Blain’s Morning Porridge – May 9th, 2023: Stagflation is much more likely than Deflation – prepare accordingly..
“Hope is never a strategy.”
This morning: The Market Commentariat think deflation will counter inflation, rates will fall, and recession will be limited. The world is more complex – supply side factors are more volatile. Stagflation is a more likely outcome than recession.
I seem to have developed a reputation as an uber-bear. On recent Radio/TV appearances I’ve been greeted as a bad-news Cassandra, always warning of economic catastrophe approaching around each and every corner. Nonsense. I am a happy person with a bright and sunny disposition who only sees joy and happiness in the spring sunshine and bluebell woods…. (Sarcasm alert.) I do believe things are never as bad as we fear… but that doesn’t get you air-time! The critical point is we need to understand the reality – and my concern today is markets are completely misreading the threat-board. Its worse than they assume!
Why? This week will be dominated by inflation. Just how sticky will US core inflation look when we get CPI tomorrow? The market risk is inflation across the West proves more persistent than the market bulls have been praying for. We might be headed for something different and much worse– recession and sticky prices in some economies; Stagflation!
Yesterday, I noted a number of banks quietly rowing back expectations Central Banks are about to start reversing the recent run of rate hikes – putting cuts back to 2024. Macro hedge funds are shorting rate cuts. What do they know that we don’t? They’ve got a view on sticky inflation and how central banks will respond.
Deflation is a hope – not a reality.
The professional market commentariat of economists, analysts and guessors, are largely talking about deflation – that interest rates will shortly come down in line with inflation as a result of downwards pressure on prices. Reasons for them to think inflation will fall include the slowing economy, declining demand for goods and services as a result of crashing discretionary consumer spending, but also that recession will be limited by the reopening of the global economy and supply chains post-Covid (particularly in China), boosting the supply of cheap goods. There is a general expectation spikes in food and commodity prices will reverse in much the same way as energy prices. And, the collapse in “broad money” “M2” is seen by the monetary augurs as proof positive that prices must fall.
Conventional thinking for unconventional times.
Wishing for deflation to magic away the present raft of troublesome economic issues is not a good strategy. It falls into the same bucket of misplaced hopes as Central Banks telling us how “transitory” inflation would be last year. Conventional wisdom says inflation can only be addressed by higher rates – any phule know that! But real interest rates are still negative – clearly unaddressed. (Sadly, the truth is employing economic austerity to pray away stubborn inflation that’s been triggered by a series of exogenous shocks isn’t likely to work – a lesson in political economy we really need to talk more about..)
To figure out what comes next in inflation and thus interest rates, we need to understand the current crises in supply and demand, and the fundamental causes of the current market instabilities and uncertainties. The market is full of contradictory signals.
Yesterday was a bank holiday here in the UK, but US 3 month Treasury-bills hit 5.2% (a 20-years plus record level). That was partially a reflection of fears a US debt ceiling shutdown will hit as early as next month, but also the reality of an inverted curve presaging recession. Warren Buffet told his audience at the annual Berkshire Hathaway jamboree a downturn is coming: “Get used to making less.” He has been selling stocks this year.
One analyst report informed me the collapse in container prices from Asia to Europe is profoundly deflationary, while another said it is normalising the volatility in shipping costs and a sign of a stabilising market. Taken in conjunction with the slower than expected pace of the Chinese economy, I humbly suggest it means less goods are being shipped. Global trade has changed – in line with changed geo-politics.
The economic reality of the last 25 years has been global deflation in the price of goods – primarily on the expansion of the Chinese and other Asian economies as cheapest-to-produce economies. Lower prices has had profound economic consequences on the West – pricing out domestic production in favour of imports. (Over the weekend I read how the UK is having to import the steel for new frigates from Poland – we allowed the strategic production of military grade steel to fall into abeyance.)
China’s priorities have changed. It’s no longer about growth to expand the economy and create jobs through exports, but about directing the economy towards rising domestic consumption. The simple reality is China is no longer the default cheapest-to-deliver manufacturer – and it will take years for new supply chains to establish that foregone production elsewhere as cheaply. (Look at Apple trying to shift production to India.)
What is inflation?
Inflation is a consequence of mismatched demand and supply.
We pretty much know what will demand will be – that’s why companies, banks and governments employ legions of researchers to measure and determine demand and thus what they produce and supply. The demand side of the economy changes slowly – in line with demographics. When we get a paradigm shift, as we are seeing in the switch from ICE to Electric vehicles, it has all kinds of complex economic consequences on supply chains and materials costs.
