The latest data gives no sign of respite in US inflationary pressures. Europe, too, remains exposed to inflation risk. Having completely repriced expectations for US and European monetary policy in 2022/2023, financial markets are, for the moment, better positioned to cope with stronger inflation data.
The Ukraine/Russia situation continues to hover over markets as the major known unknown. The Cboe Volatility Index (VIX Index) has risen sharply this week to levels around 32, reflecting nervousness among investors.
In Europe, the main potential macroeconomic implication of the Russia/Ukraine crisis is the risk that any deterioration will impact the energy markets, possibly putting a stop to any easing of natural gas prices, and potentially worsening the short- and medium-term inflation outlook.
Having risen sharply in the wake of the European Central Bank’s hawkish pivot in the first week of February, German bond yields have stabilised (see Exhibit 1), but remain vulnerable to any news suggesting that energy prices could stay higher for longer.
Inflation – the beats go on…
Each week this year has brought new episodes in what constitutes a major policy shift by the leading US and European central banks, caught short by the faster and more persistent-than-anticipated pace of inflation.
Recent days have seen no change in this narrative.
Broader-based inflationary pressures
US consumer price inflation (CPI) for January, published on 10 February, showed core inflation, on an annual basis, reached its highest rate since 1982. Inflation was strong and broad based with core goods inflation rising by 11.7% YoY, approaching the all-time record of 12.6% in 1975. Nor were inflationary pressures confined to goods supply chain pressures; core services inflation is now running at its fastest clip since the early 1990s.
Then came January US producer price inflation data on 15 February, showing an increase (+1% in January and +9.7% on an annual basis) that was well ahead of market expectations.
The US Bureau of Labor Statistics described January’s price increases as broad based, adding to market concerns that inflationary pressures are spreading.
FOMC minutes: Inflation risks ‘weighted to the upside’
Published on 16 February, this latest set of minutes of the meeting of the Federal Open Markets Committee on 25-26 February suggested FOMC members were concerned by the rise in US inflation and saw a number of reasons why inflationary pressure was likely to persist:
“Participants agreed that uncertainty regarding the path of inflation was elevated and that risks to inflation were weighted to the upside. Participants cited several such risks, including
- The zero-tolerance COVID-19 policy in China that had the potential to further disrupt supply chains
- The possibility of geopolitical turmoil that could cause increases in global energy prices or exacerbate global supply shortages
- A worsening of the pandemic
- Persistent real wage growth in excess of productivity growth that could trigger inflationary wage–price dynamics or
- The possibility that longer-term inflation expectations could become unanchored.”
Another section of the minutes suggested policymakers might be prepared to tighten monetary policy, even to an extent that some might consider excessive:
“Most participants noted that, if inflation does not move down as they expect, it would be appropriate for the Committee to remove policy accommodation at a faster pace than they currently anticipate. Some participants commented on the risk that financial conditions might tighten unduly in response to a rapid removal of policy accommodation.”
Markets take the minutes on the chin
The response in financial markets to these minutes was stoic. The absence of any specific reference to an intention to raise policy rates by more than 25bp led the fed funds futures market to lower the probability of a 50bp hike at the FOMC meeting in mid-March from 65% to 50%.
The US yield curve steepened (after having flattened markedly last week). Overall, the market’s reaction suggested relief that the news from the minutes was not worse (i.e. more hawkish).
Given the magnitude of the shift in the inflation narrative so far this year, a pause or even the notion that we have passed a point of peak inflation angst may seem plausible. We resist this idea and remain underweight interest-rate risk in both our fixed income and multi-asset portfolios.
In our multi-asset portfolios, we favour commodities and, on a tactical basis, equities in Europe (ex-UK) and Japan.
The latest data on the fourth-quarter 2021 company earnings season suggest European companies are benefiting from less wage pressure and a weaker euro, which is helping their earnings and sales, respectively.