How inflation stole Christmas

By John Middleton

2022 started with a positive bias. Covid was starting to look less scary. It had arrived in New Zealand, but vaccination rates were high, lockdowns were working and while the new variants were more transmissible, they were also proving less deadly. The hope was that we had at last got a handle on Covid.

Yes, lockdowns had disrupted life, working practices and global supply chains, but the feeling was this was now behind us and we could look forward to life getting back to normal. Government support and covid restrictions had meant that most parts of the economy were in good shape and while supply chains were disrupted (although stocks of toilet paper remained high!!) with ports clogged due to lockdowns and absenteeism, this did not feel overwhelming.

In hindsight, we were underestimating both the underlying global supply chain disruption and the impact of extended fiscal support on inflation.

But we believe it was the Russian invasion of the Ukraine on February 20, 2022 and China’s decision to extend its zero-covid policy and continue to impose rolling lockdowns that pushed the global economy over the edge.

War in the breadbasket of the world (in addition to changing weather patterns elsewhere) drove up food prices and sanctions on Russia drove commodity prices (energy – oil and gas, raw material prices and fertiliser) higher, while China’s rolling lockdowns meant that supply chains were regularly interrupted.

So goods were regularly in short supply, but consumers had the savings to pay for them, thanks to government support and lockdowns, so costs rose and Central Banks realised that inflation was less transitory and more structural and started to raise rates in March.

Roll forward eight months with the US Federal Reserve raising interest rates from 0-0.25% to 3.75%-4.00% so far (the most since 1980s) the first question is has inflation peaked?

In the US, we believe the answer is yes. After a number of false dawns since June, we believe inflation is peaking. The October US CPI report demonstrated inflation did fall month-on-month with the rate rises of 2022 starting to have an impact on sentiment and the economy.

We would go further and write US inflation has peaked as a number of anomalies in recent months’ data have now flushed through which should allow month-on-month inflation to start to fall.

Outside the US, inflation is running at different rates, but all countries have the big issue that if their central banks do not match or exceed the measures being taken by the US Federal Reserve then they run the risk of a negative impact to their exchange rate and importing inflation through higher priced expensive US goods and commodities.

We would note that two countries Australia, Japan that did not follow the US rate hikes September and October saw their exchange rates fall 10% against the US$. The flip side is that in countries like New Zealand the mechanism for passing higher rates onto consumers i.e: the mortgage market is far faster than in the US (we estimate 50% of NZ mortgages will refix over the next 12 months with average interest rates likely to rise from c2.5% to c7%) so while inflation outside the US could outpace the US for a couple of months it is likely to fall away faster thereafter.

Is inflation under control?

Is a trickier question answer. Looking at the maths of US inflation, three categories (shelter 32.6%, commodities 21.2% and food 13.7% as at October 2022) drive the lion’s share of the print in the US. Annual inflation was running at 7.7% and monthly inflation 0.4%, but while commodity inflation fell 0.4% in October, Shelter and Food grew at 0.8% and 0.6% month-on-month seasonally adjusted. 

So without these two items that account for 46% of CPI slowing we do not expect to see a material reduction in US inflation over the coming months.

Furthermore, falling inflation tends to coincide with rising unemployment, but employment also remains high. The FANG stocks demonstrated that things have started to change for the job market and falling consumer sentiment would imply job cuts are coming in the new year.

But while Covid-19 lingers and absenteeism remains high, companies that choose to cut staff run the risk of being caught short if covid were to resurface.

So, we would not expect to see major job cuts to materialise until the Northern Hemisphere flu season is past in the first quarter of 2023. Unfortunately, for inflation to drop materially from here, we do need to see unemployment rise.

Furthermore, one needs to determine what under control really means. Classically Central banks have looked to cut rates when inflation is past its peak (ie now), but if Central Banks truly want inflation to fall to below 2% then rates are likely to remain at current levels for some time.

Data from Research Associates would imply that the median time to get inflation from 8% to 3% is two and a half years.  We maintain the view that neither consumers (mortgage payers and payers of rent) nor governments (paying interest on gilts after a massive increase in Government borrowing in recent years) can survive interest rates at or above current levels for a prolonged period.

So, while we see scope for rates to continue to rise in coming months, we would expect them to peak in 2023 and start to fall long before the stated target of 2% inflation has been reached.

We would also note that heightened global tensions remain and the frustrations of recent years and covid lockdowns are causing regime change across the world.

With most global economies finely balanced with rising interest rates, high inflation, economic growth starting to slow, low consumer confidence, and political tensions high (Russia / Ukraine Eastern Europe, North Korea to name a few) we see little margin of error.

China’s rhetoric about Taiwan has also risen in recent months, but we are more concerned the Chinese economy and recent political changes which we fear will mean that the decades of China exporting deflation to the rest of the world are likely at an end.

As the UK demonstrated politicians and central banks can make mistakes, so we see a need for increasing flexibility from authorities going forward if a serious recession is to be avoided.

Looking forward, we believe that inflation is the 2022 story and would expect the focus to move to unemployment, and corporate earnings and the general economy over the months ahead and into 2023.

We expect unemployment will start to rise, but see downside risk to 2023 market earnings outlook as corporates are forced to come to terms with slowing revenues as it becomes harder to pass through rising costs. Unfortunately, we see a reasonable chance of a recession in New Zealand, and a number of other countries.

But if Governments react early to deteriorating economic conditions and cut rates as aggressively as they have hiked then we should be able to avoid too much hardship.

2022 has been a tough year for markets, but has gone a long way to resolving some of the issues that have lingered since the Global Financial Crisis.

Most mortgage owners will feel the pain of rising rates in 2023, but we see the market charging a more realistic price for risk, as something that has needed to happen for a decade which should allow us to look forward with increasing confidence in the future.

Nevertheless, 2023 looks set up to be a difficult year for the economy and corporate earnings, even if this is what the market has pricing into markets in 2022.

Disclaimer: John Middleton is a Portfolio Manager of the Mint Australasian Equity Fund at Mint Asset Management Limited. The above article is intended to provide information and does not purport to give investment advice.