Inflation: What If It’s Higher For Longer? Bonds Or Stocks?

Authored by Bill Blain via MorningPorridge.com,

“What do you mean you can’t swim, the fall’s going to kill you!”

There are lots of outlooks and scenarios on the inflation threat: what if its longer and turns stagflationary, and just how much more destabilising would the fraxious global economy become?

Yesterday, I spent some time with two of Shard’s senior investment professionals discussing inflation – and the contrasting outlooks for the US and Europe. They are smart guys and have rein to think outside the box – one of the key reasons I joined Shard a few years ago. Together we recorded a new Shard Lightbite Podcast on inflation expectations. (It should be available on-line later this week – I will post it.) Toward the end of the Podcast I asked them both for their views on where inflation will be at year-end 2022 and 2023, and gave them a straight choice: Bonds or Equity?

Both expect inflation to remain stubbornly high in the US and Europe, that Stagflation (recession plus inflation) is possible in the US and likely in Europe, and yet both favoured bonds (on the basis real yields may be below inflation, but at least you get your money back…) As said; the podcast will be available shortly – but broadly; persistent inflation and a stressed global economy is bad for risk assets, i.e. stocks! If they are right, and it looks to be happening… the current stock rally could still prove a massive bear trap.

(Remember – Blain’s Mantra No 1: The market has only one objective: to inflict the maximum amount of pain on the maximum number of participants.)

Of course, the recent rise in US stocks and Treasuries says otherwise! Give or take Nancy Pelosi starting a war or the San Fran Fed Head, the lines on the charts suggest markets believe US inflation will prove short-lived, recession can be avoided, and the Fed will calm the pace of anti-inflationary monetary tightening. I wrote about it yesterday and concluded the early US recovery and growth scenario makes sense – if inflation can be tamed – and that Europe faces a much tougher time.

Ding Ding Ding!… alarm bells going off in my head…

Over the nearly 40 years I’ve worked in finance I’ve come to understand the dangers of looking at the global economy and financial markets in terms of “snapshot” explanations. Typically, the market commentariat discerns the future in linear terms; how the shape of a graph describing what happened will determine what happens next by referencing what similar shapes have done in the past, what a particular number or event means for markets based on experience, and how the behaviours that drive markets are largely predictable.

Funnily enough, if enough people believe in what a chart is apparently showing them – then it can predict what happens next:  if the individual participants that make up the market collectively believe in the chart, then it’s their collective vote that determines what happens next. If I can persuade enough market participants Pelosi going to Taiwan will trigger WW3, then then the market will trade accordingly.

However, facts and beliefs don’t always coincide.

The problem with inflation is it’s not a snapshot event. It’s a trigger event for much wider consequences and fundamental change – and the effects of the current inflation shock continue to ripple out across the global economy in so many ways they become effectively impossible to predict or model – with conventional thinking.

We know this inflation event is different; triggered by the collapse of global supply chains during the pandemic, the subsequent pandemic responses and changing geopolitical tensions, all reinforced by the consequences of Russia’s invasion of Ukraine – which includes the chronic energy insecurity of Europe. But we also need to factor in other sociological factors. (Wow.. a market strategist using “sociological” in a comment.. is that a first?)

At best we can make educated guesses on the economic and behavioural events we can expect to see in coming months. We tend to think in terms of linear consequences, like price inflation driving wage demands – and rising industrial tension, but this time it could get more serious… If you want to understand where we are going, I suspect we need to look through a glass darkly:

First up is the structure of global trade and production.

Everyone assumes that Covid restrictions in China will prove short-lived, will ease, and trade and supply chains reopen. Not so. Supply chains are evolving and encountering new splits and hurdles. These are being exacerbated by rising Geopolitical tensions – such as Nancy’s shopping trip to Taipei. Global Trade and manufacturing will remain stressed for longer.

Second up is conflict.

Europe faces some ultra-bleak challenges in coming months as winter bites and gas prices rocket. Energy insecurity is going to bite across Europe – and inflict serious economic and political damage.

Third up is Society.

Since the global financial crisis that began in 2008 we’ve seen extraordinary monetary experimentation by Central Banks to sustain the global economy – with the bonus effect of boosting markets. Almost immediately, smart traders realised Central Banks distorting cash and liquidity was a free-good for markets. So it proved: from 2010-2022 the value of every single financial asset (stocks, shares, you name it) went up, fuelled by the cheapness of money.

The result was a massive reallocation of wealth across the global economy towards the owners of financial assets. Wealth became increasingly concentrated in very few hands. Asset owners and the C-Suites saw their wealth multiply, while real incomes stagnated, middle classes were asset stripped, and new generations of workers find themselves with lower disposable incomes, no chance of climbing on the prosperity ladder, and increasing resentments towards a society that looks to be failing them. The rich can afford private doctors, the rest of us queue for weeks in failing bureaucracies.

I don’t believe in dystopian outcomes, but I do expect folk to become increasingly angry. Angry voters vote for populists who make grandiose promises, struggle to deliver them, and then have to distract the masses. That makes the world increasingly less secure.

To illustrate the point, let’s switch to the UK. The National Institute of Economic and Social Research – NIESR – sees a deepening cost-of-living crisis, 5.3 million more UK households finding themselves with zero fall-back savings, and rising food and energy prices putting more low-income families into poverty. It notes the high savings accumulated during pandemic lockdown are distributed “highly unevenly”.

In five weeks we will get a new UK Prime Minister, likely to be Liz Truss. I have no idea if she will be good/bad/indifferent. But I’m pretty sure nothing will really change before the next election in 2024 and the UK electorate will be looking for someone to blame. She is darn lucky the Labour opposition is so ditheringly week they can’t exploit it. In short, I don’t see any sign of a UK political fix – a necessary precondition for a sustained UK economy recovery – any time soon.