Investors face an inflation conundrum due to competing global forces 

Strong labor markets and household balance sheets indicate economic buoyancy but central bank rate hikes amid warnings of recession confound the outlook

The world’s major central banks are determined to curtail decades-high levels of inflation, and whether they are winning or losing this fight is the fundamental question investors are grappling with.

At its heart, we have seen the composite of various economic strands spool together to create the current economic backdrop.

Whether it’s labour supply and its effect on wages, housing costs, or consumer demand-driven inflation, different factors have their own impact on how much prices rise.

While it is true that inflation can be accompanied by economic growth, financial institutions and market commentators are eyeing a global economic slowdown^[1].

At Mercer’s Global Investment Forum (GIF) Asia, I shared the stage with Ben Abell, principal at Mercer Investments, to discuss the indicators investors need to be aware of to best position portfolios thoughtfully to navigate these challenging economic forces.

Inflationary fuel

We started by looking at the big picture. Across the globe, we are seeing distinct factors coming together to drive inflation. The International Monetary Fund believes a third of the world economy will contract this year or next amid shrinking real incomes and rising prices, but whether this means that inflation will recede is difficult to ascertain^[2].

At the individual level, a strong bounce-back after Covid-19 lockdowns led to unemployment rates in the US and Europe plummeting rapidly. This persistent trend downwards is pushing wage growth up, in some cases to multi-decade highs.

As such, workers are in a stronger position to ask for pay rises because firms are struggling to find the skills they need, and with prices for goods and services rising, employees are pushing for their wages to reflect this.

As I told those in the audience, these factors come together to potentially create a self-perpetuating inflationary loop, where prices rise and wages are elevated to keep pace.

But Ben and I suggested that even if firms regain the upper hand where pay bargaining is concerned, the importance of housing costs must be carefully considered. They make up 40% of the US core CPI basket^[3] and their upward trajectory doesn’t look like it will be interrupted soon. So-called Shelter Inflation in the US, the cost of mortgage payments or rent, has increased by more than 6% in the past year, well above the 2-3% level that has been the norm during the past few decades^[4].

The Federal Reserve’s tightening policies are aimed at cooling demand here, however, with an endemic shortage of housing supply compared to the need for homes, many believe that house prices and rents will be elevated for some time.

The cost of housing is seen as a major factor in curbing inflation, because the higher rent and mortgage payments are, the less disposable income people have.

However, households in the US built up more than $2.5 trillion in savings during the pandemic, and so far only about $500 billion has been spent, meaning consumers there can tolerate rising prices for longer.

In short: regardless of where it stems from, it’s our view inflation is something that every institution and investor will have to navigate over the coming months.

Don’t fight the Fed

But these scenarios are not certain. Even if consumers maintain their spending levels, inflation might not rise across the board.

Lockdown meant that consumers turned their attention wholeheartedly to goods given that services had been shuttered, but with Covid-19 restrictions eased across much of the globe, consumers are again prioritising services and experiences, which could help reduce the supply chain constraints for physical products that emerged during the pandemic.

Indeed, the Federal Reserve Bank of New York’s global supply chain pressure index has dropped precipitously in 2022 from its extremely elevated levels.

And if investors were in any doubt about the Federal Reserve’s willingness to fight inflation, they need look no further than the statement from its Chair, Jerome Powell, that he is taking “forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored”.

Interestingly, data suggests that consumers now expect inflation to moderate, while recent figures show that headline inflation has started to moderate.

The China factor

During the session, we touched on the idea that the cooling in price rises could be indicative of the beginnings of a recession, and that risk central banks’ tightening actions may be too large and too quick.

Indeed, the OECD’s leading economic indicators have turned negative for developed and emerging economies, while the interest rate futures market is suggesting that the US will begin cutting rates in November 2023 – a sign some believe is indicative of deteriorating economic conditions.

But recessions are always preceded by a decline in employment, which is certainly not happening in the US, while the average payroll growth in the US so far this year has run over four times the typical pace of the past two decades.

Furthermore, household debt as a percentage of disposable income has fallen to 2001 levels, suggesting consumer balance sheets are strong.

As ever, China is the proverbial elephant in the room. The country’s central bank is one of the few globally to be cutting rates at this point in time, while the country continues to loosen fiscal policy at a time when the G7 is aggressively reining it in.

But with tepid growth in retail sales following the end-of-lockdown flurry, and an under-pressure property sector that has seen sales volumes well below prior years and prices dropping for 13 straight months as of September, the country doesn’t have an obstacle-free path.

Closing the session, Ben and I offered our advice to investors: closely monitor competing forces on a global and national level while remaining sufficiently diversified in the face of numerous possibilities and outcomes.

Preparedness for tomorrow starts today.

Footnotes

_{[1] https://www.imf.org/en/Blogs/Articles/2022/10/11/policymakers-need-steady-hand-as-storm-clouds-gather-over-global-economy}

_{[2] https://www.imf.org/en/Blogs/Articles/2022/10/11/policymakers-need-steady-hand-as-storm-clouds-gather-over-global-economy}

_{[3] US Bureau of Labor Statistics}

_{[4] Bloomberg, Bureau of Labor Statistics}