Reconciling the Ripple Effect

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An Increased Interest in Inflation?

Inflation.?

Inflation.?

Inflation.?

The term consistently infatuates politicians, investors, and central bankers, having kicked into overdrive in 2021 as every news network under the sun sought to capitalize on an emerging trend in the most impactful macroeconomic variable. However, for all the time in the spotlight – it is rare that a true explanation of inflation is provided beyond a simplistic definition, roughly equivalent to the rap-lyrical “more money, more problems.”?

Chat GPT (the hyped up – but also truly fascinating Artificial Intelligence engine) does a strong job explaining the fundamentals in simple terms and we will articulate here the more complex intricacies of inflation... When looking at the sources of inflation, we can interpret this in two core camps; supply-driven inflation and demand-driven inflation.??

The former, supply-side inflation, also known as cost-push inflation, reflects the willingness to pay more for goods or services threatened by scarcity. Either through increasing the material or labour costs associated with production, producers are disincentivized to produce the same volume of goods at declining profit margins. However, scarcity can also be synthetically derived through trade negotiations, sanctions, and/or government intervention, as was primarily the case in 2022, with sanctions against Russia and Chinese lockdowns limiting the supply of energy and manufactured goods alike. 2022, meet cost-push inflation.?

However, inflation was at the front of many minds before these restrictions rose to prominence. Demand-side or demand-pull inflation reflects the increase in aggregate demand resulting from an increase in the money supply of a given economy. This may occur as a result of quantitative easing, increased government spending, an expanding economy, or increased foreign investment. As the COVID 19 pandemic spurred increased government and monetary stimulus, corporations and consumers alike saw a rise in “work-free wages” paired with a decline in formerly fixed expenses as lockdowns limited mobility and baseline activity. Joined by a significant wealth effect as markets soared under the supportive eye of central banks and surge in household savings as a percentage of disposable income, consumer largely saw stability in income and a decrease in non-discretionary spending; enabling many to use their new-found wealth (and often borrowing more...) to spur spending. Introducing demand-pull inflation, a la 2021.?

However, what if inflation could be conceptualized differently? With the analogy of too much money for too few goods reflecting supply and demand respectively, how can we better conceptualize the root causes of micro-economic inflation? What if our economy had pressure points, by which subtle shifts to select factors?could cause ripple effects??

Here we return to Dr. Weber’s piece:

Just as systemic shifts in supply and demand can shock inflation, we can see that 3 primary factors can drive inflation; Relative significance (weight), expected volatility, and the up-vs-downstream nature of the sector. While oil prices may directly impact gasoline, transportation, and utilities, it will also impact plastic, packaging, and derivative consumer goods. Similarly, service inflation is embedded within goods inflation whether through delivery, installation, sales, or servicing; our economy is interwoven, even if our data cannot convey this, and we can re-construct these risks.

A Pathway Past Persistent Price Pressure

While a relatively resilient supply chain appeared to limit the risk of outsized inflation resulting from the initial demand-pull, inflation remained elevated although seemingly constrained within a 3-5% band. While above long-term targets, these values reflected inflation levels typically reached one to two times per decade. However, 2022 brought new challenges to meet existing threats, as most developed markets witnessed inflation reach a 40 year high, challenging the historic levels witnessed in the 1980s.?

Looking below, we can see that most of the key countries appear to be moving past-the-peak of inflation, with Q2 seeing the peak in North America and Q4 seemingly bringing the turn of the tide for Europe. However, as we move from the past into the present, changing macroeconomic conditions present a barrage of opportunities for inflation to accelerate downwards, while balancing a collection of tail risks holding inflation at sticky levels.?

As we look ahead, one thing is clear: Inflation must continue to fall quickly, in order to renew the ability of central banks to proactively react to the economy that lies ahead rather than that of the past. Too high inflation is tying central banker’s hands as they must address inflation first, before being able to focus on other important aspects of their (ex- and implicit) mandate. If inflation continues to steadily decline, central bank flexibility will return, and with this, the increased stability to be afforded to markets and economies alike.??

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A Sizeable Spread of Surprises?

In the chart below, reflecting the Citi Inflation Surprise Indices (i.e. how inflation data comes out relative to expectations/survey of forecasters) for multiple countries/regions, it appears that the peak in inflation surprises has largely come and gone, with recent surprises coming increasingly to the downside. After a favourable CPI print in November spurred the performance of the best day in bond market history, economic data will continue to deliver volatility.?

The ‘live’ inflation view by State Street’s PriceStats (scanning/scraping the internet for online prices and building a daily price index) points into the same direction (below).

While the battle may not be over, the tide has turned significantly since the "peak” of the 2022 inflationary cycle. As the narrative continues to evolve, the release of CPI data from the US and Canada highlights that headline inflation appears to enter a disinflationary (slowing down the rate of inflation) phase as the structure of inflation has changed. While not under-reported, the most recent print highlights a key change in the structure of inflation; previously dominated by commodity price rises, year-over-year service inflation in the United States now exceeds commodity-based inflation. Extremely favourable weather in Europe alleviated some of the pressure for Eurozone energy inflation. ?

