Because inflation will not cool too much

Because inflation will not cool too much

Inflation visions and forecasts. The analysis by Alessandro Fugnoli, strategist of the Kairos fund

Until the beginning of the summer there was only one story. Strong recovery, transient inflation, pandemic under control. With a unique narrative, equity markets have only followed one direction, upward.

It was a very favorable period for portfolios, but not very stimulating on an intellectual level. In fact, everything appeared to be planned from above as if there was a sort of central planning office in charge that dictated the way forward.

The path appeared marked not only for 2021, but also for the following years at least until the middle of the decade. Investors had no choice but to take note of the semi-nationalization of economies and markets and calmly get in the wake of the equity rise, remaining structurally overweight and taking advantage of any downturn to buy more.

Then everything started to get complicated. The delta variant, persistent inflation, demand here and there limping or falling (think of cars), supply bombarded with problems of all kinds and, above all, visibly less elastic than prices (just think of energy and the labor market). Accustomed as we were for forty years of supply economics to seeing flexibility, fluidity and abundance in every corner of the world and in all production sectors, we have awakened in a stiff and stiffened world.

If the 2008 crisis had been a crisis of finance and its blocked pipelines (with Bank A not trusting to lend a penny to Bank B and vice versa), today's world was beginning to appear malfunctioning in the real economy, in particular in the goods blocked on the ships or in the ports, in the energy at risk of rationing and in the people who remained at home unoccupied while the companies were looking in every way for someone to hire.

This rude awakening in the new world where demand works better but supply works worse has blown up the narrative in unified networks and forced everyone to resume thinking for themselves and formulating new hypotheses about the present and the future.

Thus began a less rewarding phase for portfolios but much richer and more stimulating on an intellectual level.

Alongside the official narrative, which nevertheless continued to inspire a significant part of the market, other highly different hypotheses emerged. We group them into three research paradigms and summarize them briefly.

Stagflation. Even the horrid has its charm and stagflation at this moment exerts a Seventies suggestion that becomes almost irresistible if an energy crisis is added to persistent inflation and declining growth. It is a very useful hypothesis to create amazement and disappointment but it lacks, at least, one of the two legs on which it should march, namely stagnation.

Risks of recession and deflation. This is a hypothesis presented as a tail scenario by its own supporters, but it is interesting in its radicality. Moreover, it has many historical precedents in war economies in which the spending boom financed with money or debt is replaced, after the war, by a recession accompanied first by inflation and then by deflation (think of the depression of 1920-21).

Those who put forward this hypothesis highlight the Chinese slowdown, the deflationary thrust deriving from the real estate crisis, the growing difficulty in finding new infrastructure projects that make economic sense and the consequent willingness of the Chinese leadership not to follow this path anymore. Added to China is the possibility of a creeping and permanent global energy crisis that destroys demand in industry and takes away purchasing power from families.

It is then underlined that wage inflation does not compensate for the loss of purchasing power and joins the depressive fund created by the pandemic in making the recovery in consumption weaker than expected.

Then there is the possibility of policy errors similar to those committed during the New Deal, with premature fiscal and monetary restrictions that, in the presence of an unprecedented level of debt, risk stifling a fragile recovery in the bud.

2022 better than 2021. On the other hand, an increasing number of rumors (IMF, Goldman Sachs on the United States, German research institutes) cut their estimates for 2021 but bring back to 2022 the growth that did not occur this year .

Take the case of Germany. In October 2020, the Monetary Fund forecast growth of 4.3 percent for this year. Today, German institutions cut 2021 to 2.4 but raise the estimate for next year from 3.9 to 4.8.

What conclusions can we draw from this interesting cacophony of hypotheses? We have one left over.

The system of the official narrative that accompanied us in the first part of the year remains standing, but must be revised and corrected. Inflation will go down, but it will not return to two and rather settle on the abundant three in America (one point less in Europe). Growth will continue as a result of the backward demand for public and private productive investment and the replenishment of inventories. Supply bottlenecks will tend to correct themselves at least in part. Governments and central banks will be very cautious about returning to fiscal and monetary normality.

Having said that, as we have learned in recent months, the risks of queuing will be far from negligible. Some of these, such as energy, will be structural and will accompany us intermittently for many years.

Furthermore, nothing prevents negative alignments of events, probably temporary but fearful, from occurring. Apart from the possible geopolitical crises, unpredictable in time and manner, let's think of the most banal hypothesis of a negative alignment consisting of companies that have just filled their warehouses by taking advantage of the loosening of bottlenecks just as it flares up due to the cold (or the heat) the energy crisis and final demand falls, while the central banks have ongoing monetary normalization. Or let's think about the risk of a new Covid variant, today not calculated by any of the estimates in circulation.

So let's try to remember the lesson we have learned in the last three months even when the market, as it seems to want to do, picks up its tone, returns to highs and tries to score new ones in the coming months. We remain constructive, but prepare for more difficult markets and slower, more erratic rises.

This is a machine translation from Italian language of a post published on Start Magazine at the URL on Sun, 17 Oct 2021 05:49:22 +0000.