In their latest walk, Olga and Hugo bring a new perspective to the frenzied discussion around inflation and discuss what’s really causing sector rotation in the equity markets. Why is the recovery so far uneven, and what will drive growth in the post-COVID economy?
Hugo Scott-Gall: Olga, it’s nice to be doing one of these walks again. I think events are forcing us right now to talk about the dominant narrative that people are using to explain the volatility in equity markets. This narrative is that inflation has stayed too high for too long, and the Fed, having fallen behind the curve, is now furiously sprinting to catch up with inflation in the form of multiple rate increases.
The narrative continues that these rate increases are responsible for a violent rotation within the equity market, and in particular, a sell-off in the prices of long-duration equities, those seen as having a high proportion of cash flows in the distant future.
We should unpack that narrative and test some of its axioms to see whether they are indeed true. Inflation’s what’s done it: agree, disagree?
Olga Bitel: If it is inflation what’s done it, then we should see a significant change in the slope of the yield curve. But, in fact, the only bit of the yield curve that has steepened is the front end—the first 18 months. In other words, the market seems to suggest that whatever inflationary pressures are surprising to the upside, they are short-lived.
We have a mismatch between highly nationalized responses to the COVID pandemic and highly integrated, global supply chains. This mismatch is wreaking havoc with our prices.
Unfortunately, the current inflation increase will likely persist for as long as COVID remains a pandemic. With each passing week and month, my conviction is strengthening that we have a mismatch between highly nationalized responses to the COVID pandemic and highly integrated, global supply chains. This mismatch is wreaking havoc with our prices.
Specifically, China and many of the East Asian countries have adopted a zero-tolerance policy for COVID. Every time somebody tests positive, production facilities are shut down on short notice. For ports and airports, the value of the product is relatively low, but the cost of the disruption is very, very high. We saw this in June, when several Chinese ports were closed and then we had a spike in inflation. We saw it again in August, when a very large port was closed, and then Shanghai’s international airport was closed for a period of time for outbound cargo. This was a time when there were a ton of shipments for Christmas.
Not surprisingly, we saw a significant acceleration in inflation in October and November. Now that these closures and the Christmas holidays are behind us, the disruption has receded, and sequential inflation is coming back down.
What I’m saying is that we’re not used to this type of volatility in the numbers. The headline numbers should recede one year after the pandemic becomes endemic—and not just in the West, but more importantly, globally.
Hugo: So, the yield curve’s right? What you said is that inflation is really being driven by the mismatch between demand and supply. We’re really getting inflation because of the waves of COVID. I suppose an inflation bull would say there’s more to it, that if you get higher inflation, then it goes into wages, and then it becomes a self-fulfilling thing.
But is the yield curve saying, well, look, COVID is probably becoming endemic, and then we’re going back to a world of quite low GDP growth and quite low inflation? Is that a reasonable interpretation of the message from the yield curve?
Olga: I think you’ve synthesized it well. A month ago, a five-year number implied an interest rate of 1.25%. Today, that interest rate is 1.5%. This is hardly saying that we are going to be in for a prolonged bout of inflation. The 30-year number, not that it’s relevant for much of anything, is just barely north of 2%. And a month ago, it was barely south of 2%.
In terms of the wage-price spiral, increasingly, I have been thinking that all these scaremongering narratives on inflation are conflating our mismanagement—whether willful or otherwise—of our economies with the way things work naturally, if left to their own devices.
We’ve experienced wage-price spirals in periods of hyperinflation in different parts of the world. We experienced one here in the United States in the ’70s. But a crucial component to those is a supply restriction. In this case, it would be tethering today’s wages to yesterday’s inflation. Wage indexing was very, very popular in the ’70s. And it wasn’t just in the United States; it was in large parts of the world.
We don’t have wage-price indices anymore. Employees and employers can respond to current conditions as they see fit. There’s a lot of chatter that people are demanding higher wages. Well, people can demand a lot of different things, but the question is whether or not they’re going to get them.
Yes, employers will pay higher wages, but only if it remains profitable for them to do that. So far, what we’re seeing is significant increases in wages in the industries most disrupted by COVID: hospitality, restaurants, hotels. This is exactly the part of the wage distribution that you could argue has been underpaid for quite a long time. In other words, in real terms, this cohort of employees has not seen significant wage increases in several decades.
So, in the very near term, by which I mean a couple of years, sustained wage increases are more likely to go into stronger demand growth rather than outright inflationary pressure. In fact, inflation in the last couple of months has been, in year-on-year terms, so high as to make real wage growth appear marginally negative. In other words, the data would suggest that, far from a wage-price spiral, real wages are declining, and real purchasing power is not keeping up with inflation. Even if we were to meddle in the economy for political reasons, it is far too early to worry about something like this.
