Deflation or Stagflation – we’re at risk!

Markets are at an inflection point: bonds are more attractive, but credit risks rise in a deflationary bust? Or should higher oil prices remind us what triggered inflation, and raise the risk of consequential Stagflation!

Blain’s Morning Porridge, Sept 6th 2023: Deflation or Stagflation – we’re at risk!

“You can’t have sustained economic recovery in a time of repeating financial crises.” 

Markets are at an inflection point: bonds are more attractive, but credit risks rise in a deflationary bust? Or should higher oil prices remind us what triggered inflation, and raise the risk of consequential Stagflation!

As rates peak and UK National Savings with a 6.2% yield look the best risk/return proposition on the market, it’s clear we need to do some scenario thinking. I like the idea of owning a UK government guaranteed security, paying almost as much as cash-challenged, debt-burdened, managerially incompetent, profit-addled corporates with tired product range aimed at broke consumers. Yep. That about sums it up. Risk is relative. Timing is critical.

According to many analysts, the most likely scenario for the global economy is a relatively containable “deflationary bust”. Inflation will continue to fall, but recession risks (the conventional cost of curing inflation by cooling activity) will rise as consumer spending adjusts downwards, companies slow production, hiring and profits fall, while China’s slowdown is exported around the globe – with further falls in prices as a result. Markets can live with that.. and even start to buy into recovery around the corner.

That’s conventional wisdom. It might not be how it plays out. Every successful nation is successful in the same way, but every broke nation is broke for its own reasons. Every economy is different – there is no reason to expect the same outcomes across the West.

If we are very, very lucky, Central Banks fine tuning interest rates, and the magic of their words, may achieve variations on a “soft landing”, where the economic pain is minimal. It’s a fact central banks have limited policy options, but their influence is all about how they wield words and influence sentiment – their most powerful lever upon the economy. In other words; it’s not facts, but how they are explained that matters. That’s why legends like Alan Greenspan, or more recent “stars” like Mark Carney, are so “famed”. The current Bank of England incumbent, Andrew Bailey, is less scintillating and has proved less effective at steering sentiment, even though he has the requisite skills and knowledge.

The power of words as employed by central bankers illustrates how markets, inflation and economics are not mechanical. They are subject to “Headology”, the multiple ways in which sentiment, psychology, rational and irrational behaviours interreact with facts, data and numbers in the everchanging soup of opinion, rumour and sigh we call the economy.

A soft landing is rare. If you believe it likely, I have some Blue Cheese mines on the Moon we should probably talk about.

Folk forget a falling inflation rate means prices are still rising – just a little bit slower. Falling inflation is seized upon by governments and central bankers as a win, and the populace thinks they are in the clear. They resume spending, but the gap between incomes and costs continues to get wider – and the squeeze between the two continues to impact present consumption. The effect of inflation is like compound interest… compound inflation is long-term. Consumers think they are saved, bring forward spending plans, exhaust their savings accounts and continue to ramp up the credit card.

I experienced compound inflation in action last night. The division of labour in the Blain household leaves me something of a stranger to the weekly supermarket shop. (I am not trusted.) She-Who-is-Mrs-Blain has been away, back home in North Wales looking after the parents. I decided to surprise her by picking up just enough to fill up the fridge with fresh veg and restock items in the larder. (I am trying to build an illusion I am domestically competent – on which the jury remains out.) I knew we needed some decent Olive Oil. £12? FFS! 2 bags of goods came to over £100, and no big ticket items.. but £3 for good butter, £10 for the ready-made Chicken Tikka I know she loves. Food inflation is very real. Why?

The costs of food production, especially fuel, logistics and labour have gone through the roof. These costs are not coming down, but are still rising.  How fast? It all depends on “events, dear boy, events,” as a Prime Minister Harold Macmillan responded when asked what scared him most.

Conventionally inflation occurs as a result of too much money chasing too few goods and services – “each and everywhere a monetary phenomenon” as the monetarists blather and chunter on about. But this outbreak of inflation is very much more event driven – a shock in the price of energy, triggered by the outbreak of the Ukraine War. And now energy volatility will be sustained by the new geopolitical reality.

It looks like the West has won the war on Gas prices, dealing competently with the stranglehold Russia thought it had over Europe via the Gas pipelines, but high energy prices remain a threat. (All it takes is a strike in Australia to send up prices of gas again.) Oil at $90 a barrel is such a threat. Saudi Arabia’s flexing of its oil-muscle by extending production cuts is not just economic, but a clear signal to the West: don’t mess.

We will see the effect of higher oil very quickly as inflation numbers drop less quickly, and costs of production, pushing up food costs, start to rise again. Ahead of next year’s critical US and UK elections its worth remembering the cost of “gas at the pump” is the clearest signal voters have about the economy. It’s always about the “Economy, Stupid”, so it’s a massive negative for Biden and Sunak. Across Europe higher petrol prices will quickly feed across the economy and spur renewed wage-inflation as that all-import income-to-costs squeeze gets tighter. Thus far, Europe has avoided a “summer of discontent”, but this late September summer the UK is finally experiencing could yet see social unrest on the back of renewed, oil-triggered, inflation.

The thing is, again, its not conventional monetary policy mistakes that has triggered another outbreak of inflation pain, but exogenous actions – this time Saudi looking to boost prices and assert its power – that is moving prices. It begs the question – are higher rates and cooling the economy (economic levers designed to fight monetary inflation) the right instruments to address geo-political realities? Just asking.

In the event a sustained rise in oil prices reignites the inflation fires, just as the economy slips into the engineered “deflationary bust” recession… well, that is dangerous. That’s called Stagflation – recession and inflation combined.

A nasty dose of stagflation will have all kinds of economic and market consequences – demands for higher yields will hammer bonds, stocks will suffer as demand continues to fall from maxed-out consumers, and pay demands (embedding the nail of wage inflation right into the government’s anti-inflation rhetoric) will rise. Higher interest rates for longer in an economy struggling already? This could get very painful and messy very quickly.

It begs the question – what is the right policy to deal with a renewed round of energy driven inflation upon the economy? Can government bear the cost? They can draw down reserves – which is why everyone will be watching oil strategic depots. They can cut taxes, or they can bail out consumers and producers, but that requires the market to be confident in bond markets (to raise the necessary funds) and in government competency to address the crisis.

Here in the UK the current government, trapped by the consequences of the Trussterf*ck last year, is committed to addressing inflation by conventional means. They have no choice – the markets trust them not after Kwarteng and Truss single-handedly upturned the UK’s virtuous sovereign trinity of a stable currency, a sustainable bond market and political common sense. Sunak and Hunt have no choice but to hope, pray and gamble on inflation remaining low – and that means hoping for petrol prices to fall. Hope is never a good strategy.

My conclusion? A deflationary bust is still most likely, but rising energy prices should remind us this is different, and that puts Stagflation and unintended consequences up the top of the threat board.

Five Things to Read This Morning:

WSJ                  Russian and Saudi Oil-Production Cuts Flash Warning on Chinese Economy

FT                     Global Financial Watchdog warns of “further challenges and shocks” ahead

BBerg               ECB’s Knot Says Market Risk Underplaying Hiking Chances

Torygraph         “Skimpflation” is the latest neat trick from the multitrillion food industry

Guardian          UK workers will be worse off in 2024 than in 2019, thinktank warns

Out of time and back to the day job!

Bill Blain

Strategist – Shard Capital