- Portfolio Manager
Switzerland, Intermediary
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Year-over-year (y/y) US headline Consumer Price Index (CPI) inflation peaked at 9.1% in June 2022. It’s since retreated to 6.5%1 and fixed income markets have priced in y/y inflation below 3% later this year. Hope has emerged that the worst of the COVID shock is behind us, and we can return to a world of 2% growth and inflation — essentially goldilocks for the S&P 500 Index.
We believe that the market could be underestimating just how complex and volatile the global economic cycle remains. There are structural drivers at play that make a return to the 2010s cycle unlikely, in our view. While we agree with consensus expectations that inflation will likely trend further downward this year, it’s likely to rise again as growth eventually picks up.
Understanding the near-term disinflationary story
The near-term disinflation story is straightforward at this point, based upon a few key points:
- Goods: After a two-year surge, CPI Commodities ex-food and energy (i.e., goods) inflation has been decreasing. Compared to three months ago, it’s deflated 1.2% thanks to healing supply chains, weakening demand, and built-up inventories.
- Energy: The worst of supply fears from the Russia/Ukraine conflict haven’t been realized. High base effects have taken hold and demand has weakened. A warm winter has further deflated natural gas prices, which have been at the epicenter of the recent European energy crisis.
- CPI shelter: CPI shelter remains strong, but it’s the most lagging of indicators and will probably decelerate in coming quarters following the weak housing market.
- Wages: Wage inflation and the related services inflation (which also tends to lag) remain a wild card but are easing from 2022 highs.
Taken together, this is encouraging, and the market has benefited with a rally in bonds. In fact, the MSCI ACWI leapt 17% from its October low2 and the S&P Index is trading at 18x earnings, a historically high multiple outside the dot-com bubble and the COVID market.
But we’re not sold on a soft landing
A soft landing is possible; however, we expect a disinflationary recession later this year as the labor market is showing signs of weakness underneath the surface. A third possible scenario could see a sharp economic pickup in China combined with a weakening US dollar (which could be at a major turning point from 30+ year highs) accelerate inflation. The range of outcomes for 2023 remains very wide. In any case, we believe that structurally higher inflation is more of an issue than investors are used to, which means that market performance is likely to be very different than it was in the 2010s.
Higher-inflation periods have historically come with more macro volatility, and today’s geopolitical tensions exacerbate this relationship. Looking ahead, we believe that pressure on inflation will be apparent whenever growth is strong for three reasons:
- The era of rising goods and labor supply has ended. Working-age populations are shrinking, so the labor supply versus demand trade-off is unfavorable. Ongoing deglobalization reinforces this dynamic.
- Policy remains inflationary. While governments are attempting to retrench from COVID stimulus, it’s complicated. European governments implemented stimulus measures again in 2022 to support energy consumption in the face of extremely elevated prices, a policy that risked further exacerbating the scarcity. We expect fiscal policymakers to continue to act aggressively to shield consumers from recessions but note that central banks’ inflation-fighting abilities remain constrained thanks to high government debt loads and a decades-long reliance on boosting asset prices to drive growth, making it very painful to sustain high real yields.
- Supply conditions in long-cycle commodity industries remain challenged for several reasons, including ESG concerns and spending needs, long-term uncertainty, regulation, bad memories of oversupply, and shifting management incentives. Remarkably, in 2022, despite elevated prices, we saw minimal increase in real capex. This is a multiyear problem. There will be significant supply/demand gaps under any decent growth trajectory in coming years, yet no structural solution has emerged.
Identifying the market opportunity
So, where to find market opportunity? Figure 1 shows industrial mining companies’ capex/depreciation versus relative performance. When capex gets low, it’s historically driven a multiyear period of outperformance that concludes after capex has responded.
From levels of below-average capex/depreciation, five-year outperformance vs. global equities is 34% on average. From levels of above-average capex, performance in the following five years is -30% on average. We’re in year seven of low capex, and miners have quietly outperformed global equities by 117% over this period, but spending hasn’t increased. This dynamic exists today across all natural resource sectors.
Figure 1
Inflation may have peaked for now, but don’t mistake the cycle for the structure
The bottom line is that inflation has peaked for the near term and may continue to decelerate to a normal level. However, weak demand, tight financial conditions, and high base effects are driving this, and it isn’t normal or repeatable. Simply put, structural fundamentals have changed and despite any short-term decline in inflation, we wouldn’t recommend extrapolating that further.
We believe that many investors are unprepared for the reality of structurally higher inflation, as we have not observed a significant reallocation of institutional investor assets from the winners of the disinflation decade to the beneficiaries of higher inflation. Investors may be well served to view any weakness as an opportunity to gain exposure to cheap assets that may be in the early years of a positive regime change.
1As of 25 January 2023
2As of 25 January 2023
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