Supply is more volatile. It’s the cost of producing things that’s the primary variable in an economy. Key components in production costs include the price of labour and materials. A key factor in what we buy is its relative cost of production – the cheaper it is to make, the more will be sold. (The China effect!) At present the global economy is still adapting to a succession of supply-side economic shocks:
- Supply Chains
- Energy Spike
Each of these factors triggered a host of ancillary consequences – such as workers leaving the market or switching out of one sector to another, or redefining supply-chains. These are not “transitory” – they have long-term effects how the supply side of the economy works.
Post-Covid we had a brief demand side inflation spike, fuelled by money not spend during lockdowns, and economies reopening. We are now into the supply side inflation. Companies are being accused of artificially pushing up prices – but their material and energy costs have risen dramatically and become increasingly uncertain. Across industry I am hearing multiple supply chain issues that could take years to stabilise. For instance; in the aviation market the supply of parts is severely constrained, and combined with a shortage of engineers (many retired during Covid or left the industry), its taking months longer for planes to be serviced and maintained – thus pushing up costs.
At present the costs of labour remain elevated. We know that from both the resilient US employment reports – which keep surprising to the upside, and from the shortages of labour across all aspects of the economy in the UK. There is no downside pressure on wages from the slowing economy. As the current slew of strikes in the UK and across Europe highlight, workers are complaining they are not paid enough to meet basic needs.
What does it all mean: Deflation or Stagflation?
Strip if down to the basics and I doubt we are in a deflationary environment – that is just too simple a view of the complex global economy.
Global supply chain uncertainty and reinvention, shifting trade patterns, commodity volatility, and labour shortages will keep prices unstable for longer. I suspect inflation remains highly elevated for longer. Addressing it by cutting wages is not sustainable. Governments and central banks may need a rethink on wages – which will further fuel inflation. Therefore, in a slowing economy, when nations like the UK have stalled… Stagflation rather than deflation looks nailed on
Not an easy call..
UK: I was asked whether we should worry about UK Gilts in wake of expected increased supply. My answer is no, but we should worry – because after the Tories were humiliated at the polls last week, the pressure on PM Rishi Sunak to pander to electorally pleasing policies from within his own party is increasing. There were even muttered rumblings of yet another revolution and his possible replacement. That would be yet another clear break of the UK’s Virtuous Sovereign Trinity of a stable currency, a sustainable bond market and competent politics – resulting in yet another Lis Truss style economic disaster. Watch this space.
Stripe: Last week I went off on a rant about Stripe and the impossibility of getting any help to resolve an issue trying to set them up on the Morning Porridge. I got an email direct from the CEO, and co-founder of the company – Patrick Collinson. He apologised for the problems and committed his senior leadership team to fixing the problem. It happened. They sorted it. Respect to him. I now a Stripe fan.
UK Coronation: The undoubted star of the Coronation was Princess Anne’s Red Hackle on her Admiral’s Hat. Seated directly in front of the Ginger Whinger, the hackle obscured his face for the whole event. Brilliant – someone on the production/planning team will get a gong for that.
Five Things to Read This Morning:
Bloomberg Vanguard’s Trillion-Dollar Man Leads a Fixed-Income Revolution
FT Bank of England set to raise rates to highest level since 2008
FT With a liquidity crisis looming, investors must switch their thinking
WSJ Zoltan Pozsar’s Writing is Dense, Esoteric – and a Hit. Now He’s Left Credit Suisse.
Guardian About 700,000 UK Households missed rent or mortgage payments last month
Out of time, and back to the day job….
Strategist – Morning Porridge
Great news ref Stripe!! Not so good news re Stagflation. And, thanks for helping me sort out subscription issues…. Cheers Sean
As always, I enjoy the commentary. I have been taking the long-term macro view of things. Given that I work in technology and in particular, AI applications, my view is that we are right in the middle of a really messy transition/inflection point economically that is fairly seismic. The industrial revolution, the advent of railway networks, the telegraph, 1920s electrification of the US economy, it should feel familiar to our current state. I can see operational AIs feverishly being stuck into the enterprise business stacks of companies with almost overnight micro-productivity gains. All those are cumulative.
When I read this economist article recently, it resonated. https://www.economist.com/briefing/2023/04/13/from-strength-to-strength
I can see everything being retooled around me as we speak. There is going to be turbulence. If we can avoid f***ing things up with the stupider, crazier parts of US society (e.g. Republicans), we will emerge with the next stage of the economy in place.
I don’t comment very often, but today I have been chairing a meeting of people involved in the drilling of a new production well in the North Sea. One of the biggest problems that was identified today was the breakdown in the global supply chain. Spare parts that were available ‘off the shelf’ three years ago, now have a lead time of three to six months. As a result, prices are secondary to availability… This does not bode well for the inflationary outlook.
Hearing exactly the same thing across lots of sectors.
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