Blain’s Morning Porridge – Nov 1st  2023: Inflation? Dead or Resting?

“I would say, if anything, I understated the position.”

Is inflation dead or just resting? Are rates likely to remain higher for longer, or are we poised on the edge of a bond bull market? Everyone is watching energy and tensions around the Middle East. I suggest we worry about wages as well.

After yesterday’s unpleasantness with image rights, this morning’s photo is proof I went for a swim in this morning’s rising gale, piddling rain and incoming tide. Nothing like setting myself up for a tough day by making myself cold, wet and miserable!

There is no other country on the planet that could turn an official Inquiry into Covid into prime-time TV comedy gold. It is so tempting to write about Dominic Cummings’ mad-eyed take down of Boris y’day… but what’s that got to do with markets? More than you think, but it will have to wait.

Today is notionally a double trouble day. What will the Fed do – most likely nothing – and what quantum will the US Treasury announce in the Quarterly Refunding? While no move on US rates is expected, markets will be listening to the nuances of what Jerome Powell says about on-going Fed vigilance re bringing inflation back down to target, rates, and the current market threats and shocks. The refunding announcement has been well briefed at $776 bln – lower than threatened, and below the record July-Oct quarter.

The message will be the Fed retains a tightening bias on the strong and resilient economy vs decreasing inflationary pressures. They will remain closely focused on the data and events, and will not hesitate to further raise rates if and when the situation merits. I wonder what he will say about energy cost threats?

Reading across markets there are two distinct perspectives on where we go from here. They are neatly summed up in the UK Torygraph newspaper where two well-respected commentators, Jeremy Warner and Ambrose Evans-Pritchard, go head-to-head across its pages:

• Warner: Markets are right to bet on higher for longer interest rates
• Evans-Pritchard: Inflation is dying and bonds are a screaming buy

Both articles make solid points – but I’d take issue with aspects of both. (That’s what economists do – put three of them in a room and expect at least 4 different opinions.)

Generally, the market mood is swinging towards the Fed, The ECB and the Bank of England as done raising rates. That certainly plays to bond bulls. If any further hikes come – they will be fine tuning in response to events. I am wondering how such positive equity market DNA thinking seems to have infected the normally soberly-pessimistic bond markets? Equity players believe hope springs eternal – while bond markets believe hope is never a good strategy!

I am confused. Interest rates are falling and central banks are increasingly able to keep rates steady in the face of a declining inflation threat. Hang on? If the economy is robust – why cut rates? If the economy is vulnerable to recession, why are equities rising? If we are headed into a slower economy then surely earnings will decline? Ah, yes, but, no but, er… the relative yield of equities over bonds has improved. Makes perfect sense? Not..

One-to-watch is the Bank of Japan. It over-cautiously dipped its toes into the murky waters of tightening policy y’day, announcing diminished Yield Curve Control, but giving no forward guidance on where rates would go, and in the face of sub 2% inflation rather than support the Yen, the Japan currency tumbled. That’s an interesting moment – this morning the BoJ was in with comments in the Forex markets supportive of Yen. Will the BOJ be forced to actively support the Yen with traditional tools like a rate hike?

In terms of a renewed inflationary threat – its complex. Many historical charts of inflation show complex inflationary events tend to be long lasted and typically feature a double top: when inflation rises dramatically on the shock, then falls again as market believe/hope the issue is resolved. It then rises to a new higher, stubborn level as the shocks work through the economy.

The current inflationary shock is just such a complex event: it began way back in 2008 when QE created a massive asset bubble, transferring new money from the real economy into financial assets (the everything bubble), then Covid fracturing global supply chains in 2020-21, accompanied by bursting bubbles in real estate, followed by the Gas/Energy shock of Ukraine in 2022. Now we have another real energy shock, plus all that inflation from QE was stored up in financial assets is a threat to markets. (Exactly how it will transmit from financial assets to the real economy is unclear, but older pension savers spending their money is being cited as one reason for strong US consumption!)

The Middle East remains a literal powder-keg. Thus far oil prices have barely moved – but that’s understandable as we are still in wait and see mode. Any escalation will be closely watched by the energy markets (because Qatar is a key component this is about Gas as much as its about oil). Meanwhile, I strongly suggest reading this analysis of the balance of Western Naval Power in the region: it’s fascinating. It mentions the UK’s much vaunted HMS Big Lizzie, which is yet again docked up in Portsmouth with its full air power – all of 8 F-35s – on display! Drove past it. If I spotted it… so did everyone else.

While we could certainly see a renewed Energy Shock to global markets triggering a second inflation spike, or maybe a chip and supply chain crisis if China starts making outward bound comments about Taiwan, I’m thinking we should probably be looking internally.

I’m surprised at the lack of critical comment on the wage settlement achieved by US auto-workers union, UAW, with the big car makers. Its members will receive 25% over 4 years plus, plus improved pensions, cost-of-living adjustments and other benefits. It looks a good deal for union members – who are likely to approve it. The UAW is not only union to have scored a big win. Airline pilots, teamsters and others have all secured large pay gains on the back of labour supply bottlenecks and the “resilient” economy.

I’ve oft written how FOMO – Fear of Missing Out – is the most powerful force in finance. Non-unionised workers across America will be looking closely at the benefits of membership – less than 7% of private workers are in organised labour. Non unionised workers are well placed to demand parity while the labour market is tight. US wages are high relative to other nations, but if the unions are delivering members big, public wins, then it’s highly likely non-union labour will use the threat of unionisation against their employers to secure even more attractive deals.

Wage rises are like pebbles on a mountainside. When one rolls down the hill, others follow. Moments later, the whole mountain is moving. A “catch-up” wage spiral is entirely possible.

Which of course brings me to The Philips Curve…. I dread moments of this, because I guarantee any mention of “academic” economics will put most readers immediately to sleep. But bear with – I promise a joke at the end.

The Philips Curve, of course, is a statement of the downright bleeding obvious. Prof Philips observed that over a period of some 90 years UK unemployment tended to fell when wages rose. If wages are rising, unemployment decreases because works are more willing to work for more pay. (I posit that if wages are rising it means companies can afford to pay more.. as much as labour supply is tight, but I digress.)

That Philips Curve moment of clarity has all kinds of inferences – rising wages and falling unemployment are equilibrated with rising inflation = wage inflation feeds into general inflation. However, in periods off high inflation, we may have negative real wage rises – meaning more money actually buys fewer goods – thus workers demand even higher wage increases to give them a positive boost to their spending power. When we get stagflation, galloping inflation and crashing growth, unemployment tends to rise because workers won’t work for lower real wages (or could it be collapsing companies can’t afford to pay them?)

What happens during periods of wage spiral inflation – as many market watchers still fear could be set to occur in the US and UK? Rising industrial strife becomes inevitable as workers demand relative pay rises. Wage inflation spirals and drives wages higher. Danger, Danger, Will Robinson, Danger. When does it reflect in rising inflation numbers?

These remain uncertain times… they remind me of the physicist, the mathematician and the economist washed up on the desert island. Sure enough they were starving when a tin of beans floated in on the tide. The physicist says if we light a fire underneath it, the tin will expand and explode. The mathematicians says he can calculate the trajectory of each bean so they can collect them in leafs. They turn to the Economist and ask what he thinks… “Well, assume we had a tin opener.”

I promised you a joke. I did not say a good one..

One thing to read today because I’m out of time..

BBerg                          World’s Safest Market Becomes a Magnet for Big Investors

Bill Blain

Market Strategist, Author of the Morning Porridge