High levels of inflation in most advanced economies are starting to make some policymakers and households nervous. The recent rise in U.S. government bond yields and inflation expectations shows that some investors are worried about getting burned as last spring’s lows roll off year-over-year calculations and pent-up consumer demand is likely unleashed.
The 2007-08 Global Financial Crisis (GFC) marked a turning point in international trade. World exports fell by 10% in one year as global demand dried up. And while subsequently, exports recovered to pre-crisis levels, the growth rate slowed considerably towards the end of the last decade.
The three key driving factors were as follows:
- First, wage growth in emerging economies reduced the monetary benefits of offshoring away from advanced economies
- Second, new technologies (3D printing and artificial intelligence) reduced the benefit of labour cost arbitrage
- And third, trade tensions between the US and China disrupted global trade flows
But in 2020 another global economic shock changed the trajectory of global trade. As the COVID-19 virus swept across the world, governments tried to deal with shortages of certain goods and equipment by restricting their exports.
This is mainly related to ‘critical’ medical goods such as pharmaceuticals and PPE. This move also emphasised some of the downsides associated with having highly integrated supply chains that span more than one country.
Despite higher consumer spending numbers and a near-full labor market, significant macroeconomic concerns have given investors hesitation. For one, many industries are still dealing with a labor shortage that has left businesses across the country understaffed. Additionally, recent job reports show a growing number of people leaving the workforce, even as official unemployment numbers remain extraordinarily low.
The current food security crisis, oil price fluctuations, and precarious market positions amid the Russia-Ukraine war and China’s sustained lockdown are ringing warning bells, and experts expect stagflation to be a recession and have stagflation effects, namely depressing output and spending and rising inflation all around the world. Stagflation occurs when inflation and unemployment are high and economic output is low.
On the demand side, even though the rebound has been strong in the G7 (the Group of Seven is an inter-governmental political forum consisting of Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States), most are still operating with a significant degree of slack or an output gap.
The International Monetary Fund (IMF) estimates that this will persist for a few years for all of the G7 except the United States (US). However, the employment data suggests that even the US labour market is operating with significant slack.
On balance, we think that the risk of demand-pull inflation is low. On the supply side, large and unpredictable swings in demand have stretched supply chains and logistic networks. Nevertheless, we are seeing evidence that consistent with economic theory, prices are acting as signals to both producers and consumers to change behaviours.
The US is experiencing inflation at 40-year highs and the Fed is under pressure to try to bring some of those price pressures down before they cause serious harm to the economy, but there is also concern the central bank could tip the economy into a recession. The Fed raised interest rates by 50 basis points in May, the biggest increase at one meeting in 22 years to quell inflation. The faster hiking cycle will primarily fight inflation by weakening demand.
The bond market moves are more reflective of economic prospects and inflation worries directing moves for interest rates. Stock markets have fallen from record highs partly due to those concerns, with tech stocks hit hardest as investors sour on their valuations in a rising interest-rate period.
The five-year breakeven inflation rate, a rough measure of the bond market’s view of inflation over the next five years, is the highest level since July 2008. We believe that markets across various asset classes offer various buying opportunities and investors should capitalise on them.