Hugo: What I take from what you said is that inflation will come off the boil and—I don’t want to say normalize, because what’s normal?—but will be back to something we’re more familiar with, based on the last 10, 20 years.
The question I want to ask you next is, for long-duration assets, those whose payoff for investors is weighted toward the future, what’s the right discount rate? One-year, two-year, five-year, 10-year, 20-year, 30-year? Because the yield curve has steepened for 18 months while the 10-year is still below 2%. Should I be matching the duration of the asset with the appropriate part of the yield curve? That doesn’t seem to be happening.
Olga: No, in fact, I don’t think that ever happens. The reason we and so many others are focused on the 10-year is because, for cultural and historical reasons, it is one that many economically sensitive interest rates are priced to.
For example, in the United States, fixed-year mortgages are priced off this rate, even though they’re 15 or 30 years. Auto loans and certain portions of corporate credit and business loans are priced off the 10-year yield. So, things in the economically sensitive credit markets, for lack of a better term, are often priced off the 10-year yield. It’s the rate that reverberates through the real economy. And I suppose, inadvertently, it’s used as a shorthand for the discount rate in equities.
It’s not difficult to decipher what’s moving. But why is the more interesting question. It’s difficult in real time to decipher why because we’re in an unusual confluence of cyclical and structural, and cyclically, what we’re seeing is a slowdown in growth.
We’ve actually done very well during the pandemic. The fiscal and monetary policy response was, for once, quite appropriate, both in Europe and in the United States, and our economies have weathered the pandemic disruption quite well. We’ve seen a robust, V-shaped recovery.
If and when the virus finally is seen in the rearview mirror, what remains of our recoveries will likely be reached in short order. We believe these large, developed market economies will not only reach pre-COVID levels of output, they will reach their pre-COVID trajectory of output growth. In the United States, we’re closer to that than in Europe, which means that, naturally, the U.S. economy will have to slow quite a bit from the rates of growth we saw last year.
It’s not inflation what’s done it. It’s always growth what’s done it. Go looking for growth, and when you find it, the truth is always close behind.
In our view, this is not a slowing toward a recession; this is very much a slowing toward a healthy expansion. But when your growth rate in output slows from something like 5.5% or more for 2021 in the United States to something closer to 2.5%, that’s a significant slowdown. That has to come out of somebody’s earnings.
And, incidentally, earnings growth for large chunks of the S&P 500, or probably even the broader benchmark last year, was something like 50% in year-on-year terms. That’s a nominal rate, of course, but in a normalized expansion, we see earnings growth for this cohort of companies closer to 20%, 25%, in year-on-year terms.
A significant deceleration in growth is required for our economies to level off at a comfortable cruising altitude. And so, it’s this slowdown in growth, more than the discount rate, that explains the current sell-down and rotation in equities. It also explains why there is no havoc in the credit markets, or in any of the fixed-income space. If it was all about inflation and the discount rate, we would have seen something in the high-yield space.
Hugo: That’s very interesting. That comes back to perhaps the central theme of all our walks, which is growth: the importance of growth and the rate of change of growth. What you’re saying is, this is a change in growth rate and maybe a change in where growth is. Is that a fair summary? The rate of change really matters, and that’s inevitably slowed, because we had such massive fiscal expansion. But also, the hotspots, where growth is, are changing by type of industry.
I started off trying to frame—perhaps too simplistically—the narrative of what’s happening in the markets. But your thesis here is that it’s not inflation what’s done it. It’s always growth what’s done it. Go looking for growth, and when you find it, the truth is always close behind.
Olga: That’s music to my ears. This recovery, like you said, has been exceptionally uneven. We couldn’t consume any services. So, what did we do with our checks? We bought a ton of new products. And so, we’ve seen a situation where, in several sectors, the output is up 80% relative to 2019 levels, while in some other sectors, the output remains down some 50% relative to 2019 levels. We’ve never seen that level of disparity in relative growth right within the U.S. economy. That’s really the nature of the COVID recession, and ultimately, so far, the COVID recovery.
If the market is right in thinking that we are closer to the endemic stage of this virus than the middle of the pandemic, some of this unusual disparity in growth should begin to normalize. Sectors such as consumer products, industrial products, bits of structural growers such as software, where a lot of the growth was perhaps brought forward a bit, are quite likely to sequentially decelerate, as consumers shift their share of wallet to services.
That’s really what the market is saying. That’s where the relative expectations are. Some of these earnings have been really beaten down. It’s unreasonable for us to expect that we’re never going to travel again, or that we’re never again going to use hairdressers and nail salons and dry cleaners. So, it’s about intracountry growth and the normalization of growth patterns, and reducing that extreme dispersion in growth brought on by the pandemic, much more so than the change in the discount rate from 1% to 2%.