Financial markets have an inflation problem – and it’s not going away
With inflation running rampant, economists agree that US interest rates should be materially higher than they are today. But what would it mean for markets if they were? What are the risks from the Ukraine crisis? Are China’s markets really undervalued? Monetary policy experts and a stock exchange leader share their views.
Stanford University economist John B Taylor in 1993 outlined a data-driven formula for US interest rate policy that has become an integral part of economic theory. With inflation now at a 40-year high, the Taylor rule that was named for him calls for interest rates to be at 4% or 5% – or even higher, depending on the calculations used.
The Federal Open Markets Committee (FOMC) decided to raise policy rates by 25 basis points at the March 15-16 meeting, and has signaled its willingness to do more. But the target range for the Federal Funds Rate remains at 0.25-0.50% and Taylor believes the Fed is moving too slowly.
“We can't just hold it at wherever it is now, forever,” Taylor told the 25th Credit Suisse Asian Investment Conference (AIC). “If it was 3% at the end of this year, that would be in the right direction. But they seem to be below that even at this point in time.”
Taylor is not alone in believing that the Fed has been behind the curve. Mohamed El-Erian, President of Queens' College at the University of Cambridge, Chief Economic Adviser, Allianz, and former Chair of the Global Development Council during the Obama Administration, shares a similar view.
“Just to illustrate how far behind the Fed is, in a week in which we got the last inflation print of a CPI of 7.9%, the Fed was still purchasing assets. The Fed was still injecting liquidity into the economy; it still had its foot on the accelerator.” he said.
James Bullard, President & CEO of the Federal Reserve Bank of St. Louis and a voting member of the FOMC, also argues for more action. A dissenting voice at the March policy meeting, Bullard views a 50-basis point increase as more appropriate.
“We are certainly moving in the right direction, but you have to move at a pace that makes sense for the situation,” he said. “We were at zero because of the pandemic, so it makes sense that we have to move quite a bit to get to neutral here to make sure we're not continuing to put upward pressure on inflation.”
Bullard points to the 1994 experience, when rates rose by 300 basis points in a single year. In the following years, inflation stabilized at around 2% and the economy boomed in the following years.
This dramatic reset of interest rate policy has significant implications for investors, but economists worry that the market believes the Fed may not stay the course.
A wild ride for markets
The US’s first interest rate increase since 2018 arrived at a time when global markets are reeling from higher commodities prices and international sanctions in response to the Russia-Ukraine conflict.
The week of March 14 saw extreme market volatility with the benchmark Hang Seng index falling by 10% in just two days, before rebounding, with technology stocks proving especially volatile.
But Andrew Garthwaite, Head of Global Equity Strategy at Credit Suisse, sees a strong case for remaining overweight Chinese equities, noting that valuations are now at historic discounts to global stocks. Chinese policymakers have also indicated their support for the economy despite renewed Covid-19 lockdowns and pledged to work towards restoring market stability.
“The excess liquidity will likely go into financial assets as policy is eased, given capital controls and the reluctance to restart a housing bubble,” said Garthwaite.
In the longer term, Nicolas Aguzin, CEO, HKEX, believes China’s capital market is “a once in a generation opportunity.” He expects the Chinese debt and equity capital markets to grow to US$100 trillion by 2030 from around US$30 trillion, given China’s relatively low levels of equity ownership as a percentage of Gross Domestic Product.
Is the US overvalued?
While monetary policies in China and the US are moving in opposite directions, capital market volatility has become a common factor.
The Fed’s Bullard warns that there might be excesses in some parts of the US financial markets. He points to rising house prices and rents, as well as high valuations for non-traditional assets, as potential examples.
“Obviously, equities have sold off in the first part of this year so there's probably less froth there than there was, but there's certainly points of the US economy you could point to that look like they might be overvalued,” he said.
Warning signs are flashing in other areas, too. Higher energy prices threaten to erode corporate earnings by squeezing margins, and the sudden spike has triggered warnings of a recession as consumers rein in their spending.
Jonathan Golub, Chief U.S. Equity Strategist and Head of Quantitative Research at Credit Suisse, argues the opposite, though.
“There is little question that revenues – measured in dollars – rise with inflation,” he said. “A common investor refrain is that higher commodity prices and input costs put downward pressure on margins. While we understand the logic behind this argument, the data indicates that margins move in tandem with higher materials.”
Inflation is here to stay
Inflation and the policy response are likely to remain at the top of the agenda for investors in the coming months.
US inflation hit a fresh 40-year high of 7.9% in February, when the spike in commodity prices following Russia’s invasion of Ukraine were not yet fully reflected in prices.
The conflict is creating upward pressure on inflation, compounding the effects of the recovery from the pandemic. Higher energy prices and the impacts of Russian sanctions may well prove short-lived, but investors have learned not to rely on short-term reversals.
“These are things which we hope are transitory – and I use that word, which is out of popularity at this point,” said Stanford University’s Taylor. “But the difficulty is distinguishing the things that are happening because of that and the things that were happening before.”
There is a case for expecting inflation to be a persistent problem, as supply side factors such as shipping and labor remain tight because of the pandemic.
Covid-19 prompted many workers to retire or exit the workforce, leaving companies competing for staff as they resume normal activities.
“At least in the medium term, I'm not really expecting a lot on the labor supply side, although I will say the most recent jobs reports have shown improvements in labor force participation,” said Bullard at the Fed.
El-Erian at Allianz argues that stagflation – high inflation and low economic growth – is becoming a baseline scenario, rather than a tail risk.
“I think the transitory question has been answered. It is not transitory,” he said. “We have got an inflation issue. I would have said that before the invasion of Ukraine, and the invasion of Ukraine has made the inflation issue even more challenging.”