Listening to the news, a political debate, or overhearing a conversation on the bus (yes, I ride the bus), the one recurring topic appears to be inflation. This should not be viewed as the wisdom of the crowd as once an economic topic reaches the masses, it is often completely priced into the market or about to start reversing. Now that isn’t a well-researched cause and effect relationship but the easiest cure for inflation, outside peace in Ukraine, is slower economic activity, which is happening.
There is no denying the global economy is starting to slow. Rate hikes, tightening financial conditions, a strong U.S. dollar, higher energy prices, China growth…the list goes on. This was widely expected by just about everyone. And over the past few weeks the fear from the market’s perspective has clearly shifted from inflation/yields/Fed to the global economy. But this market is pretty manic in how it reacts to news, perhaps because of the preponderance of bad news so far in 2022.
Some good news – inflation fears starting to fade
Inflation, or price adjustments, are slow-moving processes in the economy. An economy that we froze and then thawed, rather abruptly, caused many dislocations. And while inflationary pressures are not ending as the dislocations continue to reverberate through the economy, many of the previous forces are abating. Look at copper prices—they had been rising for most months this year and have now fallen 12% over the past month. Shortages are also easing.
Much of the inflation was caused by imbalances. Supply too slow to respond (due to Covid) to stronger-than-anticipated demand resumption. Shortages and a low inventory to sales in 2020 till near end of 2021 fuelled inflation. Now the ratio is better, supply is catching up as demand is starting to slow for general merchandise. This trend is evident in other categories as well from home furnishings to building supplies. Autos remain the outlier now as supply continues to struggle.
This improving trend is also evident during company earnings calls. The number of mentions among Russell 3000 companies of labour shortages, supply shortages, and supply chain disruptions has fallen this quarter. While the quarter is not over, about 90% of companies have held an earnings call so far. On the rise though is interest rates, which is a concern.
Inflation isn’t gone, but the upward direction appears to be. Yes, China lockdowns remains a risk for inflation, but the system appears to be getting more resilient. Also worth noting from a content perspective, household durables and apparel have a high China content—these two categories have seen some of the biggest slowing of demand, which should help.
It is difficult to have both slowing growth and inflation rising. As growth slows, the inflationary pressures should ease in the coming months. The bond market has already sniffed this out. 10-year U.S. and Canadian yields, which both reached 3.12% have retreated to below 2.90%. 5-year forward breakevens, a measure of how much inflation is priced into the bond market, have been falling over the past month after rising significantly in March and half of April. And the amount of Fed hikes priced into the futures market has stopped climbing and even ticked a bit lower.
Add all this up, the market is becoming less concerned about inflation. This is good news and has helped bonds once again start to behave as bonds should. That is, during periods of equity weakness, bonds have started to rise in price, providing a stabilizer for portfolios. A much more pleasant behaviour compared with the previous months that saw both equities and bonds falling together.
The following chart shows the performance of the S&P 500 and U.S. bonds since the beginning of December. What has made this a more painful corrective phase in the market is bonds have been falling with equities. This can be seen in the lower part of the chart, which is the two-week rolling correlation between equities and bonds. This was around zero or even positive for the past few months. Until recently, as the correction turned strongly negative, a more normal relationship between bonds and equities during periods of equity market weakness. Equity markets moving lower is never a good, but bonds behaving more as a stabilizer is a good encouraging that the price resetting may be nearing an end.
Less inflation is good news for markets but trading that news for rising recession risk is bittersweet. Admittedly, we did consider, “Out of the Inflationary Frying Pan and into the Recessionary Fire” as the title for this week’s Ethos. But it’s way too early to combine the word “recession” and “fire.” Yes, the probabilities of a recession have risen but it still remains far from the base case. We went down this road last week and will likely be going down the road again in multiple future editions.
Investment Implications
The cure for inflation has always been slower aggregate demand (that is eco talk for economic growth) and that is starting to materialize. This has already begun relieving inflation fears within the bond market, which likely has a better gauge on the situation than folks talking on the bus or the random interviewee on the news. This could open the door for a broader bounce, assuming the slowing growth talk doesn’t become too loud. Asset price correction (that is where we are now), market reprieve (bounce), and then another correction caused by slowing growth have remained our most likely path for markets this year. Of course, we say this with the cautionary note that markets typically surprise everyone in one direction or another.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L.P.
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