James Wilson, Senior Portfolio Manager

Over the past two and a half years, global inflation markets have gone from shot to prominence for investors, as global lockdowns switched to global re-openings fueled by excess savings and generous fiscal transfers.

In what has been a perfect storm for inflation, global economies have experienced a once in a generation spending impulse of fiscal, monetary and central bank stimulus that put money directly into consumers’ pockets, who had nothing else to do but to spend on goods, rather than services (services is usually 65% of GDP). Throw in issues with supply chains, a war to drive global energy and food prices higher, and the consumer has seen inflation spike to levels not seen in over 40 years.

The question is often asked by investors: What can central banks do when the problem is on the supply side (supply chains) and the cost of energy?

The answer is clearly to take away the proverbial punch bowl by destroying demand, allowing the supply constraints to heal in time. No more extraordinary fiscal support, no more loose monetary policy and an unwinding of central bank balance sheet liquidity to lower asset prices and thus temper demand.

According to research by the San Francisco Federal Reserve in March 2022, the ‘excess demand’ created by the stimulus as a collective in the US has added around 3.00% to the annualised inflation levels of 8%. If we assume 2% is base inflation (US Federal Reserve target), then we are left with an additional 3.00% for supply constraints. The US Federal Reserve has put the blinkers on and wants to inflict the significant demand destruction on this “excess demand” part of inflation, and trust that the “supply constraints” will come down in time as capitalism responds to excess demand by allocating capital towards these areas of the economy (or enough people return from a pandemic-induced interrupted life that will see production normalise).

And the tide is turning. Data prints and market pricing are starting to exhibit signs that the peak in inflation may have been seen in the past couple of US CPI prints. Inflation is a rate of change function − prices need to continue increasing at sustained percentages higher to hold an inflation rate constant. A good example is oil prices. Oil from $40 a barrel to $80 a barrel is 100% inflationary. Thereafter, in the next recorded data period, oil from $80 to $120 is only 50% inflationary. Then if oil started the observation period at $120 and finishes that observation window at $120, it is 0% inflationary. The rate of change in many prices is now slowing. That doesn’t mean they aren’t expensive – filling up your car on a Saturday is still eye opening, but the recorded inflation is moderating as a rate of change.

Keep in mind that inflation expectations have been distorted by the US Federal Reserve bloating its balance sheet with inflation linked bonds (known in the US markets as TIPS or Linkers) as a part of its Quantitative Easing (QE) program, which has meant break even inflation (the difference in yield between inflation linked bonds and nominal bonds) have been artificially widening − resulting in higher inflation expectations as per market pricing.

With the US Federal Reserve no longer buying inflation linked bonds as part of its QE program, the US 10y TIPS market has underperformed lower by 40 basis points from its highs of April, now expecting an average inflation rate of around 2.63% over the next 10 years.

Recent commentary from many market economists suggests that the highs have been set in US inflation. And the market pricing is right behind them.