Monday digest

Posted 23 May 2022

Talking up recession to drive down inflation
Last week was another rocky one for capital markets, with talk turning to an ‘inevitable’ recession, prompting the most recent cohort of DIY retail investors to throw in the towel. The S&P 500 found support early on in the week, but Wednesday brought sharp and sustained selling pressure. While we have now become used to tech stocks underperforming in this year’s extended sell-off, the downbeat investor sentiment spread quickly into other sectors. However, thin trading volumes – plus the lack of a clear directional stock market trend – suggested institutional investors were staying put. So why is that the media is full of recession talk but long-term investors remain unconvinced? Perhaps because central bankers have convinced them of their inflation-fighting resolve.

US Federal Reserve (Fed) Chair Jay Powell confirmed it will keep raising rates until inflation is back under control. But the tough talk is not only confined to the Fed. The Bank of England’s (BoE) Governor Andrew Bailey raised pulses last week by discussing “apocalyptic” conditions, while Chief Economist Huw Pill warned that inflation wouldn’t be brought under control before the end of the year. Central bankers may believe threatening worse to come (unless we cut back spending and/or refrain from asking for pay rises), may be a more effective at curbing consumer demand than the more blunt (and slower to work) instrument of a raft of rate hikes. Indeed, economists and institutional investors may well be counting on the falling prospect of persistent rate rises. Although recent headline inflation figures shocked the general public, they were widely anticipated by markets, and therefore priced in. The fact that inflation numbers did not overshoot expectations, and were very clearly driven by quite explicit components (rather than being structural) was enough to lower recession expectations. These expectations are often best taken from the yield premium that the lowest-quality corporate borrowers must pay for their finance. After rising sharply over the past four weeks, there was little evidence of this yield premium going up further last week.

It seems the aggressive messaging from central bankers could succeed in driving down demand while global supply issues ease. The European gas price issue may not be solvable before winter, but recent redirection efforts indicate that the longer-term fallout may be less than feared, while also stoking economic activity to prove to Vladimir Putin that Russia’s energy exports are not indispensable. The price pressures we are all experiencing are unpleasant, but the economic and financial backdrop has much stronger parallels with the price pressures the US experienced just before the onset of the ‘Golden Fifties’, than the dire stagflation of the 1970s.

Bailey’s bleak outlook messaging
When Andrew Bailey used the word “apocalyptic” to describe the outlook for Britain’s food prices, his choice of words was no doubt a little sensationalist – something we don’t usually expect from a central banker who knows his every utterance will be picked apart. But then the latest economic data provided quite the sensation for some. Inflation as measured by the UK Consumer Price Index (CPI) rose 9% year-on-year in April, while so-called ‘core’ CPI (excluding volatile components like food and energy) jumped to 6.2%. This means the UK has experienced larger price rises than any other G7 country, and they show little sign of slowing down. Despite last month’s 69% annual increase in energy costs, Britons will not feel the full force of the ongoing energy shock until October, when the energy price cap is expected to be raised again. Should this transpire, it would bump inflation up to 10% in the Autumn.

The hardest part to take in all of this is that inflation is not coming from economic overheating. Some MPs criticised Bailey for not pre-empting price jumps and raising interest rates sooner, but he rightly pointed to a series of significant and unrelenting supply-side shocks, ranging from COVID effects to Ukraine (and indeed, Brexit frictions) beyond the power of influence of any central bank. In truth, Bailey and his team have little room for manoeuvre in their efforts to tame inflation, and will be particularly on the lookout for signs that inflation is becoming more broad-based and spreading to the services sector.

We wrote recently that the US Federal Reserve (Fed) may have to engineer a (hopefully short-term) recession in order to cool its overheating economy – by raising rates above the so-called ‘neutral’ level for growth. On his part, Bailey admitted that deliberately increasing unemployment to destroy demand was something the MPC would consider if needed. Inflation must get “back to target”. The wage-price spiral, rather than supply constraints on their own, is clearly the BoE’s biggest challenge. While admitting there was little the MPC could do about 10% inflation in the short term, Bailey’s openness to a deliberate recession shows where his priorities are. Input-cost inflation will inevitably come down as supply constraints pass through, but stopping the demand-side reaction is key and monetary policy on its own would take a long time to achieve that. Frightening the public with stark or even apocalyptic rhetoric may have a much more immediate impact on consumer demand.

Retailers struggle to adapt to the new normal
Walmart and Target – two of America’s biggest retailers – recorded their worst weekly performances since 1987 last week, falling 20% and 29% respectively after reporting their results. Dour earnings reports seemingly drove investors to the exit. Both Walmart and Target missed their profit projections, recording weak sales growth of 2% and 4% compared to last year, while increasing their inventories by 32% and 43%. Increased supply-chain costs hit their margins, while poor post-pandemic inventory decisions meant unwanted items like TVs or kitchens had to be marked down heavily to make room for faster-moving goods. Department store Kohl’s also lowered its guidance last Thursday, sending shares down as much as 7.3%. Rising input costs are a problem for profit margins, but the surge in inventories points to a problem of retailers struggling to address changing preferences of the demand side. If sales are expanding at or above trend, cost increases are not so problematic and profits generally hold up well. But the disappointing Q1 margin results show retailers are struggling to pass price hikes onto consumers, while consumer preferences are shifting from ‘stay-at-home’ essentials to ‘going out’ discretionary goods. Walmart said many of its customers were switching to cheaper brands, while some were scaling back non-essential purchases altogether. Retailers are paying more for their goods, only to be left with fewer willing buyers than expected.

Continued global supply pressures have prevented prices from reaching equilibrium – demand continues to be greater than current supply. This is the dreaded ‘stagflation’ that made headlines last year, where low or negative growth is matched by stubbornly high inflation. Normally these forces keep each other in check, but the clogging of global supply chains has prevented this from happening. This is a double whammy for consumers, who are getting hit with higher costs as well as fewer opportunities to grow their income. It also makes life more difficult for producers, who cannot pass on costs as easily without stamping on delicate demand. We are seeing this now in the effect on retail profit margins, but the same holds for many other industries. Companies always want to maintain their profits, but this is extremely difficult in the current scenario.

It is worth pointing out, that profit margins were exceptionally high before the current troubles. Big-name companies have been handsomely rewarded over the last two years, reflected in the impressive stock market returns through the pandemic. In the earlier period of the global supply shock, businesses were still largely able to pass on costs, meaning their bottom lines were safe. Now this is no longer the case.  It seems that the poor results of big US retailers are a combination of poor inventory planning and consumers feeling the pinch on their discretionary spending. This suggests the easy times for big retailers are over and they will have to get used to lower margins. For the time being, the jury is out on whether these margin pressures are already the first signs of a building stagflation dynamic, or are simply part of the post-pandemic normalisation process,  a picture that is so much harder to see given the other factors currently in play. Overall, we attribute last week’s shifts more to the ongoing rotation away from the pandemic winners than as a harbinger of a new stagflation era.

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