate earnings.  We are in the midst of seeing the markets adjust their expectations lower to reflect the near-term headwinds facing some companies, and being pleasantly surprised by the resiliency of others. 

The medium-term (3-12-month) view: the Fed is chasing inflation data, and is tightening both in rhetoric and action just as the numbers (both growth and inflation) begin to turn lower.  Disinflationary forces are appearing everywhere, companies are seeing a softening in business momentum, layoff announcements are climbing, supply chain strains are easing, and aggregate demand is cooling. It’s not just central bank policy that’s becoming restrictive – fiscal policy has swung massively too.  The U.S. budget deficit was 15.6% of GDP in ’20 and 10.8% in ’21 but will drop to 4.2% this year and 4% next year. Just as the stock volatility increases when rate expectations approach 4.5%, the economy (and Treasury yields) won’t withstand all this tightening and the result will be a sharp drop in rates (which will help equities stabilize and eventually rally).   During this period, companies that have high levels of debt will run into trouble, and they may not be bailed out this time around.  But this period of creative destruction should create a sustainable base upon which the next cycle will emerge.

The long-term (12-24-month) view: inflation isn’t going back to where it was before the pandemic for a host of reasons, many of them geopolitical.  Supply chains could decouple due to the souring of the U.S. - China relationship, climate change, the evolution of the decades-long trend of globalization as companies favour resiliency over efficiency (Globalization 2.0?), and the permanent isolation Russia will find itself in for as long as Putin is running the country. The shift in the world’s approach to Russia, coupled with years of underinvestment, should keep energy prices elevated, while deteriorating demographics in the world’s major economies (most notably, China) shrinks the pool of eligible workers (thus keeping a bid beneath wages). If inflation won’t return to the pre-COVID days, neither will rates, and it wouldn’t be surprising to see several quarters of disinflation toward the end of 2022 and throughout 2023 before CPIs globally get structurally “stuck” a bit above current central bank targets.

None of this will derail the long-term prospects for the global economy, as productivity enhancements in health care and technology, coupled with improving demographics in the emerging markets and the emergence of the huge cohort of the millennial generation into prime working age should drive growth going forward.  But we should prepare ourselves for the potential that the era of low, and, in some cases, negative borrowing rates, may be behind us, along with the inequities and imbalances that they created.