Too Much of a Good Thing


As we noted last week, team transitory has taken a credibility hit after the recent inflation data. Martin Wolf put it well in the Financial Times; the false premise that inflation is pending a normalisation through supply side adjustment is a potential costly policy error. Put differently, recent inflation pressure is not simply a function of supply side constraints but it is also due to strong demand. That was confirmed by the latest retail sales data this week. In both real (inflation adjusted) or nominal terms, aggregate retail sales are well above the 20 year trend and cannot be a supply-chain issue (chart 1). Moreover, the strength in retail spending is in spite of the recent deterioration in consumer sentiment. While the strength in consumer spending is likely a function of the policy stimulus (both fiscal and monetary) and a pulling forward of future demand, the big picture point is that it is inconsistent with emergency policy settings.

Another way to view the inconsistency in the argument of team transitory is by comparing US and European core inflation (chart 2). How can a global supply chain shock cause core inflation to spike only in the United States? A more plausible argument is that the difference between the two is also a function of relative final demand and output. This is also a point made by the famous $140 billion Hedge Fund in a paper this week.

The context of the macro news flow on final demand and inflation is the nomination of the next Fed Chair. The decision appears to be down to a dovish incumbent (Jerome Powell) or a challenger that is expected to be even more dovish (Lael Brainard). From our perch, it is challenging to believe that the US requires even more dovish policy conditions. Of course, Powell has a Republican background while Brainard is a money-donating Democrat and that is a distinction evident in their attitude toward regulation. However, it might be difficult to distinguish between the two on a practical monetary policy perspective. Nevertheless, if Brainard was appointed it might reinforce the odds and exacerbate the potential policy error noted above. We may never know or that may only be evident over the next few years.

There are two key implications for markets. First, the recent impulsive rally in the US dollar could be reversed if Brainard was appointed. Second, stock market valuation partly hinges on the inflation being the “good kind” or beneficial for corporate pricing power. A supply shock can enhance pricing power and be normalised through expansion of capacity (production/logistics). In that case it would be positive for valuations especially if it does not usher in a sharp reversal of negative real rates. Of course, if that assumption proves to be false, then the “bad kind” of inflation implies profit margin compression and a rise in real interest rates. Given US (and European) profit margins are at a record level both would not need to move very much to undermine current valuations and contribute to P/E compression. In a US context, it is also important to note that the major mega-cap stocks now have a very high sensitivity to long bonds (around 70% on a trailing 12 month basis).

In conclusion, this is a key reason why we have a preference for Asia Pacific which has materially lagged (partly due to credit tightening in China) and on a relative valuation basis (largest discount since SARS in 2002 compared to the United States). Within the region it is also why we have a preference for companies with strong cash flow, low balance sheet leverage and sustainable growth. If global growth re-accelerates further as the economies re-open and supply chains recover Japan (which has high operating leverage to world growth) will also likely outperform (more on that next week). In contrast, non-profitable liquidity beneficiaries would likely be vulnerable to an unanticipated impulsive rise in real rates. Of course, in the very short term a Brainard Fed might help stoke the performance of liquidity beneficiaries. It would likely depend how the bond vigilantes responded to a potential policy error.

About the Author:

Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.