Hopes that this year’s inflationary storm might be over were dashed by last week’s US inflation figures, which showed consumer price growth of 9.1 percent on the year to June.
Markets had expected 8.8 percent with some analysts predicting inflation had already blown up, but now the optimists are in overdrive.
There is clearly more to come, and that means more bad news for stocks, bonds, real estate and cryptocurrencies, although it’s good news for the safe haven US dollar.
Markets were expecting the US Federal Reserve to hike interest rates by 0.75% to between 2.25% and 2.50% in July. Now they are betting on a full 1 percent increase.
Normally such a surge would be unheard of, but these are not ordinary times, says Joshua Mahony, senior market analyst at online trading platform IG.
“The Bank of Canada has already implemented a 100 basis point rate hike. The Fed could follow with its own outsized rate hike.”
Interest rates are a blunt instrument. In effect, they repeatedly smack the economy in the head until it slides into recession.
Higher borrowing costs are hitting businesses and consumers alike, and investors are already sharing their pain.
But hope is everlasting, and amidst today’s global economic uncertainty, many continue to look for the positive.
And there are some positive aspects. The core personal consumption expenditure (PCA) price index, which excludes volatile seasonal food and energy prices, is slipping, says David Morrison, senior market analyst at Trade Nation.
“It peaked at 5.3 percent in February and has now fallen to 4.7 percent for three straight months.”
Supply chain disruptions are easing as the global economy adjusts to the fallout from the pandemic, Morrison says.
“Markets are also pricing in the likelihood that the Ukraine war will be a protracted war of attrition,” he says.
Oil prices have slipped below $100 a barrel after surging above $130 in early June.
Commodity prices are also on a downtrend, with the Bloomberg Commodity Index falling from its eight-year high of 136.61 on June 9 to about 111 at the time of writing, a decline of more than 18 percent. Copper, aluminum, nickel, tin and other base metal prices have all fallen.
That signals a recession is looming if demand slows, but that’s unlikely to deter the Fed, which will front-load rate hikes to bring inflation under control regardless of the collateral damage, says Mr Morrison.
The Fed’s interest rate could hit 3.5 percent by the end of the year, but that could be as high as it gets and central banks could return to easing. Once there are signs that inflation has peaked, expect risky assets to rally.
Once that happens, “investors will be big buyers of anything that’s down this year: stocks, bonds and precious metals,” says Mr. Morrison. “We can also expect a sharp decline in the US dollar.”
We’re not there yet, says Richard Carter, head of fixed interest research at Quilter Cheviot.
“Central banks are clearly struggling to contain inflation and more action will be needed to bring it down, regardless of the economic fallout. Markets are likely to remain volatile,” he says.
Much depends on whether US President Joe Biden can persuade Middle East oil producers to increase oil supplies, says Arun Leslie John, chief markets analyst at Century Financial.
“This could prevent the world from sliding into recession, although Saudi Arabia and the UAE have said they have no additional spare capacity.”
Inflation is likely to peak, but not until next spring as the base effect of this year’s consumer price hikes falls out of the numbers, says Leslie John.
The storm could last another six months, so brace yourself.
“Futures markets are now saying the Fed will stop rising by Christmas and start slowing around this time next year,” said Ben Laidler, global markets strategist at social investment network eToro.
With prices soaring around the world, families are looking for bargains – in pictures
Some regions will be hit harder than others, he says.
“In Europe, high energy prices are the overwhelming driver of inflation. Oil may have fallen, but natural gas prices have doubled in a month. In the US, the biggest concern is the tight labor market, with unemployment near a 50-year low. The UK faces both problems.”
UK inflation is also at 9.1 percent and interest rates are now expected to more than double from 1.25 percent to 3 percent.
Inflation needs to come down sharply and earlier than forecast to halt future rate hikes, says Colin Leggett, investment director at wealth manager Collidr.
“Core inflation has eased slightly in recent months but is still at elevated levels and well above the 2% inflation targets set by the Fed and Bank of England.”
Food and energy prices will continue to depress disposable incomes, especially if wages lag behind, he says.
“The war in Ukraine will continue to affect energy and food prices,” Leggett says.
Far from cooling off or peaking, inflation is on a runaway train
Jessica Amir, Market Strategist at Saxo Bank
Far from cooling off or peaking, inflation is on a runaway train, says Jessica Amir, market strategist at Saxo Bank.
“It could lead to an economic derailment or recession, most likely in Europe first.”
Businesses are being squeezed by higher material costs, higher freight costs, higher wages, rents and higher debt repayments.
Don’t be lulled by the recent falls in oil and commodity prices, which were mainly due to the Covid-19 lockdowns in China, the world’s largest oil importer and commodity consumer, she says.
“Once demand picks up in China, the lack of supply will come back into focus and prices will rise again,” Ms Amir says, noting that OPEC forecasts global crude oil demand will exceed supply by a million barrels next year per day will be exceeded.
Germany is expanding coal to free the country from its dependence on Russian gas, which will drive up prices, while big coal exporter Australia is having its own energy crisis and suffering power outages in the coldest winter since 1904.
“Demand for heating energy is increasing, but supply remains punishingly low as global environmental, social and governmental regulations restrict lending to coal companies,” says Ms. Amir.
“The market is vulnerable to shocks in the coming months as inflation is likely to be higher than expected. History tells us when CPI is hotter than expected, markets fall.”
Investors should be wary of interest rate sensitive sectors such as technology, consumer discretionary and real estate.
In contrast, bond yields are likely to rally higher as central banks hike interest rates while gold may regain its shine.
“Gold has outperformed stocks in every rate hike cycle since the 1970s. We expect the price of gold to reach a new record high later this year,” says Ms. Amir.
Returns on cash will also improve, making it worth having some exposure even as inflation continues to erode its real value.
Real estate is currently risky. “Values could potentially fall by 20 percent if central banks aggressively raise interest rates,” says Ms. Amir.
We could be heading for the eye of the storm now. If Russian President Vladimir Putin retaliates against the sanctions and stops gas supplies to Europe, things could get really turbulent.
Like all storms, this one will pass, with a bit of luck until next spring. If this is the case, central banks will become dovish again. But we can expect to take a lot of damage first.
Updated July 19, 2022 at 5:00 am
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