Exposure rates of the Dorval Asset Management Range – 6th May 2022
From these various inflation components, the dent from the surge in commodities prices is shared across all households worldwide, slowing consumer spending in the short term, as already indicated by consumer confidence surveys. However, there are major disparities from one country to another (cf. chart 1) depending on the energy mix, tax and the degree to which states and public corporations absorb the shock. The short-term outlook for this type of inflation will hinge largely on the extent of continued escalation in Western sanctions on Russia, as well as the degree of protective tax measures set up. Meanwhile in oil-producing countries – including the United States – rising commodities prices are generating profits and partly offsetting slower consumer spending.
Energy shock varies greatly for consumers from one country to another
Energy component of consumer prices (source OECD), % chg. since Oct. 2021
Italy / Spain / Germany / France / United States / Japan / UK / China
The second type of inflation covers various supply difficulties, particularly the hangover from the Covid period i.e. inadequate inventories, delivery costs and timeframes, shortages, etc. Additionally, recent lockdowns in China and the war in Ukraine have exacerbated the situation in certain sectors, particularly in Europe. Meanwhile in the UK, these effects add to the impact of Brexit. However, certain indicators do point to the beginnings of an easing in the situation, such as on used car prices in the United States, and sea freight prices. Vehicle production and sales are already recovering in the United States, while figures are plummeting again in Germany (cf. chart 2). Things should continue to ease out to the end of the year, particularly if China somehow manages to get over its Omicron outbreak. German carmakers thus expect a gradual improvement in sales and production in the second half of the year.
Automotive production rising in the US, but flagging again in Germany
Automotive production in Germany (LHS) / Automotive production in US (RHS)
Lastly, the third type of inflation – the pick-up in wages – raises no threats for growth in the short term, but actually most often reflects a boom on the labor market. However, this wage acceleration is a threat for medium-term growth when its momentum worries central banks and compromises their pursuit of price stability, which they have defined as 2% inflation in developed markets. This is where situations vary most from one region to another.
In the US, this type of inflation is the main reason behind Jerome Powell’s moves to step up monetary tightening. In the words of Milton Friedman, the lag in the economy’s reaction time to these rate hikes is “long and variable”, so investors fear that the Fed will end up triggering a recession in 2023 as it strives to combat growth and keep a handle on wage inflation. The likelihood of this scenario will vary over the months ahead on the basis of multiple factors. Ironically, the probability of this outcome would decrease if US activity were to moderate swiftly as a result of the rising cost of living for households, which would reduce the risk of a continued surge in interest rates. The likelihood of a recession will also hinge on wage momentum, which seems to have moderated slightly over the past three months (cf. chart 3), as well as the pace of core inflation, which was on a better trend in February and March 2022. Investors will pay very close attention to these various figures over the weeks ahead.
Wages in the US have increased at a slower pace over recent months
Hourly wages in the private sector, annualized changes
Over 1 year / Over 6 months / Over 3 months
Wage inflation remains high in the UK at around 5%, with the Bank of England hiking interest rates to 1% on May 5th. However, the bank published projections that point to a stagnation in GDP for several quarters as a result of the rising cost of living and supply difficulties that have been exacerbated by Brexit. Between the stagnation expected in its models and high inflation, policies from the so-called Old Lady of Threadneedle Street are becoming increasing unpredictable.
In the euro area, the wage question remains less of a worry for the ECB at this stage, with rises of 2-3%. The labor market is definitely undergoing pressure, but with war on Europe’s doorstep, the situation is not conducive to meeting major wage demands. The ECB’s increasingly clearly stated aim is to put an end to negative interest rates by the end of the year. However, unlike the Fed, the European Central Bank does not intend to put the brakes on an economy that is already hampered by the situation in Ukraine.
In Japan, wage inflation remains low, while inflation is under control. For the moment, the country enjoys a solid position with the economic recovery gathering pace on the back of the economy reopening post-Covid, but without excessive inflation.
Lastly, looking to China, the question is completely different in the country, with regulated energy prices and a fresh Covid crisis. The economy will need more support over the months ahead, with the hope of a clear recovery once health restrictions are relaxed.
On the markets, investors quite naturally remain troubled by the ongoing deterioration in the growth outlook resulting from the inflation triple whammy. We slightly trimmed our equity exposure again this week. On the international arena, the broad diversity of situations substantiates our conviction of the importance of extensive regional and sector diversification supported by our equal-weighted approach. Asia’s (25% of our equity exposure) relatively more favorable situation on inflation in particular helps partly absorb the shock from the market dip, although international markets still remain correlated.