US Inflation looks beaten, but what are the risks the Global Economy might still stall?

Blain’s Morning Porridge – July 13^th 2023: US Inflation looks beaten, but what are the risks the Global Economy might still stall?

“A good landing is one you walk away from. If you can still fly the plane the next day, it’s an outstanding landing.”

US Inflation looks to have been beaten, but that might not mean very much if the global economy is still headed into recession. Rates and consumption are a lagging problem for the markets, and there is a chance even strong economies will stall.

The most dangerous four words in modern markets are: “this time it’s different”.

Yesterday’s US inflation data suggests something remarkable is happening in the world’s largest economy. Jobs remain buoyant, the economy resilient, and inflation looks to have been beaten. CPI was down to 3% is within spitting distance of the Fed’s 2% target – although core is 4.8%. The market loved these numbers – below expectations and making folk hopeful the happy times are coming back.

What should the Fed do? Is it time for the Fed to:

1. Declare victory, as the economy has been “soft-landed”?
2. Tell markets they are staying vigilant – but remind them they might resume hikes.
3. Should they stay resolute – and keep hiking to douse any remaining hotspots of potential inflation?
4. Ease swiftly to prepare the economy for what is shaping up to become a deep, deflationary global recession?

But, but and but again (and you knew I was going to write something like this….) the problem is….

Let me start with a short digression; In aviation, “stall” is defined as a sudden reduction in the lift generated by an aerofoil when the critical angle of attack is reached or exceeded. The wing might fall putting the plane into an uncontrolled spin, the nose might fall, it might lose height suddenly, or the plane might start shaking as its buffeted in the corrupted airflow.

I think stall is a good metaphor to consider when thinking about where risk, the economy and markets could go next.

First, everything in finance is consequential – knock-on effects and no-see-ums are what makes economics such a fun and jovial pursuit. The conventional wisdom is you beat inflation by sharply raising interest rates and taking money out the system (by slashing discretionary spending), but these have consequences – many of which are lagged. Stall risk becomes elevated. Higher interest rates leave households struggling and corporates straining to stay afloat and finance themselves. These are lagging consequential effects – and haven’t yet played out in the economy.

Follow that logic and the next step is the economy stalling on a wave of corporate defaults collapsing confidence in credit and stock markets, putting banks under renewed pressure, while households seek to downscale housing and other spending, triggering a collapse in home prices (the key indicator of confidence in Western Economies), inevitably and irretrievably leading to an economic downturn and recession! That’s when a good landing turns into a crash.

However, there are also balances – as the threat of further US interest rates hikes diminishes and recession looks likely, then the dollar weakens, meaning the price of everything in the global economy gets cheaper, and the threatened global recession gets a little bit shallower. I suppose that’s a bit like the economic aircraft model stalling, but putting the nose down to regain enough speed to resume normal flight.

If only it was simple… but you get the drift…

Second, even though the US might have successfully dodged an inflation recession, the rest of the world might not. In the UK attempts to stem inflation have stalled – simple as. Controlling inflation is a confidence game. It can be controlled if economic players can be convinced it’s not a problem and price rises are seen to be transient. In the UK, the Bank of England was seen as too slow to act on the danger, while workers perceived politics to be broken, thus the impetus behind higher wage demands to precede inflation quickly became the key driver.

Wage demands have led rather than followed inflation – buffeting any hopes of correcting the economic stall. Wage demands have become something of a doomloop for the UK – a repeating stall reinforcing sticky inflation – where the apparent inexperience of The Bank and political incompetence has left the plane in a spin. Wages are a subtle but critical issue when it comes to understanding why inflation in the UK remains stubbornly high.

Of course, there are other reasons why inflation is so much more difficult to constrain in the UK and in Europe – ranging from Brexit frictions, to trade, energy, food prices, investment, etc that will impact the whole region for longer.

Third, there is China. For decades China exported “positive deflation” (yes, I know that sounds a non-sequitur but it kept inflation artificially low for decades) around the globe as it became the “cheapest to produce” economy. The current uncertain path of China growth, and the new cold war, rather suggests it again will be exporting deflation, but this time of the negative variety as The Middle Kingdom’s unquenchable demand for raw materials, commodities and goods begins to stall.

The result is quite simple – the US is going to look more stable while Europe and ROW continues to struggle.

Fourth, if only it was that simple.

There is a fundamental problem at the core of markets and economies, the hang-over from the QE era. Markets have come to believe central banks are there to ease market crises – that they will step in with lower rates to stem bank collapses and market confidence glitches. They see lower rates not as an opportunity to invest in new productive capacity and plant, but as a signal to go out and buy financial assets (stocks and shares) on the simple basis these will rise on lower rates. Speculation is a dangerous thing.

Err… somewhere we seem to have forgotten the reason equites have value is because well managed companies will produce profits to distribute to the owners (shareholders) and bonds are safe because countries and corporate borrowers will follow policies to ensure lenders are paid back. (I am awarding myself a No Sh*t Sherlock award for the above statement of the downright bleeding obvious – but sometimes it doesn’t hurt to remind ourselves.)

Fifth – have looked at the weather recently?

Floods, droughts, fires and pestilence are not just things that happen on TV. They are very real and have real price consequences. If you have missed the headlines about the hottest month in history, the rains in India and Vermont, the heat in Europe, or the new El Nino.. then catch up. Read the article below.

Five Things to Read This Morning

World Meteorological Organisation:  Preliminary Data shows hottest week on record. Unprecedented sea surface temperatures and Antarctic sea ice loss.

WSJ                 How Fast Can Inflation Cool? Not Fast Enough for the Fed

BBerg              How to tell where the global economy is headed

FT                    A global subsidy war? Keeping up with the Americans

FT                    Howard Marks – Investor lessons from taking the temperature of markets

Next week the Morning Porridge will be… intermittent. I am taking a week off on my favourite French Island off the Atlantic Coast. If anything happens… let me know..

Out of time and back to the day job

Bill Blain

Strategist – Shard Capital