The Market’s Dangerous Optimism About Inflation

The Market’s Dangerous Optimism About Inflation
Reda Farran, CFA

about 1 year ago4 mins

  • When inflation crosses above 8%, it historically takes a very long time to return to normal levels. And China’s recent reopening and strong real income growth in the US are only adding to the upside risks to inflation.

  • Taken together, inflation is likely to remain elevated for a while. That raises the possibility that central banks will have to hike interest rates even higher than previously thought – and keep them there for longer than previously expected.

  • In that scenario, stocks and bonds could be in for a difficult year – especially expensive-looking growth stocks. The US dollar could emerge a winner, if the Fed takes rates higher than its peers and keeps them there for longer.

When inflation crosses above 8%, it historically takes a very long time to return to normal levels. And China’s recent reopening and strong real income growth in the US are only adding to the upside risks to inflation.

Taken together, inflation is likely to remain elevated for a while. That raises the possibility that central banks will have to hike interest rates even higher than previously thought – and keep them there for longer than previously expected.

In that scenario, stocks and bonds could be in for a difficult year – especially expensive-looking growth stocks. The US dollar could emerge a winner, if the Fed takes rates higher than its peers and keeps them there for longer.

Inflation doesn’t just fall like a stone, and thinking that it will is just dangerously optimistic. Sure, inflation has started to come down from its 40-year highs, but it could still take a lot longer than you might expect to return to more normal levels of 2% to 3%. Here are three big reasons why inflation could stay higher for longer – and what that means for your portfolio.

1. China’s reopening could fuel global inflation

China’s fairly recent abandonment of its Covid restrictions is already providing a welcome boost to global growth. But it’s also expected to bear an unwelcome side effect: higher global inflation at a time when central banks in much of the world are racing to bring it back under control.

Bloomberg Economics, for example, is forecasting that China’s economic growth will jump to 5.8% this year, from 3% last year. If that happens, it could lift global inflation by close to a full percentage point in the final quarter of 2023 according to the research group, which modeled the relationship between China’s growth, energy prices, and global inflation. If China’s economy does even better, with growth surging to 6.7% this year, the global inflation boost would be closer to two percentage points.

China's reopening could boost global inflation by up to two percentage points, depending on how its economy performs this year. Source: Bloomberg.
China's reopening could boost global inflation by up to two percentage points, depending on how its economy performs this year. Source: Bloomberg.

2. Strong real income growth could lead to spiraling inflation

Despite all the headline-grabbing layoffs across Big Tech, the US job market is still showing a ton of strength. The key labor market report for January showed the US economy added a whopping 517,000 new jobs in January – more than twice as many as the month before and shattering economists' estimates of 187,000. At the same time, the unemployment rate fell to a 53-year low. And with roughly twice as many job openings as there are unemployed people in the US, wages have been getting better too. After more than two years of Americans’ pay not keeping up with rising consumer prices, real hourly earnings – that is, inflation-adjusted earnings – are finally rising again.

Real average hourly earnings for US employees have been steadily rising since June 2022. Source: Statista.
Real average hourly earnings for US employees have been steadily rising since June 2022. Source: Statista.

But here’s the catch: when incomes are outpacing inflation, that often leads to a boost in spending and higher consumer prices. What’s more, it only gets worse as companies raise the prices of their goods and services to offset their higher wage costs. That new increase in inflation, in turn, pushes workers to demand even higher wages – something they can more easily pull off in a red-hot labor market. This loop leads to higher and higher (i.e. spiraling) inflation.

Now, in the current macro environment, where we’re already starting off from a high base (i.e. inflation is already quite elevated), perhaps we don’t get the extreme scenario of hyperinflation – but these dynamics could push inflation to remain stubbornly high.

3. High inflation has a way of being sticky

History tells us that once the “inflation genie” is out of the bottle, it can take a long, long time to shove the little guy back in. For example, the last time US inflation was in double digits was during the ’70s and ’80s. And when Federal Reserve (Fed) Chair Paul Volcker took office in 1979, he pushed up interest rates to an unprecedented 20% – more than 5 percentage points above the previous peak inflation rate. Now, interest rate increases are one of the best weapons there is against inflation. Even so, it took two years for this extreme policy intervention to cut inflation to just half its peak level (to around 7%), and over six years to bring it down to the central bank’s long-term target of 2%.

A similar pattern plays out throughout history and across many different countries. An excellent study by Research Affiliates looked at all the times when inflation surged above 4% in 14 developed-economy countries between January 1970 and September 2022. Here’s what they concluded: returning to 3% inflation is easy from 4%, hard from 6%, and very hard from 8% or more. Once inflation pops above 8%, getting back to 3% usually takes six to 20 years, with a median of over 10 years.

Once inflation crosses above 8%, it takes a very long time to fall back below 3%. Source: Research Affiliates.
Once inflation crosses above 8%, it takes a very long time to fall back below 3%. Source: Research Affiliates.

What does all this mean for markets?

Well, with all these things conspiring to keep inflation on the high side, it’s going to be tough for the Fed to announce the pause in its rate-hiking cycle that everyone seems to be waiting for. And that probably means that interest rates will climb to a higher peak than previously thought – and stay there for longer than previously expected.

Right now, investors are betting that the Fed will hike rates to a peak of around 5.1% in July, and then begin cutting them, to around 4.8% by year’s end. But if it instead takes rates to, say, 5.5% and keeps them there for the rest of 2023, investors would be in for a nasty shock. In that scenario, bonds and stocks would be expected to have a rough year – especially expensive-looking growth stocks, whose valuations are more sensitive to interest rates.

The US dollar, meanwhile, would be expected to have a good year if the Fed takes rates higher than its rivals and keeps them there for longer. Higher US interest rates, after all, would make the dollar more attractive to international savers and investors, pushing up its value.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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