Financial update from Brewin Dolphin - 12 August 2022
The Weekly Round-up
Friday 12 August 2022
In his latest weekly round-up, Guy Foster, our Chief Strategist, analyses what the latest US inflation and inventory figures tell us about the likelihood of an imminent recession.
Planes, like the economy, take off and land routinely. Passengers on those planes can normally rest assured that the landing will be a soft one. The rate of economic growth also rises and falls, analogous to the arcs of aeroplanes. However, it does so less frequently and the landings, in particular, can be anything but routine.
Over before it has begun?
Without meaning to stretch the analogy to breaking point, some economic cycles are distinctly ‘short haul’ in nature. These kind of mini fluctuations in economic growth reflect the way in which small changes in consumer demand cause companies to find themselves slightly over or understocked. Being overstocked results in companies placing orders with wholesalers, for whom the effect is exaggerated and who, in turn, need to increase their orders from manufacturers. This bullwhip effect causes inventory cycles every three years or so, most of which do not result in a recession. We’re just a month into the third quarter, but already it appears that the inventory drawdown may have eased – reducing the only recessionary force that had been at play.
Or a taste of what’s to come?
The longer economic cycles that are more likely to result in recessions are similar, but instead of inventory levels, it is employment levels that drive the cycle.
The difference between the two quarters of negative growth that the US economy probably suffered during the first half of 2022, and a more classically defined recession, is that so far this year we have only seen an understandable adjustment in inventory levels. What we have yet to see is any weakening in the labour market. This week’s jobless claims continued to trend higher but remain at a very low level. There is continuing evidence that the labour market is loosening slightly, even though there is currently an outright shortage of workers.
The factor that would trigger the labour market to move into a position of excess workers would be a significant decline in demand. The sharply inverted US yield curve suggests that investors are anticipating this. They likely see current levels of consumption as unsustainable with wages falling in real terms (after adjusting for inflation). Wage growth and inflation are critical components of recession risk. During July, wages seemed to grow at a faster rate than inflation. That reflects fairly strong wage growth but also a very low hurdle from inflation, as the US consumer price index didn’t increase at all during July.
As ever, the most meaningful driver of inflation is energy. What’s driving the weakness in oil is a decline in global oil consumption relative to production. Part of our justification this spring for believing that oil prices had peaked in March was that, historically, when global oil consumption drops below production for the first time in the cycle, the oil price tends to peak very shortly afterwards. So far that appears to be playing out.
Oil does not contribute directly to CPI, but oil products do, most notably gasoline. This has actually been surprisingly weak, suggesting that oil consumption is back to levels last experienced when the economy was locked down. It is possible that oil has become more price elastic, with the advent of hybrid working perhaps allowing employees to save on commuting costs by working from home more often. But it is certainly surprising that this would have such a big effect on oil consumption.
Food for thought
Another key driver of inflation is food inflation, but that was actually quite strong in July. The decline in food commodity prices will likely cause some of the pressure on food CPI to ease eventually. The fact that food exports are now able to leave Ukraine by ship is another positive development. More generally, the strong dollar dampens inflation in imported goods, and supply chain pressures have been easing in recent months. Consumers have been reducing their purchases of goods which were elevated during the pandemic. Services consumption still remains subdued, but the pockets of travel-related services prices that have contributed towards very strong inflation in recent months all declined during July.
Federal Reserve angst
Continuation of these trends would see inflation lower still, but it is hard to see it getting close to the Federal Reserve’s 2% target without adjustments in two additional factors.
Firstly, the labour market is tight, enabling workers to demand higher wages as we have discussed above.
The second factor that should keep inflation from decelerating too quickly toward the Fed’s target is shelter. Shelter in the CPI tends to follow what happens in the residential rental market, with a lag. A leading indicator of rent inflation comes from Zillow, which has been reflecting double-digit rental growth. Shelter CPI will rise slower than that, as it takes time for tenancies to come up for renewal and incorporate the higher rents. However, this means it will continue to rise for longer too.
These factors mean that even though inflation will come down, it will likely take a long time to get back down towards the target rate. These data are welcome at the Federal Reserve, which has tightened policy substantially but has so far seen little effect on inflation. Tightening has slowed housing market activity, although it is not yet reflected in house prices or wages and therefore will take time to lower inflation.
Inflation around the world
Outside the US, several other countries announced their inflation rates for the month of July with far less impact. The inflation rate may have stabilised in Germany and Italy, but continues to climb in France and Spain. Throughout Europe, it is historically very high.
China’s CPI rose in August, but despite a rebound in pork prices the increase was less than expected (to a mere 2.7%). Producer prices slowed too and, if this continues, may also contribute to lower inflation for China’s trading partners. Survey data shows a weakening Chinese economy and, despite loose monetary policy, consumers and companies aren’t borrowing. Outside of officially sanctioned infrastructure projects, demand and supply of loans has been weakened by mortgage boycotts from consumers who are unhappy to be paying for loans on properties that have not been finished due to cash shortages at developers.
A return of animal spirits to China may seem unlikely. Typically, however, a weak monetary environment and weak housing market tend to spur stock prices because Chinese savers have a relatively limited choice when deciding how to invest their savings.
A stronger growth environment with slower inflation is the kind of thing that would normally be considered a goldilocks environment for global stocks (inflation not too hot, growth not too cold). It doesn’t seem quite the right label at a time when inflation is in the high single digits and growth is negative, but it is the change that matters for investors.
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