Many economists and policy makers argue that the outsized growth in Owner’s Equivalent Rent and the broader shelter category currently reflect an overstatement of current inflation, just as it understated the value in 2021. As rents and home prices continue to come under fire, the assessment of outdated leases will eventually lose prominence. Indicators of?a more up-to-date view of the rental market (Zillow, RealPage Market Analytics) point towards a meaningful slowdown – particularly in the hottest/leading urban centers. The time-lag for that to show up in the official CPI is somewhere around 12 months. ?

What is also clear is that not all inflation is equal, even with other nations, this is further proof of the idea that 2023 will not be unilaterally defined on a global scale. As the composition, and speed of inflation continues to diverge from country to country. Month-to-month values take precedence over the annual print given the relevance and timeliness of the monthly print, it can be more helpful to consider the trend of the past one to six months, in comparison to the entire year. This will be highly obvious to most of you, but when constructing the year-over-year inflation number – we know 11 out of the 12 monthly prints – we are just kicking the oldest one out and adding the latest one. We know that many of the older monthly figures are exceptionally high, and they will drop off, month after month. Creating a massive downward pressure for YoY inflation figures. ?

A Pragmatic Policy Pause?

As markets spent much of the past year asking when enough would be enough, with claims of “higher for longer,” “higher for shorter,” and “watch and wait” battling for market supremacy. However continued diligence from central bankers sought to honour their mandate of price stability. We have seen Powell, Macklem and recently Lagarde become determined inflation fighters all within a few quarters?after downplaying the necessity of doing so. These 3 central banks delivered a collective series of hikes exceeding 1000 basis points, let by the Fed’s cumulative 425.?

As we look ahead, many inflationary concerns remain. The tactical drop in inflation appears to be a given, yet a major question for markets is about the stickiness of inflation above and beyond the big swings we currently see. While decades of reliance upon China and Russia for manufactured goods and energy respectively maintained stable prices in a time of peace and stability, globalization has become increasingly polarized. As proactive investments in renewables, and the reinvigoration of nuclear energy has provided strength to a energy-sapped west, supply chains are increasingly broadening after a shock to the core. While the reopening of China, emerging from years of COVID-Zero, may provide a catalyst on the supply side of basic goods, the outsized demand may provide an offset to the initial market relief. The significant event of the Chinese reopening will likely prove more inflationary.?Moreover – inflation is also a psychological phenomenon and as such, spending years in a high-inflation environment increases the likelihood of this manifesting in people’s behavior and expectations. ?

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In Search of a Steepening Slopes?

As policy and inflation diverge, from an investor’s standpoint, many ask the eternal question; what comes next? Just as with our Final Words at the end of our “4 Messages for 2023” article, we contextualize the same themes.?

Just as not all inflation is the same, our key message to start the year is that not all duration is the same. After 2022, which brought not only a shift upwards, but a significant “bear flattener”. These re-shaping scenarios are often reflective of changing expectations towards monetary policy, while long term rates balance long-term economic growth expectations, factoring in a duration risk premium. In the chart below, the Canadian yield curve is shown in blue, while the US curve is shown in green/yellow.?

In North America as policy expectations are expected to evolve, we begin to expect a re-steepening of the yield curve in the near future as inflation tames and the momentum of monetary policy softens. Should the inverted curve return to a baseline upward-slope, investors would see a nearly 5% initial yield compounded by positive price movement, potentially delivering mid-high single digit returns for high quality paper.?

However, when we look to Japan, not only have rates failed to recognize the growing stress of inflation, with the Bank of Japan lagging their peers in monetary tightening. Having seen the impact of rate hikes on much of the developed world, Japanese duration offers significant risk, while short positions present low carry cost and potential upside in the event of a hawkish pivot. Likewise, as Europe continues to hike, despite recession risks, peripheral economies such as Italy and Portugal face double trouble from a spread and rate perspective, as bearish headwinds persist.?

While macro conditions offer favourable tailwinds, uncertainty remains, with the reopening of China, presenting a potential high volatility catalyst. While the supply function increases, so too will pent-up demand, as was observed in North America. As a result, the outlook for global growth is uncertain, with a potential global recession ahead. As the world’s third largest economy looks to shift from the world’s most dovish policy, the world’s second largest economy emerges from a multi-year lockdown, and the largest economy seeks to conclude the fastest rate hiking cycle in modern history; the stakes are high, and the opportunities are generational.?

Here the advertised extra: If you have already played around with ChatGPT, you are probably somewhat fascinated by it . If you haven't, go try it out. Here is a rap about inflation written solely by Chat GPT - if you can beat it, or have any clever and creative outputs, please leave them in the comments or send them my way!

Congratulations on making it to the end - I hope that you found this piece enticing and educational... Economic data continues to evolve rapidly, inviting changing market sentiment, and the painting of a previously unseen picture. As inflation, the dominant theme in markets last year, begins to wane, the question of resilience and stickiness remains at the front of many investors’ minds. As the global economy is challenged by risks to globalization and continued tensions, regional opportunities continue to emerge within Fixed Income and multi-asset markets. I hope that this piece provides yourselves and your clients with insight and confidence towards the direction of fixed income markets.??

If you have any thoughts, comments, or questions - please reach out.??

All the best,??

Konstantin?